not eliminated because the long and short positions are not in identical assets or are not held over the same time intervals. To the extent that investment professionals use the term arbitrage more loosely, these investment programs can be said to contain active risk and to generate relative returns.
An obvious goal of virtually any investor is to earn a superior combination of risk and return. If the primary objective of including an investment product in a portfolio is the superior average returns that it is believed to offer, then that product is often referred to as a return enhancer. If the primary objective of including the product is the reduction in the portfolio's risk that it is believed to offer through its lack of correlation with the portfolio's other assets, then that product is often referred to as a return diversifier.
1.8 Overview of This Book
The CAIA curriculum is organized into two levels, with Level I providing a broad introduction to alternative asset classes and the tools and techniques used to evaluate the risk-return attributes of each asset class. Level II concentrates on the skills and knowledge that a portfolio manager or an asset allocator must possess to manage an institutional-quality portfolio with both traditional and alternative assets.
Thus, Level I focuses on understanding each category of alternative investments and the methods for analyzing each. Level I also provides an introduction to portfolio allocation and management as a foundation for the more advanced treatments covered in Level II. This book has been written with the expectation that readers have a moderate background in traditional investments and quantitative techniques. In some places, a Foundation Check is inserted to alert readers to particular content that is necessary background for the ensuing material. Readers may find the following sources useful in obtaining background information: Quantitative Investment Analysis by DeFusco, McLeavey, Pinto, and Runkle (John Wiley & Sons, 2nd edition, 2007) and Investments by Bodie, Kane, and Marcus (McGraw-Hill, 10th global edition, 2014).
This book is organized into six parts:
Part 1 introduces foundational material for alternative investments.
Parts 2–5 cover the four categories of alternative investments in the CAIA curriculum by providing extensive introductions to each:
Part 2: Real Assets
Part 3: Hedge Funds
Part 4: Private Equity
Part 5: Structured Products
Part 6 introduces portfolio and risk management concepts central to alternative investments. These concepts are covered from the perspective of both managing a portfolio of alternative investments and adding alternative investments to a portfolio of traditional investments.
Review Questions
1. Define investment.
2. List four major types of real assets other than land and other types of real estate.
3. List the three major types of alternative investments other than real assets in the CAIA curriculum.
4. Name the five structures that differentiate traditional and alternative investments.
5. Which of the five structures that differentiate traditional and alternative investments relates to the taxation of an instrument?
6. Name the four return characteristics that differentiate traditional and alternative investments.
7. Name four major methods of analysis that distinguish alternative investments from traditional investments.
8. Describe an incomplete market.
9. Define active management.
10. What distinguishes use of the term pure arbitrage from the more general use of the term arbitrage?
CHAPTER 2
The Environment of Alternative Investments
This chapter provides an introduction to the environment of alternative investing, including the participants, the financial markets, regulations, liquid alternatives, and taxation. Its focus is on explaining the purposes and functions of these components so that readers gain an understanding of why the investing environment is structured the way it is and how the different components interact.
2.1 The Participants
Participants can be divided into four major categories: the buy side, the sell side, outside service providers, and regulators. This section briefly describes the primary roles of the first three categories of participants; the primary role of regulators is discussed in section 2.3.
2.1.1 The Buy Side
Buy side refers to the institutions and entities that buy large quantities of securities for the portfolios they manage. Buy side entities include asset owners and asset managers. The buy side contrasts with the sell side (detailed in section 2.1.2), which focuses on distributing securities to the public. Examples of buy-side institutions follow, with an emphasis on the perspective of alternative investing.
PLAN SPONSORS: A plan sponsor is a designated party, such as a company or an employer, that establishes a health care or retirement plan (pension) that has special legal or taxation status, such as a 401(k) retirement plan in the United States for employees. Plan sponsors are companies or other collectives that establish the health care and retirement plans for the benefit of the organization's employees or members. Plan sponsors are responsible for determining membership parameters and investment choices and, in some cases, providing contribution payments in the form of cash or stock (or both). In many cases, one individual, the plan trustee, is designated with overall responsibility for managing the plan's assets, whereas the plan administrator is charged with overseeing the plan's day-to-day operations. Both the trustee and the administrator are identified in the plan's summary plan description.
FOUNDATIONS AND ENDOWMENTS: A foundation is a not-for-profit organization that donates funds and support to other organizations for its own charitable purposes. An endowment is a fund bestowed on an individual or institution (e.g., a museum, university, hospital, or foundation) to be used by that entity for specific purposes and with principal preservation in mind.
FAMILY OFFICE AND PRIVATE WEALTH: Family office and private wealth institutions are private management advisory firms that serve ultra high-net-worth investors. A family office is a group of investors joined by familial or other ties who manage their personal investments as a single entity, usually hiring professionals to manage money for members of the office.
SOVEREIGN WEALTH FUNDS: Sovereign wealth funds are state-owned investment funds held by that state's central bank for the purpose of future generations and/or to stabilize the state currency. These funds may emanate from budgetary and trade surpluses, perhaps through exportation of natural resources and raw materials such as oil, copper, or diamonds. Because of the high volatility of resource prices, unpredictability of extraction, and exhaustibility of resources, sovereign wealth funds are accumulated to help provide financial stability and future opportunities for citizens and governments.
PRIVATE LIMITED PARTNERSHIPS: Private limited partnerships are a form of business organization that potentially offers the benefit of limited liability to the organization's limited partners (similar to that enjoyed by shareholders of corporations) but not to its general partner. For tax purposes,
