CFA Level III Notes:
Table of Contents
Alternative Investments 2
Reading 26 2
Reading 27 12
Capital Market Expectations 18
Reading 10 18
Type chapter title (level 3) 6
Alternatives Investments Reading 26:
LOS 26.a: Discuss how hedge fund strategies may be classified.
Six categories to classify hedge funds:
, 1. Equity Related: focus on stocks, so main source of risk is equity risk. Subtypes: long/short,
dedicated short bias, and equity market neutral
2. Event Driven: related to corporate actions (mergers, bankruptcies, other business events).
Main risk is event risk: the risk that it might not unfold as expected. Strategies include:
merger arbitrage and distressed securities
3. Relative Value: profit from relative valuation between securities. Credit and liquidity risks
often complicate these strategies, because the valuation differences being exploited often
relate to securities with different credit quality or liquidity. Two relative value strategies that
will be considered further are fixed income arbitrage and convertible bond arbitrage.
4. Opportunistic: top down approach, multiple asset classes, vary with market conditions. Two
strategies: global macro and managed futures
5. Specialist: require specialized market expertise or knowledge. Risk is exposure to specific
sectors or unusual securities. Two strategies: volatility strategies and reinsurance strategies
6. Multi-manager: strategies use other hedge fund strategies and combine them together and
rebalance exposure over time. Two strategies: multi-strategy funds and fund of funds.
LOS 26.b: Discuss investment characteristics, strategy implementation, and role in a portfolio of
equity-related hedge fund strategies.
Equity Related Hedge Fund Strategies:
1. Long/Short:
Long and short positions in stocks
Beta is equal to the sum of the positive and negative betas of the various long/short
exposures
Do not seek to eliminate market exposure completely, typically have 40-60% net
long exposure
Aspire to provide returns comparable to that of long-only fund but with half amount
of standard deviation
Majority of funds take a sector-specific focus, choosing stocks from a particular
industry that are familiar with
May need to use leverage
Has high fees, taking a traditional long-only equity position may be a more efficient
way to achieve a comparable beta exposure
2. Dedicated Short Selling and Short-Biased:
Dedicated short selling funds seek securities that are overpriced in order to short
them
Examples: poorly managed firms, declining market segments, deceitful accounting
Short-biased use a similar strategy except that the short position is somewhat offset
by a long exposure
Activist short selling: fund managers not only takes a short position in a stock but
also contends that the stock is overpriced
Aim to produce a negative correlation with conventional securities. Expectations for
returns are lower, have greater volatility (markets tend to be rising over time)
Managers use a bottom-up approach to identify firms with unprofitable business
models, too much debt, shady accounting
Dedicated short selling: No long exposure, could tempter the exposure by holding
cash (short exposure typically 60% - 120%)
, Short bias: may take a long exposure while remaining net short, often 30% - 60% net
short
For both little leverage is used
Produce returns that are uncorrelated or negatively correlated with traditional asset
classes
Historical performance: unreliable and underwhelming
3. Equity Market Neutral:
Seek to attain a near zero overall exposure to the stock market
Long and short positions in various equities: the betas sum to zero
Alpha is derived by taking positions in securities that are temporarily mispriced
Goal: not only to generate alpha but also relatively immune to overall market
Without beta, returns are modest
However, offer significant diversification and low volatility
Long positions in stocks undervalued and short position in stocks overvalued
mean reversion occurs alpha
Could rely on intuition (discretionary managers), more common that they rely on a
fixed set of rules to identify trade opportunities (quantitative managers)
Market beta is hedged, use leverage to get acceptable levels of return
Popular subtypes include
o Pairs trading: (think of uber and lyft) stocks with similar characteristics are
identified that are respectively overvalued and undervalued.
o Stub trading: going long and short shares of a subsidiary and its parent
company. Position taken correspond to % of subsidiary owned by the parent
o Multi-class trading: long and short relatively mispriced share classes of the
same firm, for example voting and non-voting
Besides stocks, managers can use other asset classes to achieve zero beta: options,
stock index futures, or other kinds of derivatives
Of particular value in times when markets are volatile and performing poorly
LOS 26.c: Discuss investment characteristics, strategy implementation, and role in a portfolio of
event-driven hedge fund strategies.
