Browse CSC® Exam Prep Guide: Volume 2

Learning Objectives for Alternative Investments: Strategies and Performance

Explore the learning objectives for understanding alternative investment strategies, risk measures, benchmarking, and due diligence in the context of Canadian financial regulations.

21.1 Learning Objectives

In Chapter 21 of the CSC® Exam Prep Guide: Volume 2, we delve into the intricate world of alternative investments, focusing on strategies and performance. This chapter is designed to equip you with a comprehensive understanding of alternative investment strategies, their practical applications, and the critical evaluation methods necessary for informed investment decision-making. Below, we outline the key learning objectives that will guide your exploration of this topic.

1. Understanding Alternative Investment Strategies

Objective: Explain how various types of alternative investment strategies work, including those classified as relative value, event-driven, and directional strategies.

Alternative investments encompass a wide range of strategies that differ significantly from traditional investments like stocks and bonds. These strategies are often employed to achieve diversification, hedge against market volatility, or seek higher returns. The primary categories include:

  • Relative Value Strategies: These involve identifying and exploiting price discrepancies between related securities. For example, a Canadian hedge fund might engage in convertible arbitrage, where it takes advantage of pricing inefficiencies between convertible bonds and the underlying equity.

  • Event-Driven Strategies: These focus on corporate events such as mergers, acquisitions, or bankruptcies. An event-driven fund might invest in a Canadian company undergoing a merger, anticipating that the stock price will rise once the merger is completed.

  • Directional Strategies: These involve taking long or short positions based on market trends or economic forecasts. For instance, a fund might short Canadian oil stocks if it anticipates a decline in oil prices.

2. Identifying Strategies for Alternative Mutual Funds

Objective: Identify strategies most likely to be used in alternative mutual funds.

Alternative mutual funds, also known as liquid alternatives, offer retail investors access to hedge fund-like strategies with the liquidity of mutual funds. Common strategies include:

  • Long/Short Equity: Balancing long positions in undervalued stocks with short positions in overvalued ones.
  • Market Neutral: Aiming to minimize market risk by maintaining equal long and short positions.
  • Global Macro: Investing based on macroeconomic trends, such as interest rate changes by the Bank of Canada.

3. Risk Measures and Risk-Adjusted Return Measures

Objective: Discuss risk measures and risk-adjusted return measures for alternative strategy fund investments.

Understanding risk is crucial in evaluating alternative investments. Key measures include:

  • Standard Deviation: Measures the volatility of returns.
  • Sharpe Ratio: Assesses risk-adjusted return by comparing excess return to standard deviation.
  • Value at Risk (VaR): Estimates the potential loss in value of an investment over a defined period.

These metrics help investors understand the risk-return profile of alternative investments, enabling more informed decision-making.

4. Benchmarking Alternative Investment Performance

Objective: Explain benchmarking methods for evaluating alternative investment performance.

Benchmarking involves comparing a fund’s performance against a relevant standard. For alternative investments, traditional benchmarks like the S&P/TSX Composite Index may not be appropriate. Instead, custom benchmarks or peer group comparisons are often used. For instance, a Canadian hedge fund might be benchmarked against a composite of similar funds or a specific hedge fund index.

5. Due Diligence in Alternative Strategy Funds

Objective: Describe the due diligence process necessary when contemplating investment in an alternative strategy fund.

Due diligence is a critical step in evaluating alternative investments. It involves:

  • Analyzing Fund Strategy: Understanding the fund’s investment approach and historical performance.
  • Assessing Management Team: Evaluating the experience and track record of the fund managers.
  • Reviewing Regulatory Compliance: Ensuring the fund adheres to Canadian financial regulations, such as those set by the Canadian Investment Regulatory Organization (CIRO).

6. Identifying Suitable Investor Groups for Liquid Alternatives

Objective: Identify investor groups for whom liquid alternatives might be most suitable.

Liquid alternatives can be suitable for various investor groups, including:

  • Retail Investors: Seeking diversification and hedge fund-like strategies with daily liquidity.
  • Institutional Investors: Looking for alternative strategies to enhance portfolio diversification.
  • High Net-Worth Individuals: Interested in sophisticated investment strategies with a higher risk tolerance.

