Alternative Investments. Hossein Kazemi

debt obligations (CDOs) and similar instruments are among the best-known types of structured products. CDOs partition the actual or synthetic returns from a portfolio of assets (the collateral) into securities with varied levels of seniority (the tranches).

      Credit derivatives, another popular type of structured product, facilitate the transfer of credit risk. Most commonly, credit derivatives allow an entity (the credit protection buyer) to transfer some or all of a credit risk associated with a specific exposure to the party on the other side of the derivative (the credit protection seller). The credit protection seller might be diversifying into the given credit risk, speculating on the given credit risk, or hedging a preexisting credit exposure.

      Historically, the term structured products has referred to a very broad spectrum of products, including CDOs and credit derivatives. In recent decades, however, the term is being used to describe a narrower set of financially engineered products. These products are issued largely with the intention of meeting the preferences of investors, such as providing precisely crafted exposures to the returns of an index or a security. For example, a major bank may issue a product designed to offer downside risk protection to investors while also offering the potential for the investor to receive a portion of the upside performance in an index. Part 5 discusses these specially designed structured products along with more generic structured products, including credit derivatives and CDOs.

      When the structuring process creates instruments that do not behave like traditional investments, those instruments are considered alternative investments.

      1.2.5 Limits on the Categorizations

      These four categories of alternative investments are the focus of the CAIA curriculum. While the categorization helps us understand the spectrum of alternative investments, the various alternative investment categories may overlap. For example, some hedge fund portfolios may contain substantial private equity or structured product exposures and may even substantially alternate the focus of their holdings through time. This being said, the four categories discussed in the previous sections represent the investment types central to the Level I curriculum of the CAIA program.

      1.3 Structures among Alternative Investments

      The previous sections defined the category of alternative investments by describing the investments that are or are not commonly thought of as alternative. But the question remains as to what the defining characteristics of investments are that cause them to be classified as alternative. For example, why is private equity considered an alternative investment but other equities are considered traditional investments? What is the key characteristic or attribute that differentiates these equities? The answer is that traditional equities are listed on major stock exchanges whereas private equity is not. We use the term structure to denote this attribute and others that differentiate traditional and alternative investments. In this case, traditional equities possess the characteristic of public ownership, which can be viewed as a type of institutional structure.

      Because structures are a descriptive and definitional component of alternative investments, they are a crucial theme to our analysis of asset classes. Structures denote a related set of important aspects that identify investments and distinguish them from other investments. There are five primary types of structures:

      1. Regulatory structures

      2. Securities structures

      3. Trading structures

      4. Compensation structures

      5. Institutional structures

      For example, mutual funds are usually considered to be traditional investments, and hedge funds are usually considered to be alternative investments. But many hedge funds invest in the same underlying securities as many mutual funds (e.g., publicly traded equities). So if they have the same underlying investments, what distinguishes them? If we look at the funds in the context of the five structures, we can develop insight as to the underlying or fundamental differences. For example, hedge funds are less regulated, often have different compensation structures, and often have highly active and esoteric trading strategies or structures. Each of these attributes is viewed as a structure in this book.

      When we analyze a particular type of investment, such as managed futures, we should think about the investment in the context of these various structures: Which structural aspects are unique to managed futures, how do particular structural aspects affect managed futures returns, and how do particular structural aspects cause us to need new or modified methods for our analysis?

      1.3.1 Structures as Distinguishing Aspects of Investments

Exhibit 1.2 illustrates the concept of structures. On the left-hand side is the ultimate source of all investment returns: real assets and the related economic activity that generates and underlies all economic compensation to investors. The cash flows from those assets emanate toward the investors on the right. The placement of the second box illustrates conceptually the idea that various structures alter, shape, and otherwise influence the flow of the economic benefits of the assets to the ultimate investors. The five major types of structures are listed in no particular order: regulatory, securities, trading, compensation, and institutional. The third box lists the types of investment claims that receive the altered cash flows: traditional investments and alternative investments. Finally, at the right are the ultimate recipients of the economic benefits: the investors.

Exhibit 1.2 Structures Distinguish Alternative Investments from Traditional Investments

      For example, the underlying assets on the left-hand side of Exhibit 1.2 might include chains of hotels. Some of those hotels are ultimately owned by investors as shares of publicly traded corporations, such as Hyatt and Marriott, which are usually considered to be traditional investments. Other hotel investments, such as those owned by investors as real estate investment trusts (e.g., Host Hotels & Resorts Inc.) and those held privately (e.g., Omni Hotels), are usually considered to be alternative investments. Exhibit 1.2 illustrates the differences between these hotel ownership methods as being the structures that transform the attributes of ownership through institutional effects such as public listing, regulatory effects such as taxes, and compensation effects such as managerial compensation schemes.

      The primary point of Exhibit 1.2 is that structures alter the flows of cash from their underlying source (real assets) to their ultimate recipients (investors). In most corporations, the cash flows from the firm's assets are divided into debt claims and equity claims by the firm's capital structure. This is a common and important example of a structure: in this case, a securities structure. Structures define the characteristics of each investment; viewing investments in the context of these structures provides an organized and systematic framework for analysis.

      The exhibit is not intended to portray all investments as being influenced by all five structures. Some investments, such as a vegetable garden used for personal consumption, are not substantially subjected to any of these structures. In this example, there are no securities involved, there would typically be no important legal structures or issues, there is no investment manager layering a sophisticated trading strategy on top of the garden's output, and so forth.

      Some investments are substantially subjected to only one or two structures, and some investments are subjected to most or all. Investments can also be subjected to multiple layers of one particular type of structure, such as securities structures. For example, the economic rights to a residential property are often structured into a mortgage and the homeowner's equity (residual claim). The mortgage might be sold into a pool of mortgages and securitized into a pass-through certificate. The pass-through certificate might be structured into a tranche of a collateralized mortgage obligation (CMO) that is in turn held by a mutual fund before finally being held by the ultimate investor in a mutual fund inside a retirement account. Thus, an investment may have various and numerous distinguishing structures that identify it and give it its characteristics. The goal