Take position in stocks or related derivatives that are predicting the outcome of corporate events
1. Merger Arbitrage:
Investment schemes that attempt to earn a return from the uncertainty that exists
in the market between a acquisition announcement and completion
Can view this as an insurance on the acquisition. If the acquisition is completed as
planned, it’s like earning an insurance premium and if it fails it’s like making a payout
(because of the risk)
If acquisition failed price movements will reverse: price of acquirer will go up and
the target would fall position likely to suffer a big loss (around 40%)
huge/significant left-tail risk
Compared to typical hedge fund strategies, merger arbitrage is more liquid
In a stock for stock deal: hedge fund would purchase stock of target and short stock
of acquirer. If fund thinks the merger would fail, take the opposite position
Hedge funds pursuing a merger arbitrage would typically apply 300% - 500%
leverage in order to achieve low-double-digit returns
, Cross-border mergers and acquisitions (two countries and two regulatory authorities
involved) are more risky
Sharpe ratios of merger arbitrage strategies tend to be high as these strategies
produce relatively steady returns, but huge left tail risk
2. Distressed Securities:
Compounding the discounting of the securities of distressed firms is the fact that
institutions such as insurance companies and banks are often not permitted to hold
non-investment-grade securities. The selling of such securities can create significant
pricing inefficiencies and can open up opportunities for hedge funds seeking profit
Returns of distressed securities investing strategy tend to be somewhat greater with
larger variability of outcomes
Lock-up periods for investors in event-driven hedge funds tend to be comparatively
long (no redemptions for the first two years)
Takes multiple forms: can be a passive investment or managers can attempt to
acquire the majority of a certain class of security in order to take creditor control
during bankruptcy
Requires broad range of skills because of legal aspects of the strategy
Shorting the distressed security is possible, but usual in the form of long positions
Low use of leverage, high levels of illiquidity
Returns tend to be high relative to other event driven strategies though it can be
unpredictable and sensitive to declines in the overall market
LOS 26.d: Discuss investment characteristics, strategy implementation, and role in a portfolio of
relative value hedge fund strategies
When successful, relative value strategies will earn various premiums over time, including liquidity,
credit, and volatility premiums, reflecting differences in liquidity or credit quality between securities
1. Fixed-Income Arbitrage:
Take advantage of temporary mispricing of fixed-income instruments, by going
long comparatively undervalued securities and short comparatively overvalued
securities
Idiosyncrasies that might be exploited include the yield curve kinks or
anticipated changes to the yield curve
Managers can use a number of different fixed income securities (consumer debt,
bank loans, corporate bonds, or sovereign bonds)
Take positions in securities under the assumption that the prices will revert
toward their fair values
Use significant leverage to make sufficient levels of return
Subtypes include: yield curve trades and carry trades
1. Yield Curve Trades:
o Manager has a view of how the yield curve will evolve over time based
on macroeconomic factors (flatten or steepen)
o If the positions taken are in securities of different firms, then liquidity,
credit, and interest rate risks will be present.
o For positions in securities of the same issuer, interest rate movements
will be the main source of risk
2. Carry Trades:
Table of Contents
Alternative Investments 2
Reading 26 2
Reading 27 12
Capital Market Expectations 18
Reading 10 18
Type chapter title (level 3) 6
Alternatives Investments Reading 26:
LOS 26.a: Discuss how hedge fund strategies may be classified.
Six categories to classify hedge funds:
, 1. Equity Related: focus on stocks, so main source of risk is equity risk. Subtypes: long/short,
dedicated short bias, and equity market neutral
2. Event Driven: related to corporate actions (mergers, bankruptcies, other business events).
Main risk is event risk: the risk that it might not unfold as expected. Strategies include:
merger arbitrage and distressed securities
3. Relative Value: profit from relative valuation between securities. Credit and liquidity risks
often complicate these strategies, because the valuation differences being exploited often
relate to securities with different credit quality or liquidity. Two relative value strategies that
will be considered further are fixed income arbitrage and convertible bond arbitrage.
4. Opportunistic: top down approach, multiple asset classes, vary with market conditions. Two
strategies: global macro and managed futures
5. Specialist: require specialized market expertise or knowledge. Risk is exposure to specific
sectors or unusual securities. Two strategies: volatility strategies and reinsurance strategies
6. Multi-manager: strategies use other hedge fund strategies and combine them together and
rebalance exposure over time. Two strategies: multi-strategy funds and fund of funds.
LOS 26.b: Discuss investment characteristics, strategy implementation, and role in a portfolio of
equity-related hedge fund strategies.
