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Alternative Investments
“Outlook for the Investment
Management Industry”
San Antonio
October 17, 2007
Bank Depository User Group Meeting
The Mystery of Alternative Investments The Mystery of Alternative Investments
What are they??
and what do they do????
Perception Vs. Reality
1
Alternative Investments – Perception vs. Reality
2
Questionnaire:
Do Private Equity Funds Buy Only Private Companies?
Do Hedge Funds Hedge?
Do Real Estate Investments Appreciate with Property Values?
Do Structured Products Perform Like the Underlying Asset or Index?
3
What are alternative investments?
Incentive based investment management
Less liquid and longer term investment vehicles
Absolute return investments
Skill based investment vehicles
4
Examples of Alternative Investments
Hedge Funds
Private Equity & Venture Capital
Real Estate Investment
Structured Notes
Commodity Funds?
5
Benefits of Alternative Investments in Investment Portfolios
Performance
Diversification
Non Correlation ?
Lower Volatility?
Downside Protection?
6
Do Alternative Investments Increase Portfolio Risk?
Perception
More Volatile
Market risk is large
Highly Speculative
Reality
Less Volatile
Absolute return
Provide diversification
7
What are the real risks in alternative investments?
Illiquidity
Leverage
Redemptions
Less regulated
1. Absolute Return
2. Tax Inefficient
3. Active Risk Management
4. Variable Concentration of Holdings
5. Benchmarking Less Relevant
6. Not Dependent on Market Direction
7. Large Assets Detract from Performance
8. Less Transparent
9. Less Regulated
10.Higher Minimum Investment Required
11.Less Liquidity – “Lock-ups”
12.Higher Fees and Manager Incentives
1. Relative Return Measurement
2. Longer Term & Tax Efficiency
3. Less Turnover and Trading Cost
4. Often Greater Diversification
5. Benchmarked Performance
6. Will Lose Money in Down Markets
7. Scalable Asset Growth
8. Greater Transparency
9. Regulated
10.Lower Investment Minimums
11.Daily Liquidity
12.Lower Fees; Lower Incentives
Traditional Long Only Investments Asset
AllocationAlternative Investments
Alternative Investments vs.Traditional Funds
Pros and Cons
8
9
Mercer Investment Consulting Survey
•Diversification
•Performance
Reducing risk in combination with enhancing return is the most common motivation for asset allocation to alternative investments – more specifically hedge funds
Survey respondents pointed to a lack of understanding ofalternative investment strategies as a serious challenge
While increased asset allocations were expected….More education was needed
10
Yale Endowment Target Asset Allocation June 2004
Absoute return25%
Hard Assets20%
Cash0%
Private Equity17%
Fixed Income8%
Foreign Stocks15%
Domestic Stocks15%
Diversification - Increased Asset Classes
11
Performance of alternative investments vs. traditional
Annualized returns 1994-2006
9.45 9.726.19
8.84 10.45
24.30
0.00
5.00
10.00
15.00
20.00
25.00
30.00
Multi SectorHedge Funds
S&P Lehm Agg MSCI World P.Eq.Buyouts Venture C
Source: Goldman Sachs Thomson Venture Hennessee Hedge Fund Group
1
2006 Performance for Alternative Investments
“Boom Year”
Hedge Funds Private Equity REITs
11.36%
23.3%
36.06%
11.20%10.62%
14.79%
10 year Annualized return information - Sources:Hennessee Hedge Fund Group NAREIT, Thomson Venture Capital Assoc., Institutional Investor, JP Morgan 12
Benefits of Alternative Investments
13
Annualized Return
Annualized Volatility
Max.. Drawdown
Period
Months
Recovery
Months
Beta to
MSCI
Sharpe Ratio
9.45% 3.87% -4.14% 3 3 0.13 1.37
6.19% 3.83% -5.15% 5 8 -0.01 0.63
8.95% 2.90% -6.27% 3 5 0.05 1.66
5.82% 8.05% -7.74% 5 15 -0.05 0.28
