The aim of the book is to provide practical guidance for the investor when compiling due diligence and deciding on an investment or against it. The focus of the book lays on the risk assessment and due diligence. It captures fund’s internal and external risks and the investment style specific risks. The aim is to provide sound guidance to the alternative investment fund selection. The UCITS 3 directive widens investment tools for the traditional asset managers by allowing short selling of securities and diminishing the gap between the traditional and the alternative asset management industry and attracting traditional managers to the alternative investment universe. The author concentrates on three categories: Relative Value and Market Neutral, Event Driven and Opportunistic alternative investment funds. Whilst the industry is generally categorized into certain fund types it has to be stated that every fund is different and will have different risk attributes. Within the specific categories major risks will be the same, as the exposure towards the specific underlying will be similar. Still every single fund has to be examined on its own in detail, as it will have the specific alpha generating competitive advantage. Thus the author suggests a pre-selection of the potential fund manager or the management team by analysing the team and the fund’s performance first. The analysis goes through the quantitative figures and the qualities of the management team. Detailed knowledge about the strategies and its fit into the portfolio is worthless unless the investor is able to select the performing manager. Without that skill the probability of ending up with an underperforming alternative investment fund or a blow-up is huge. The analysis of the management team qualities shows behaviour patterns helping to detect management teams, which are tending towards moral hazard. Secondly, the alternative investment fund style specific risks are examined. The author gives an overview over major risks per investment style. The specific investment style risk depending on the combination of the major risks can be a warning sign for the future performance. Thirdly, the fund’s internal and external risks are analysed. The internal risks are directly connected to the management team and its operations. The external risks are diverse outside factors influencing the fund’s performance, e.g. the industry and the macroeconomic risks. The risk profile is categorized in five levels thereof the level five is marked as a red flag and automatically falls out of the investment focus. The level one, two and three are favourable investment targets while the level four should be preferably avoided or at least further examined before the final investment decision is done. The alternative investment funds seem to be more an opportunity than a risk for those who can accomplish thorough due diligence selecting the funds, which will deliver the superior risk-adjusted return. The investor should seek to know as much as possible and obtain information about the factors, which are beyond the manager’s control. To invest is an art based on the skill and the experience. There is no perfect model to rely on. The business is based on logical and reflexive thinking as well as the strong interpersonal relationships. This foundation creates the conditions to succeed for both, the manager and the investor.