Equity Related Hedge Fund Strategies:
1. Long/Short:
Long and short positions in stocks
Beta is equal to the sum of the positive and negative betas of the various long/short
exposures
Do not seek to eliminate market exposure completely, typically have 40-60% net
long exposure
Aspire to provide returns comparable to that of long-only fund but with half amount
of standard deviation
Majority of funds take a sector-specific focus, choosing stocks from a particular
industry that are familiar with
May need to use leverage
Has high fees, taking a traditional long-only equity position may be a more efficient
way to achieve a comparable beta exposure
2. Dedicated Short Selling and Short-Biased:
Dedicated short selling funds seek securities that are overpriced in order to short
them
Examples: poorly managed firms, declining market segments, deceitful accounting
Short-biased use a similar strategy except that the short position is somewhat offset
by a long exposure
Activist short selling: fund managers not only takes a short position in a stock but
also contends that the stock is overpriced
Aim to produce a negative correlation with conventional securities. Expectations for
returns are lower, have greater volatility (markets tend to be rising over time)
Managers use a bottom-up approach to identify firms with unprofitable business
models, too much debt, shady accounting
Dedicated short selling: No long exposure, could tempter the exposure by holding
cash (short exposure typically 60% - 120%)
, Short bias: may take a long exposure while remaining net short, often 30% - 60% net
short
For both little leverage is used
Produce returns that are uncorrelated or negatively correlated with traditional asset
classes
Historical performance: unreliable and underwhelming
3. Equity Market Neutral:
Seek to attain a near zero overall exposure to the stock market
Long and short positions in various equities: the betas sum to zero
Alpha is derived by taking positions in securities that are temporarily mispriced
Goal: not only to generate alpha but also relatively immune to overall market
Without beta, returns are modest
However, offer significant diversification and low volatility
Long positions in stocks undervalued and short position in stocks overvalued
mean reversion occurs alpha
Could rely on intuition (discretionary managers), more common that they rely on a
fixed set of rules to identify trade opportunities (quantitative managers)
Market beta is hedged, use leverage to get acceptable levels of return
Popular subtypes include
o Pairs trading: (think of uber and lyft) stocks with similar characteristics are
identified that are respectively overvalued and undervalued.
o Stub trading: going long and short shares of a subsidiary and its parent
company. Position taken correspond to % of subsidiary owned by the parent
o Multi-class trading: long and short relatively mispriced share classes of the
same firm, for example voting and non-voting
Besides stocks, managers can use other asset classes to achieve zero beta: options,
stock index futures, or other kinds of derivatives
Of particular value in times when markets are volatile and performing poorly
LOS 26.c: Discuss investment characteristics, strategy implementation, and role in a portfolio of
event-driven hedge fund strategies.
Take position in stocks or related derivatives that are predicting the outcome of corporate events
1. Merger Arbitrage:
Investment schemes that attempt to earn a return from the uncertainty that exists
in the market between a acquisition announcement and completion
Can view this as an insurance on the acquisition. If the acquisition is completed as
planned, it’s like earning an insurance premium and if it fails it’s like making a payout
(because of the risk)
If acquisition failed price movements will reverse: price of acquirer will go up and
the target would fall position likely to suffer a big loss (around 40%)
huge/significant left-tail risk
Compared to typical hedge fund strategies, merger arbitrage is more liquid
In a stock for stock deal: hedge fund would purchase stock of target and short stock
of acquirer. If fund thinks the merger would fail, take the opposite position
Hedge funds pursuing a merger arbitrage would typically apply 300% - 500%
leverage in order to achieve low-double-digit returns
, Cross-border mergers and acquisitions (two countries and two regulatory authorities
involved) are more risky
Sharpe ratios of merger arbitrage strategies tend to be high as these strategies
produce relatively steady returns, but huge left tail risk
2. Distressed Securities:
Compounding the discounting of the securities of distressed firms is the fact that
institutions such as insurance companies and banks are often not permitted to hold
non-investment-grade securities. The selling of such securities can create significant
pricing inefficiencies and can open up opportunities for hedge funds seeking profit
Returns of distressed securities investing strategy tend to be somewhat greater with
larger variability of outcomes
Lock-up periods for investors in event-driven hedge funds tend to be comparatively
long (no redemptions for the first two years)
Takes multiple forms: can be a passive investment or managers can attempt to
acquire the majority of a certain class of security in order to take creditor control
during bankruptcy
Requires broad range of skills because of legal aspects of the strategy
Shorting the distressed security is possible, but usual in the form of long positions
Low use of leverage, high levels of illiquidity
Returns tend to be high relative to other event driven strategies though it can be
unpredictable and sensitive to declines in the overall market
LOS 26.d: Discuss investment characteristics, strategy implementation, and role in a portfolio of
relative value hedge fund strategies
When successful, relative value strategies will earn various premiums over time, including liquidity,
credit, and volatility premiums, reflecting differences in liquidity or credit quality between securities
1. Fixed-Income Arbitrage:
Take advantage of temporary mispricing of fixed-income instruments, by going
long comparatively undervalued securities and short comparatively overvalued
securities
Idiosyncrasies that might be exploited include the yield curve kinks or
anticipated changes to the yield curve
Managers can use a number of different fixed income securities (consumer debt,
bank loans, corporate bonds, or sovereign bonds)
Take positions in securities under the assumption that the prices will revert
toward their fair values
Use significant leverage to make sufficient levels of return
Subtypes include: yield curve trades and carry trades
1. Yield Curve Trades:
o Manager has a view of how the yield curve will evolve over time based
on macroeconomic factors (flatten or steepen)
o If the positions taken are in securities of different firms, then liquidity,
credit, and interest rate risks will be present.
o For positions in securities of the same issuer, interest rate movements
will be the main source of risk
2. Carry Trades:
