SolMcL 6e ch08 [唯讀] - Stanford Universityweb.stanford.edu/class/msande247s/2008/eighth week...Title Microsoft PowerPoint - SolMcL_6e_ch08 [唯讀] Author YTF Created Date 7/23/2008

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 8

Alternative Investments

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 8 - 2

Introduction

In this chapter we discuss:Common features of alternative investments.Different types of alternative investments.Risk and return features of alternative investments.Explain how net asset value is calculated.Nature of various mutual fund fees.Distinguish between open-end and closed-end funds.


Introduction

In this chapter we discuss:Discuss exchange traded funds (ETFs)Venture capital investingHedge fund investments.


Alternative Investments — Features

Alternative investments are often equity investments in some non-publicly traded asset.Alternative investments beckon investors to areas of the market where alpha is more likely to be found than in more liquid and efficient markets.Alternative assets are assets not traded on exchanges.


Alternative Investments — Features

The common features of alternative investments include:

IlliquidityDifficulty in determining current market values.Limited historical risk and return data.Extensive investment analysis required.A liquidity risk premiumSegmentation risk premium


Alternative Investments – Additional Features

Alternative investments can be characterized as raising unique legal and tax considerations.Many forms of alternative investments involve special legal structures that avoid some taxes (exchange traded funds) or avoid some regulations (hedge funds).In some cases, alternative investments may look more like an investment strategy than an asset class.


Investment Companies


Investment Companies

These are financial intermediaries that earn fees to pool and invest investors’ funds, giving the investors rights to a proportional share of the pooled fund performance.An open-end fund stands ready to redeem investor shares at net asset value, but closed-end funds do not.Closed-end funds issue shares that are then traded in the secondary markets.


Valuing Investment Company Shares

The basis for valuing investment company shares is net asset value (NAV).NAV is the per-share value of the investment company’s assets minus its liabilities.

Liabilities may come from fees owed to investment managers.

sharesofNumbersLiabilitieAssetsNAV −

=


Fund Management Fees

Investment companies charge fees, some as one-time charges and some as annual charges.Front-end fee — a sales commission charged at the time of purchase.A redemption (back-end) fee — a charge to exit the fund.Annual fees include distribution and operating fees.


Fund Management Fees

Only management fees can be considered a portfolio management incentive fee.

assetsAverageExpensesOperatingratioExpense =


Exchange Traded Funds (ETFs)



ETFs are not truly alternative investments. They are included here because of their particular legal structure. But they are liquid investments.They are shares of a portfolio, not of an individual company.ETFs are index-based investment products that allow investors to buy or sell exposure to an index through a single financial instrument.



ETF is a special case of a fund that tracks some market index but that is traded on a stock market as any common share.In the US, ETFs have adopted three different legal structures:

managed investment companiesunit investment trustsgrantor trusts.


Exhibit 8.1: Creation/Redemption Process of Exchange Traded Funds


ETFs — Advantages

ETFs have the following advantages:DiversificationTrading similarly to a stockCan be sold short or bought on margin.TransparencyCost effectiveness (no load fees)Management of their risk augmented by futures and options contracts on them.Avoidance of significant premiums or discounts to NAVTax savings from payment of in-kind redemptionImmediate dividend reinvestment for open-end ETFs.


ETFs — Disadvantages

ETFs have the following disadvantages:Only a narrow-based market index tracked in some countriesIntraday trading opportunity is not important for long-horizon investors.Large bid-ask spreads on some ETFs.Possibly better cost structures and tax advantages to direct index investing for large institutions.


ETFs — Types

ETFs can be grouped under the following categories:

Broad domestic market indexStyle (such as value and growth)Sector or industry (can be found in the United States, Europe and Japan)Country or region (multiple countries. iShares are indexed to several developed and emerging markets).Fixed IncomeCommodityActively managed funds


ETFs — Risks

Listed are the major risks faced by ETFs:Market RiskAsset class/sector riskTrading RiskTracking error riskDerivatives riskCurrency risk Country risk


ETFs — Risks

Market risk, trading risk and tracking error risk affect all ETFs.Sector risk, currency risk and country risk may affect some sector and country ETFs.


ETFs — Applications

Following are some popular applications of a variety of investment strategies:

Implementing asset allocationDiversifying sector/industry exposureGaining exposure to international marketsEquitizing cashManaging cash flowsCompleting overall investment strategyBridging transitions in fund managementManaging portfolio riskApplying relative value, long/short strategies


Real Estate


Real Estate

The most common form of investment in tangible assets.In many countries, real estate is a common investment vehicle for pension funds and life insurance companies.Difficulties in investing in foreign real estate:

Difficult to monitor properties located abroad.Taxes, paperwork and unforeseen risks may make foreign real estate investment impractical.Mortgage-backed Eurobonds are growing in popularity.


Real Estate- Characteristics

Characteristics include:Each property is immovableBasically indivisible and uniqueNot directly comparable to other propertiesIlliquidBought and sold intermittently in a generally local marketplace.High transaction costs and market inefficiencies.


Forms of Real Estate Investment

There are several forms of real estate investment:

Free and clear equity (sometimes called “fee simple”)Leveraged equityMortgagesAggregation vehicles (RELPs, commingled funds, REITs)


Real Estate - Valuation Approaches

The following four approaches are used worldwide:

The Cost ApproachThe Sales Comparison ApproachThe Income ApproachThe Discounted After-Tax Cash flow Approach

The net operating income from a real estate investment is gross potential income minus expenses, which include estimated vacancy and collection costs, insurance, taxes, utilities, and repairs and maintenance.


Real Estate -Valuation Approaches

Cost Approach:What is the cost of replacing the building in its present form?

Sales Comparison Approach (similar to “price multiple comparables” approach):

An adjusted value from a benchmark of comparable sales.Hedonic price estimate from a regression model



Income Approach:Capitalized net operating income.

NOI = gross potential income – expenses (which incl. estimated vacancy and collection costs, insurance, taxes, utilities and repairs and maintenance)

ratecapMarketNOIpriceAppraisal =



The NPV of a property to an equity investor is obtained as the present value of the after tax cash flows, discounted at the investor’s required rate of return on equity, minus the amount of equity required to make the investment.


Real Estate - Example

Question: Refer to the statistical analysis in example 8.2. You wish to value a house that has 8 rooms, a garden of 15,000 square feet, a swimming pool and a distance of three miles to the nearest shopping centre. What is the appraisal value based on this sales comparison approach of hedonic price estimation?


Real Estate - Example

Answer: The appraisal value is given by the equation:

Value = 20,000 x (#Rooms) + 5 x (Garden surface) + 20,000 x (pool) – 10,000 x (Distance to shopping centre)

Value = (20,000 x 8) + (5 x 15,000) + (20,000 x 1) –(10,000 x 3)

Value = £225,000


Private Equity


Private Equity

Private equity investing has grown rapidly in the 2000s.Private equity investments are equity investments that are not traded on exchanges.The limited partnership is called the “Fund”.General partners are sometimes designated as the “Management Company”.


Private Equity

There are three main categories of private equity:

Venture capitalLeverage buyoutDistressed investing


Private equity – Leveraged buyout investing

The largest category of private equity Investors put up a equity stake (20-40%) and borrow the rest.Company is then taken private. Private equity firm then gets involved in the management of the acquired company and takes steps to increase its value.The objective is to resell the company a few years later at a higher price.


Venture Capital — Stages

Venture capital financing is done in many stages:

Seed-stage financingEarly stage financing

Start-upFirst-stage

Formative stage financingLater stage financing

Second-stageThird-stageMezzanine


Venture Capital — Stages

Expansion-stage financing includes second and third stage. Balanced stage financing is a term used to refer to all stages, seed through mezzanine.Exit strategies are crucial for venture capital investing.


Venture Capital — Characteristics

Some of the characteristics are common to alternative investing, but many are unique:

IlliquidityLong-term commitment requiredDifficulty in determining current market valuesLimited historical risk and return dataLimited informationEntrepreneurial/management mismatchesFund manager incentive mismatchesLack of knowledge of how many competitors exist


Venture Capital — Characteristics

Some of the characteristics are common to alternative investing, but some are unique:

Vintage cyclesExtensive operations analysis and advice may be required.

The challenges to venture capital performance measurement are:

The difficulty in determining precise valuationsThe lack of meaningful benchmarksThe long-term nature of any performance feedback.


Venture Capital — Valuation

The expected NPV of a venture capital project with a single, terminal payoff and a single, initial investment can be calculated, given its possible payoff and its conditional failure probabilities, as the present value of the expected payoff minus the required initial investment.


Venture Capital Example

0.150.150.250.300.350.4Failure (Prob)654321Year


Venture Capital Example

Determine the probability that the project survives to the end of the sixth year.

Prob = (1-0.4)(1-0.35)(1-0.30)(1-0.25)(1-0.15)2

Prob =14.79%


Vulture investing

Distressed investing, or vulture investing, or special situations.The concept is to invest in operationally sound, financially distressed companies and to reorganize them.


