Friday, December 7, 2012

Black et al., Advanced Core Topics in Alternative Investments, 2d ed.

The Chartered Alternative Investment Analyst (CAIA) Association offers a two-tiered exam process (Levels I and II) through which a candidate can earn the CAIA Charter. The Charter is designed for individuals specializing in institutional quality alternative investments. Earlier I reviewed the Level I text. It’s now time to look at CAIA Level II: Advanced Core Topics in Alternative Investments, 2d ed., edited by Keith H. Black, Donald R. Chambers, and Hossein Kazemi (Wiley, 2012).

This book is yet another educational triumph and a worthwhile read not only for those in search of certification but for every investor who wants to expand his horizons and be intellectually challenged in the process. It’s divided into five parts: asset allocation and portfolio management, private equity, real assets, commodities, and hedge funds and managed futures.

I spent some time deciding what to choose to write about in this post. It was a tough decision. After all, the book is some 700 pages long and covers a host of important topics. I debated whether to focus on farmland and timber investments—or perhaps investing in intellectual property. Then I thought I’d write about convertible arbitrage, a strategy that represents less than 3% of the assets managed by hedge funds and that is not available to the retail investor but nonetheless remains a strategy that options traders should understand. That choice, however, was fatally flawed because there was no way I could condense the chapter into a reasonable blog length.

Then there were the geekier topics, such as unsmoothing appraisal-based real estate returns, which I’d be hard pressed to write about with any degree of confidence. I hope you’re beginning to see the richness of this book, and my dilemma.

So here are just a couple of snippets, chosen almost at random. First, art as an investment asset. Odds are that this is out of your league (at least really high-end art), but don’t feel depressed. You’re not missing out on high returns, and you may be avoiding high volatility. In the U.S. the return for high-quality art between 1980 and 2007 was 4.85%, the volatility 20.95%; for medium-quality art 3.78% and 14.49%; and for low-quality art 3.25% and 11.13%. So unless you’re trying to impress your friends, you’re a true aesthete, or you’re a Russian oligarch trying to stash some of your wealth abroad, there’s no compelling reason to invest in art.

Second, an example of how securities can become drastically mispriced—and here I’m dipping my toe into the chapter on convertibles. In 2008 the Dow Jones Credit Suisse Core Convertible Arbitrage Fund fell by over 30%. “Convertible arbitrage hedge funds were required to liquidate assets both to meet redemptions and to reduce leverage as the price of convertible bonds declined. The liquidation included the sale of convertible bonds, the sale of put option hedges, and the covering of equity short sales. This massive selling pressure … drove bond prices even lower, which necessitated further selling, as the asset value was declining as the prime brokerage loan balances remained stable, which was increasing the leverage multiple. Finally, prime brokers reduced the amount of leverage available. If a prime broker reduced the maximum leverage from 10 times to 5 times assets, a fund manager would be required to sell half of the fund’s positions in a matter of hours or days. … The mispricing of convertible bonds became so extreme that the convertible bonds of some firms were priced at below the option-free debt of the same firm, essentially offering the valuable stock option for a negative price.” (p. 518)

CAIA Level II is an excellent text and reference work for anyone interested in alternative investments either in and of themselves or as part of a diversified portfolio. And, of course, it’s essential for those aspiring for certification.

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