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Cfa1 9 Alternative Investments Notes

Finance Notes > CFA Level 1 Notes

This is an extract of our Cfa1 9 Alternative Investments document, which we sell as part of our CFA Level 1 Notes collection written by the top tier of University Of London (examined By LSE) students.

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CFA Level 1

Alternative Investments

Investment Company
Open-End Fund (Open-End Investment Company)
 Fund which can issue and redeem shares at any time
 Shares can be bought directly from the fund
 Shareholders receive an equity position in the underlying securities
Close-End Fund (Close-End Investment Company)
 Fund with a fixed no. of shares outstanding
 Shares issued to the public in an initial public offering
 Shares normally not redeemable
 Shares can be bought / sold on a secondary market
Valuing Investment Company Shares
Net Asset Value
 NAV = Per Share Value - Liabilities
 Management fee
 Administrative expenses
 Continuing distribution fee
 Distribution fee
Additional Fees for Managed Funds
Front-End Load
 Sales commissions charged at purchase
Back-End Load
 Redemption fee changed at exit of the fund
Contingent Deferred Sales Charge
 Redemption fee that decline the longer the shares are held to discourage quick trading turnover
Investment Strategies
 Growth strategy (focus on high P/E stocks)
 Value strategy (focus on low P/E stocks)
 Index fund track (own securities in identical proportion to the index)
 Global fund (include both foreign and home securities)
1 CFA Level 1

Alternative Investments

 International fund (exclude securities from the home country)
 Stable value fund (focus on fixed income instruments and guaranteed investment)
Exchange Traded Fund (ETF)
 Fund traded on a stock market
 Portfolio of securities
 Can be open-end (most common) or close-end
Advantages of ETF
 Diversification
 Exchange traded
 Transparent
 Regulated
 High liquidity
 Availability of hedging (using futures and options)
 Cost effective (no load fee)
Potential Disadvantages of ETF
 Narrow-based market index (diversification)
 High bid-ask spread
 Low trading volumes
Types of ETF
 Broad domestic market index
 Style (value or growth)
 Sector or Industry
 Foreign country or region (multiple countries)
 Fixed income
 Commodity
 Actively managed funds
Risk in ETF
 Market risk (systemic risk)
 Asset class risk / Sector risk
 Trading risk (liquidity risk)
 Tracking error risk
 Derivatives risk (credit risk) (if investing in derivatives)
2 CFA Level 1

Alternative Investments

 Currency risk
 Country risk
Applications of ETF
 Implementing asset allocation
 Diversifying sector / industry exposure
 Gaining exposure to international market
 Equitizing idle cash
 Managing cash flows
 Fulfilling overall investment strategy
 Bridging transitions in fund management
 Managing portfolio risk (hedging through selling short)
 Applying long / short strategies
Real Estate
 Form of tangible assets (e.g. buildings and buildable lands) divided into different divisions that can be owned by investors
Forms of Real Estate Investment
 Free and clear equity (free simple) (indefinite full ownership rights)
 Leveraged equity (full ownership rights but subject to mortgage obligations)
 Mortgages (mortgage loans) (mortgage-backed securities)
 Aggregation vehicles (collective investment in real estate)
Features of Real Estate Property
 Immovability and indivisibility
 Uniqueness in terms of location and view
 Illiquidity due to immovability and indivisibility
 Non-existence of auction market
 High transaction costs and management fees
 Unavailability of real estate information
Valuation Approaches
Sales Comparison Approach
 Uses the market data of sale prices of a comparable property
 Unique features of the property and changing market conditions should be taken into account
Cost Approach
 Consider the value of a property as the cost of the land 3 CFA Level 1

Alternative Investments

 Add the cost of replacing the property (construction costs)
 Deduct the physical and functional depreciation
 Land cost can be estimated using the sales comparison approach
Hedonic Price Model
 Major characteristics that can affect the value are identified
 Characteristics can be the age, size, location, vacancy rate and amenities
 Properties are given a quantitative rating for each of the characteristics
 Sales price for all recent transactions are regressed on their characteristics rating
 Dependent variable (Y-axis) is the transaction price
 Independent variables (X-axis) are the ratings for each of the characteristics
 Estimated slope coefficients (CE) are calculated based on recent transactions
 Estimate slope coefficients represent the valuation of each characteristic
 Value = Age  Age CE + Size  Size CE + …
Income Approach (Perpetuity Discount Model)
 Calculate the current value (CV) of the property based on the net operating income (NOI) of the property and capitalization rate (CR)
 NOI is the annual income generated by the property after deducting all expenses
 CR is the market value of a comparable property
 CV = NOI / CR
Discounted After-tax Cash Flow Approach
 Link the value of a property to an investor's marginal tax rate
 NPV of an investment equals the PV of after-tax cash flows
 PV is discounted at the investor's required rate of return minus the equity portion
 Equity portion is the percentage of ownership using capital other than mortgage loan
 Depreciation is deductible for NOI
Gross Potential Income (GPI)
 It is the income based on a full occupancy
Vacancy Rate (VR)
 The percentage of the property that is vacant
Effective Gross Income (EGI)
 EGI = GPI x VR

Private Equity 4

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