Hedge Funds


Hedge Funds: Definition

Today, funds using the “hedge fund” appellation follow all kinds of strategies and cannot be considered a homogeneous asset class.Hedge funds can be defined as:

Funds that seek absolute returnsHaving a legal structure that avoids some government regulationsHave option-like fees, including a base management fee and an incentive fee proportional to realized profits.


Hedge Funds

The 1990s witnessed rapid growth in hedge funds.In 2007, assets under management surpassed $2 trillion.In 2007, the number of hedge funds exceeded 13,000.


Hedge funds

Hedge fund managers can create leverage in trading by:

1) Borrowing external funds to invest more or sell short more than the equity capital that they put in.

2) Borrowing through a brokerage margin account

3) Use of financial instruments and derivatives.


Legal Structure for US hedge funds

The legal structure of a hedge fund largely depends who its investors will be. For example, a private investment vehicle formed for the benefit of persons who reside outside of the United States will be organized differently than an investment vehicle formed for the benefit of United States residents. Domestic US: A Limited partnership (LP) where investors are limited partners and the manager is General partner. Under Investment Act, no more than 100 investors, and no public solicitation


Legal Structure for US hedge funds

International: For the purpose of managing the assets of persons residing outside of the US, and also tax-exempt US investors, an offshore fund is ordinarily structured as a corporation and organized in a tax haven jurisdiction (e.g. Bermuda, British Virgin Islands, Cayman Islands, Ireland). Often, the manager of an offshore fund forms a corporate entity to provide advisory services to the fund. This entity serves as the investment manager of the fund. If the hedge fund manager already manages the assets of a domestic partnership through a single corporate entity, the general partner of the partnership may also serve as the investment manager of the offshore fund.


Master Feeder Structure (“hub and spoke”)

- “Feeder” refers to the legal structure used.- The master fund is generally an offshore fund


Registration & Information

In the USA, the question was raised whether hedge funds needed to register with SEC. At the end of 2007, the answer is NO, but that does not mean that they escape any form of regulation.In other countries, there is a strong drive to regulate hedge funds and impose some information requirements.The industry is lobbying hard and tries to self-regulate and educate (e.g. CAIA, Chartered Alternative Investment Analyst Association® ).


Types of investment strategies

Classifications are arbitrary and vary across data providers.Hedge funds can be classified as:

Long/shortMarket neutralFixed incomeGlobal macro

Emerging market fundsManaged futures funds

Event drivenDistressed securities fundsRisk arbitrage in M&A


Long/short hedge funds

Long/short funds are the traditional type of hedge funds, taking short and long bets in common stocks. They vary their short and long exposure according to forecasts, use leverage, and now play on numerous markets throughout the world. These funds often maintain net positive or negative market exposures; so they are not necessarily market-neutral. In fact, a subgroup within this category is funds that have a systematic short bias, known as dedicated-short funds, or short-seller funds. The distinction with traditional funds is getting blurred, as some mutual funds offer a 130/30 strategy (or 120/20 etc..). A 130/30strategy means that the funds goes short 30% and long 130%. Some hedge funds started to compete with similar products.


Long/short —Example

A hedge fund has a capital of $10 million and invests in a market neutral long/short strategy on the British equity market.Shares can be borrowed from a primary broker with a cash margin deposit equal to 18% of the value of the shares. Given the high level of cash margin, no additional costs are charged to borrow the shares. The hedge fund has drawn up a list of shares regarded as undervalued (list A) and a list of shares regarded as overvalued (list B). The hedge fund expects that shares in list A will outperform the British index by 5% over the year, while shares in list B will underperform the British index by 5% over the year. The hedge fund wishes to retain a cash cushion of $1 million for unforeseen events. What strategy would you suggest?


Answer

The hedge fund would sell short shares from list B and use the proceed to buy shares from list A for an equal amount. Some capital needs to be invested in the margin deposit. The hedge funds could take long/short positions for $50 millions:Keep $1 million in cash Borrow $50 million of shares B from a broker,Deposit $9 million in margin (18% × $50 million),Sell shares B for $50 million in cash,Use the sale proceeds to buy $50 million worth of shares AThe positions in shares A & B are established so that the portfolio’s beta is close to zero. The ratio of invested assets to equity capital is roughly 5:1.


Answer (2)

If expectations materialize, the long/short portfolio of shares should have a gain over the year of 10% on $50 million whatever the movement in the general market index. To be market neutral, the fund would aim for a beta of zero.This $5 million gain will translate into an annual return before fees of 50% over the invested capital of $10 million. This calculation does not take into account the return on invested cash ($1 million) and assumes that the dividends on longs will offset dividends on shorts.


