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2005 CFA level 1 Junwei Notes 18


“Alternative Investments”
Level 1 Session 18 Asset Valuation

Copy Right 2004 Thomas Wang, CFA

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310

“Alternative Investments”

What’s Ahead?
Introduction Investment Companies Real Estate Private Equity: Venture Capital
Level 1 Session 18 Asset Valuation

Hedge Funds and Absolute Return Strategies Closely Held Companies and Inactively Traded Securities Distressed Securities

Copy Right 2004 Thomas Wang, CFA

Commodity Markets and Commodity Derivatives
311

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“Alternative Investments”

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Alternative Investments: An Overview
Alternative investments are investments that complement traditional financial instruments such as stocks and bonds. Alternative investments can be classified into two groups:
Alternative assets, which are assets not traded on exchanges.


Examples include real estate, venture capital, etc.

Level 1 Session 18 Asset Valuation

Alternative strategies, which are investment strategies that mostly use traded assets for isolating bets and generating positive excess risk-adjusted return (called alpha).


Examples include hedge funds, and mutual funds.

Copy Right 2004 Thomas Wang, CFA

www.junwei.net

312

“Alternative Investments”

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General Features of Alternative Investments
Illiquidity
Since most alternative investments are not traded on exchanges, they usually cannot be quickly converted to cash at a price close to fair market value. As a result, investors typically require a liquidity premium on alternative investments.

Level 1 Session 18 Asset Valuation

Difficulty in determining current market value Limited information on historical risk and return Extensive investment analysis required A segmentation premium
This premium is required because alternative assets are typically not priced in a fully integrated global market.

Unique legal and tax considerations
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Many alternative investments use special legal structures to avoid some taxes or regulations.
313

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“Alternative Investments”

What’s Next?
Introduction Investment Companies Real Estate Private Equity: Venture Capital
Level 1 Session 18 Asset Valuation



Hedge Funds and Absolute Return Strategies Closely Held Companies and Inactively Traded Securities Distressed Securities

Copy Right 2004 Thomas Wang, CFA

Commodity Markets and Commodity Derivatives
314

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“Alternative Investments”

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Investment Companies: Introduction
An investment company is a financial intermediary that raises capital from investors by issuing new shares and then invests the capital into a portfolio of securities. Each investor who buys the shares of the investment company owns the appropriate percentage of the overall portfolio and its performance. The primary clients of investment companies are individual investors with small pools of capital.

Level 1 Session 18 Asset Valuation

Copy Right 2004 Thomas Wang, CFA

www.junwei.net

315

“Alternative Investments”

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Types of Investment Companies: An Overview
Investment Companies

Unmanaged Investment Companies

Managed Investment Companies

Revise the portfolio of investments over time

Level 1 Session 18 Asset Valuation

LOS 1.a

Hold a fixed portfolio of investments over Closed-End Funds the life of the company Do not redeem shares Continue to after the initial offering redeem shares at market value after their initial offerings Load Funds

Open-End Funds (Mutual funds) Continue to redeem shares after their initial offerings

No-Load Funds Do not charge commissions at purchase or exit 316

Copy Right 2004 Thomas Wang, CFA

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Charge commissions at purchase or exit

“Alternative Investments”

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Closed-End vs. Open-End Funds
Closed-end funds: just like any other publicly traded firms.
They are initiated through a stock offering to raise capital. Their stocks trade on regular secondary market. The market price of their shares is determined by supply and demand. They typically do not offer new shares after the initial offering, and no investment can be withdrawn from these funds.
Level 1 Session 18 Asset Valuation



Thus, investors must trade in public secondary market (e.g., NYSE) to buy or sell shares.

Open-end funds: commonly known as mutual funds.
Different from closed-end funds, open-end funds continue to sell and repurchase shares after their initial offerings. Some funds may charge fees on the transactions.
317

LOS 1.a

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“Alternative Investments”

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Fees Charged by Mutual Funds
Annual charges: charged by all mutual funds.
These are mainly the operating expenses of a fund, including:


Management fees Administrative fees Distribution fees, which are paid to the party that arranged the initial sale of the shares.

Level 1 Session 18 Asset Valuation

Annual charges are typically calculated as a percentage of the average net assets of the fund. The ratio of annual charges to average assets is called the fund’s expense ratio.

Sales charges:
Loads, also called front-end loads, are sales commissions charged by funds when an investor purchases the shares.


LOS 1.c

Funds that charge loads are called load funds. Funds that do not charge loads are called no-load funds.

Copy Right 2004 Thomas Wang, CFA

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Redemption fees, also called back-end loads, are fees charged when investors sell back the shares to the funds.
318

“Alternative Investments”

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The Nature of Fees Charged by Mutual Funds and the Impact of Such Fees on Fund Performance
Loads, redemption fees, and distribution fees are sales incentives.
Redemption fees are used to discourage quick trading turnover. In general, the longer the investors hold the shares, the lower the redemption fees.


Redemption fees that are set up in this structure are called contingent deferred sales charges.

Level 1 Session 18 Asset Valuation

Management fees are a portfolio performance incentive.
However, management fees are based on net assets of the fund, not on its rate of return. As a result, management fees are not an effective performance incentive because fund managers receive such fees even if the funds perform very badly.

LOS 1.c

Copy Right 2004 Thomas Wang, CFA

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Generally, fees charged by funds reduce fund performance.
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