Question

In the current economic environment, if you had to allocate 20% of your portfolio of $1.0 Billion to Alternative Investments, what type of investment strategies you will select (specify, i.e. Distressed Hedge Funds) and why (provide reason).

Answer 1

Investment= 20% of portfolio

=$1 bn * 0.2

=$0.2 Bn

Alternative Investment Strategies:

Private equity is composed of both equity securities and debt securities that offer equity-like exposure and participation. There are two major categories of unambiguous equity participations: venture capital and leveraged buyouts (LBOs). Several categories of debt securities have equity-like exposure, including mezzanine debt, distressed debt, and leveraged loans, such as bank loans.

Strategy

First-Mover Advantage:

The first-mover advantage is the idea that initial investors in new types of projects tend to reap the greatest rewards. The first-mover advantage in private equity is emblematic of this concept, which applies to many kinds of alternative investments. For example, hedge fund strategies, such as merger arbitrage and convertible bond arbitrage, generated very high returns for pioneer investors (in the 1980s). Investment strategies that generate phenomenal success attract a flood of new entrants and eventually prospective returns will be driven toward competitive levels. Investing in private equity today may offer little or no first-mover advantage. Identifying new managers who have superior skill or new areas of promising private equity investing that are not yet crowded, however, may offer an advantage.

Illiquidity Premium:

Investing is made less risky by the ability of the investor to enter and exit positions at competitively determined prices at the times that suit the investor. The illiquidity of private investments, such as private equity, hinders the ability of an investor to enter and exit at the time and quantity she desires. The illiquidity is not just an inconvenience; it is a substantial source of risk. An investor forced to liquidate private equity investments, especially during periods of distress, such as the recent financial crisis, may find liquidation values to be extraordinarily low. Furthermore, the absence of readily available market prices from competitive markets subjects investors to increased.

Diversification and the Full Market Portfolio:

Modern portfolio theory indicates that, in competitive markets, the portfolio that offers the highest risk-adjusted return is the total market portfolio. The market portfolio is that portfolio containing all accessible assets. Any portfolio other than the market portfolio contains diversifiable risk—also called unsystematic, unique, idiosyncratic, nonmarket, or firm-specific risk. By definition, diversifiable risk vanishes in a perfectly diversified portfolio. Investors bearing diversifiable risk do so without compensation in the form of a corresponding risk premium.