Practical Applications

The learning objectives outlined above are not merely theoretical; they have practical applications in investment decision-making and portfolio management. By understanding these concepts, you can:

  • Enhance Portfolio Diversification: Incorporate alternative strategies to reduce correlation with traditional asset classes.
  • Improve Risk Management: Use risk-adjusted measures to evaluate potential investments more effectively.
  • Optimize Performance Evaluation: Apply appropriate benchmarking techniques to assess fund performance accurately.

Glossary

  • Risk-Adjusted Return: A measurement that considers the amount of risk involved in producing a return.
  • Benchmarking: The process of comparing a fund’s performance against a standard or benchmark.
  • Due Diligence: Comprehensive appraisal of an investment undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential.

Additional Resources

For further exploration of alternative investments, consider the following resources:

  • Bank of Canada: www.bankofcanada.ca
  • Books:
    • “Hedge Fund Market Wizards” by Jack D. Schwager
    • “Quantitative Equity Portfolio Management” by Ludwig B. Chincarini and Daehwan Kim

These resources provide deeper insights into the strategies and performance evaluation of alternative investments.

Ready to Test Your Knowledge?

Practice 10 Essential CSC Exam Questions to Master Your Certification

### Which of the following is a relative value strategy? - [x] Convertible arbitrage - [ ] Merger arbitrage - [ ] Global macro - [ ] Long/short equity > **Explanation:** Convertible arbitrage is a relative value strategy that exploits pricing inefficiencies between convertible bonds and the underlying equity. ### What is a common strategy used in alternative mutual funds? - [x] Long/short equity - [ ] Distressed securities - [ ] Event-driven - [ ] Convertible arbitrage > **Explanation:** Long/short equity is a common strategy in alternative mutual funds, balancing long and short positions. ### Which risk measure assesses risk-adjusted return? - [x] Sharpe Ratio - [ ] Standard Deviation - [ ] Value at Risk (VaR) - [ ] Beta > **Explanation:** The Sharpe Ratio assesses risk-adjusted return by comparing excess return to standard deviation. ### What is the purpose of benchmarking in alternative investments? - [x] To compare a fund's performance against a standard - [ ] To measure the volatility of returns - [ ] To estimate potential loss in value - [ ] To evaluate the management team > **Explanation:** Benchmarking involves comparing a fund's performance against a relevant standard or benchmark. ### What is a key component of due diligence? - [x] Analyzing fund strategy - [ ] Measuring standard deviation - [x] Assessing management team - [ ] Calculating Sharpe Ratio > **Explanation:** Due diligence involves analyzing the fund strategy and assessing the management team, among other factors. ### Which investor group might find liquid alternatives suitable? - [x] Retail Investors - [ ] Day Traders - [ ] Real Estate Investors - [ ] Cryptocurrency Enthusiasts > **Explanation:** Retail investors seeking diversification and hedge fund-like strategies with daily liquidity might find liquid alternatives suitable. ### What is an example of an event-driven strategy? - [x] Merger arbitrage - [ ] Convertible arbitrage - [x] Distressed securities - [ ] Long/short equity > **Explanation:** Merger arbitrage and distressed securities are examples of event-driven strategies focusing on corporate events. ### Which of the following is a directional strategy? - [x] Global macro - [ ] Market neutral - [ ] Convertible arbitrage - [ ] Merger arbitrage > **Explanation:** Global macro is a directional strategy that involves taking positions based on macroeconomic trends. ### What does Value at Risk (VaR) estimate? - [x] Potential loss in value - [ ] Risk-adjusted return - [ ] Performance against a benchmark - [ ] Management team effectiveness > **Explanation:** Value at Risk (VaR) estimates the potential loss in value of an investment over a defined period. ### True or False: Benchmarking is only applicable to traditional investments. - [ ] True - [x] False > **Explanation:** Benchmarking is applicable to both traditional and alternative investments, though the benchmarks used may differ.