12.09% 10.05% -15.04% 29 17 0.47 0.80
11.77% 5.54% -16.05% 5 10 0.25 1.35
8.84% 13.45% -46.80%
30 401.00 0.41
Multi Strategy Fund Index
Lehman Aggregate Bond Index
Relative Value
Custom Index
Tactical Trading CTA Index
Barclay
Equity Long/Short
CSFB Index
Event Driven
CSFB Index
MSCI World Index
*Data from Goldman Sachs Jan. ’94 through Dec.’06
Non Correlation, Lower Volatility & Capital Preservation
14
Public vs. Private Investing 2005
Priv Equity, Venture, Mexx. Inflows Eq Mutual Fnd Inflows
$139.6B $135.8B
Demand for Alternative Investments
Source: Federal Reserve Bank of Chicago Private Equity Conference 2006
1
Hedge Fund Capital Under Management
$500 Billion $1.500 Billion
Demand for Alternative Investments
1999
Source: Federal Reserve Bank of Chicago Private Equity Conference 2006
$500 B
$1.500 B
2006
15
16
5.2
16.1
12.811.99.5 7.5
12.617.8
24.632.8
37.2
52.4
79.473
89.6
65
45.7
38.8
55
106.4
0
20
40
60
80
100
120
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Buyout Fund Assets
$ Billion
Buyout Funds (Excludes Venture Capital)
Source: Private Equity Analyst, Willis Stein Partners
Private Equity Dollars Raised
17
Institutional Asset Managers Offering Alternative Investments
32%
68%
Do not offer Alternative Investments
Offer Alternative Investments
1. Private Equity2. Real Estate3. Hedge Funds4. Structured Products
18
Alternative Investments - For Asset Managers… Disproportionate Profitability
Proportion of firm’s institutional assetsand revenues from Alternative Investments 2006
15% 36%
Source: McKinsey 2006
Assets Revenues
Alternative Investments
Pricing Power vs. Traditional Funds
19
0 50 100 150 200 250
QA + Index 2005
QA + Index 2006
Traditional
Alts 2005
Alts 2006
Structured Products Hedge FundsReal Estate
Equity –41 BPSFixed Inc.- 18 BPSMoney Market - 12 BPS
Firm Managed
Hedge Funds
Source: McKinsey
Annual Management Fees in Basis Points
Core & Satellite Investment Model
Consultants Getting on Board
As Traditional Managers Fall Out of Favor 20
Core InvestmentsMarket based returnsETFs, Index, Passive
Skill based
Skill based
Skill based
Skill based
Risk based
Risk based
Source: McKinsey & Company
0 10 20 30 40
Alternatives
Structured
R.E.
Intl Eq
US Equity
Fixed Inc
MM
Quant Active
Pure Index“Cheap Beta”
“Traditional”
Alternatives Alpha Strategies
International
Institutional AUM Favor Alternatives and Cheap Beta Growth Rates
21
Alternative Investments
22
Fixed Income +28%
Quantitative Enhanced +28%
U.S Equity –6%
Alpha Strategy Alternatives +12%
Defined Benefit Asset Allocations Trends 2006
Source: McKinsey & Company
23
2
9
1
10
5
23
9
37
27
21
29
0
7
005
10152025303540
<7% 7 to7.5%
7.5 to8%
8 to8.5%
8.5 to9%
9 to9.5%
>10%
1999 2006
Pension Fund Return Assumptions S&P 500 Companies
Source: JP Morgan
1999 Average: 9.2%2006 Average: 8.1%
Return Assumptions
% of Companies
24
Performance of alternative investments vs. traditional
Annualized returns 2002-2006
9.10
5.60 5.50 5.10
9.10
0.00
2.00
4.00
6.00
8.00
10.00
Multi SectorHedge
Lehm Agg S&P 500 P.Eq.Buyouts Venture C
Source: Goldman Sachs Thomson Venture Hennessee Hedge Fund Group
25
More Growth is on the Way from Pension Investors
Endowments, and High Net Worth Individuals are thereAsset Allocation Percentages –
0 10 20 30 40 50 60 70
Equity
Fixed Income
Hedge Funds
Private Equity
Real Estate
Other
Endowments DB Plans High Net Worth Indiv.
Source: JP Morgan, Merrill Lynch, Cap Gemini
26
Alternative Investment Outlook – Major Themes for 2007
Expanded Customer Adoption of Alternative Investments
Diversification Driven
Non Correlation Driven
Performance Driven
Firms will increasingly look to alternative investmentsTo generate increased revenues and profitability