Text Sample: Chapter 3.1, Relative Value and Market Neutral Strategy Risk: ‘An investment operation is one in which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.’ Benjamin Graham. Relative value and market neutral strategies are arbitrage trades in stocks, bonds, convertible bonds and subscription rights. The arbitrage represents the profit by capitalising on a temporary price difference of the same or correlating securities at different exchanges, i.e. assets moving away from their fair value or a historical norm. The investment strategy is based on the statistical and fundamental asset evaluation or a combination of both, e.g. pure quantitative models and algorithmic trading or a combination of statistical models and the fundamental securities analysis. In their plain structure both strategies are less correlated towards the securities markets than Event Driven and Opportunistic strategies. As the central part is realising the profit when assets converge to their fair value the fund seeks to hedge the alternative source of the potential return or risk, i.e. the exposure to foreign currencies, interest rates or broad market indices. To eliminate the potential risk of the mispricing fund holds long and short positions in the related securities. In the efficient and less volatile markets there are fewer opportunities to generate alpha. As the manager won’t find the substantial price discrepancies spreads are low. The leverage increases the profit and the risk especially in an uncertain economic environment. Another profitable alpha source is less liquid assets, which are bearing the unexpected risk in the changing market or economic surroundings. Though the generic strategy characteristics are avoidance of the direct long or short bias risk along with the consistent moderate returns and low volatility funds operating with the high leverage, errors in historical market data collection or the quantitative model errors can be anything else than the low risk profile funds. Any flaw in the parameter assumptions or the market data can cause discrepancy between the actual and the perceived risk. Relative Value and Market Neutral strategies offer net, excluding fee, average annual returns between 9.70% and 12.65% combined with a low annual standard deviation between 0.38% and 0.53%, which demonstrates the average expected risk/return profile of the strategy. If the fund is far out of the range the ultimate deviation cause has to be examined as the fund might bear unexpected risk either due to the management team providing false information, IT or operational bugs or the fund taking far more excessive risks than expected within the strategy or the investment mandate. The investor needs to distinguish between the correlation and the exposure. This matter in illustrated with the following example. The fund can switch between short and long future positions in the VW equity in such way that the correlation on average nets out. Thus, switching between the short and long future positions, on an average will show a net zero correlation towards the equity. Although during the observed period of time fund was alternately exposed to the underlying risk by holding either long or short future positions. If the fund on average displays a zero correlation towards the market it does not necessarily mean that the fund at any point in time was not exposed to the market risk. The investor seeking portfolio diversification and a downside protection along with the constantly moderate returns and overall low volatility is rather looking for a ‘hedge” instead of the excessive market exposure, which is equal to an unexpected risk and not corresponding to the investor’s mandate. Relative Value and Market Neutral strategies can have an investment mandate to boost the return. In such case a higher volatility as well as market exposure have to be accepted and cannot be regarded as an unexpected risk. The investor has to answer following question do I expect and accept low, mid or high exposure inside my alternative investment mandate and the specific strategy? The specific strategy and the market exposure will influence fund’s risk profile in line with the market movements especially in highly volatile markets. The liquidity of the underlying assets matters most when the fund’s leverage is excessive. The liquid assets can turn nonliquid in crisis scenarios. A best-known example was the Russian crisis in 1998 when LTCM almost caused a systemic collapse. A highly leveraged fund held most of the positions in particular securities dominating the market. During the summer 1998, macroeconomic scenario dramatically changed as the liquidity in the underlying assets dried. The liquidity risk at times outweighed market risk in high-yield bonds, emerging markets and mortgage-backed securities. An actually from the plain strategy perspective low risk fund was due to its size, leverage and the position size moving the market and almost caused a systemic collapse. Fixed Income Arbitrage: Fixed income arbitrage strategies capitalise on the price disparities in the interest rate related assets and their derivatives through an establishment of the long and short positions. The manager should possess a deep asset pricing and a quantitative modelling skill. The positions establishment and the strategy execution require a profound mathematical and statistical knowledge as well as programming and data modelling skill. The essential skill is an accurate pricing of the fixed income assets as well as the estimation, the establishment and the adjustment of the open and the hedged positions. A quantitative insight, the risk management and the securities trading experience are the necessities in order to appropriate interpret the market movements. The aim is to detect temporary credit anomaly in the similar fixed income securities that are mathematically, fundamentally or historically interrelated. Alpha stems from the capitalization on disparities in the credit spreads, the yield curve movements on a single maturity grids, the volatility spreads, the cash versus futures spreads, the counterparty rating changes and the special bond and option features, i.e. MBSs or CDOs, which offer potential profits as long as many investors fail to explicitly value these. Fixed Income Arbitrage strategy offers a net average annual return of 9.80% combined with a low annual standard deviation of 0.68%. An example of the basic strategy would consist of the long government bond position and a sold bond future contracts on the particular bond. Such construction automatically provides natural hedge though it is imperfect due to the unlike duration in future 3 months and bond up to 12 years interest rate movement sensitivity. The profit is expected from the disparity of the cheapest to delivery bond for the sold future contracts, as shifts in the demand and supply of the underlying bonds varies over the holding period. In following different risks within the strategy are considered. The long or short bond positions entail credit risk. In order to eliminate the credit default and the liquidity risk fund will trade in the liquid issues usually government or corporate bonds although the fund is not constrained to such bonds and also can invest in junk bonds depending on the skill or the risk appetite. The changes in the interest rates or the yield curve structure involve market risk. As the long and short positions do not have the same duration and might not have the same interest paying character the interest rate risk is not perfectly hedged. This exposes the portfolio to the value changes along with the yield curve moves on the different interest rate grids. The liquidity risk can result in the increasing financing costs. As the borrowing becomes cheaper the lending financing costs are expected to drop. If the financing profiles reverse the liquidity risk will arise. The legal risk can occur in taxation law changes. The extraordinary financial situations or political debacles can cause instability of the asset correlation, i.e. the derivative instruments and their underlying assets lose the stable correlation relationship and natural hedges break. The fund’s leverage is up to 30 times the fund’s equity. In a ‘normal” market conditions the spreads in fixed income assets are small ranging between 3bp and 20bp. The normal market condition refers to low spreads for the credit risk premiums and not an inverse or flat yield curve. In the stable macroeconomic and political environment holding a credit spread risk equals a low credit risk while in market turmoil credit spreads widen and the fund’s positions depending on the bet can substantially lose money. The rare events are a substantial threat for the credit spreads. The high market volatility and a worsening credit risk perception are dangerous if the fund’s positions are not properly hedged. The exposure to a yield curve, FX rate or inter-market spread risk means that the fund is taking directional bets. Combined with a high leverage it can end up in a massive risk taking, which actually is not what the low risk appetite investor would expect within Relative Value strategy.

• Opportunistic Strategy

• Relative Value

• Market Neutral Strategy

• Risk Arbitrage

• investment

• investor

Ingrid Vancas is a senior-level professional in the banking industry with 11 years of experience. She joined SEB Bank in July 2002. Since then she has worked in operations, risk management and currently in client relationship management. As account manager for financial institutions she is responsible for servicing and building client relationships as well as managing those while focusing on risk and reward. Her strong interest in the alternative investment funds and the credit analysis encouraged her to develop a framework for risk assessment of an alternative investment fund. The aim was to develop guidance for evaluation and pre-selection of the funds in the business unit. Ingrid holds a BA in Economics from Steinbeis University Berlin and a MBA in Financial Services Industry from Steinbeis University Berlin in cooperation with NYU Stern in New York and SDA Bocconi in Milano.