Market Neutral hedge funds

Market-neutral funds are a form of long/short funds that attempt to be hedged against a general market movement. They take bets on valuation differences of individual securitieswithin some market segment. Long/short equity funds are a form of market neutral funds. But there are all kinds of market neutral strategies, mostly based on some form of arbitrage:

equity long/short fixed-income hedging,pairs trading,warrant arbitrage,mortgage arbitrage,convertible bond arbitrage, closed-end fund arbitrage, andstatistical arbitrage.


Merger Risk Arbitrage —Example

A merger has been announced between a French company A and a German company B. A will acquire B by offering one share of A for two shares of B. Shares of B were trading in a €15 to €20 range prior to any merger discussion. Shares of B currently trade at €24, while shares of A trade at €50. The merger has been approved by both boards of directors but is awaiting ratification by all shareholders (that is extremely likely) and approval by the EU commission (there is a slight risk because the combined company has a large European market share in some products). How could a hedge fund take advantage of the situation? What are the risks?


Answer

The hedge fund should construct a hedged position where it buy two shares of B for every share of A that it sells short. Asthe proceeds of the short sale of one share of A (€50) can be used to buy two shares of B (€48), the position can be highly leveraged. Of course the cost of securities lending and margin deposit should also be taken into account. When the merger is completed, the hedge fund will make a profit of approximately 2 euros for each share of A.The risk is that the merger will be cancelled. It is hard to tell what will be the stock price reaction to this announcement, but it is clear that the stock price of B will drop more, because itwas to be acquired at a price well above its pre-merger market value. That would mean a sizable loss for the hedge fund.


Fee Structure

Total fee = base (fixed) fee + Incentive (performance) feeTypically 1% (fixed) plus 20% (performance), but varies across funds.The calculation of performance fee varies and is somewhat complicated because of “high watermark” feature.


Funds of Funds

Definition: Funds of funds (FOF ) have been created to allow easier access to small investors, but also to institutional investors. A FOF is open to investors and, in turn, invests in a selection of hedge funds.Additional fee: typically 1% and 10%, on top of the hedge funds fees (typically 1% and 20%).


Fund of Funds — Advantages

RetailingDiversificationManagerial expertiseDue diligence process


Fund of Funds — Disadvantages

Potentially high feesLittle evidence of persistence performanceAbsolute return loss through diversification


Hedge Funds — Risks

The unique risks of hedge funds include:Liquidity riskPricing riskCounterparty credit riskSettlement riskShort squeeze riskFinancing squeeze risk.


Hedge Fund — Index/database

There are a number of indexes that track the hedge fund industry. The list of hedge fund index providers is long:

Specialized hedge fund firms (such as HFR, Van Hedge, Hennessee, Greenwich)Banks such as ABN-AMRO/Eurekahedge or CréditSuisse/Tremont (As of 2007, the Crédit Suisse/Tremont indexes are based on the TASS database that is managed by Tremont but owned and distributed by Lipper)Index providers (such as MSCI, S&P, FTSE), and even universities (CISDM, EDHEC) offering dedicated hedge fund indexes.


Hedge Fund — Index/database (2)

These indexes are also broken down in sub-indexes for various classifications of hedge funds according to the investment strategy they follow. But the classifications vary across providers. The launching date of these indexes differs markedly. Some were launched in the 1990s, others in the 2000s. In some cases, the historical value of the index was back-calculated to an earlier date, with the risk of only including surviving hedge funds and biasing the performance upward.


Hedge Funds — Biases in performance

Investors should exercise caution when using historical track record of hedge funds in reaching asset allocation decisions.The biases present in performance reporting:

Self selection biasInstant backfilling biasSurvivorship bias on return and riskSmoothed pricing on infrequently traded assetsOption-like investment strategiesFee structure-induced gaming


Exhibit 8.2: Performance and Risk Characteristics of Various Market Indexes January 1994-December 2006, in U.S. dollars


Other Alternative Investments


Closely Held Companies and Inactively Traded Securities

A closely held company is one that is not publicly traded.Require analysis of legal, financial and ownership considerations with account taken of the effect of illiquidity.An inactively traded security is not generally traded on a major exchange.A discount is used for lack of liquidity, lack of marketability, and for a minority interest, but a control premium is added for controlling ownership.


Closely Held Companies and Inactively Traded Securities

Valuation Approaches:Cost approach (what it would cost to replace the company’s assets in their present form).Comparables approachIncome Approach


Distressed Securities/Bankruptcies

Are securities of companies that have filed or are close to filing for bankruptcy court protection, or that are seeking out-of-court debt restructuring to avoid bankruptcy.In the U.S. there are two types of bankruptcy protection:

Chapter 7 (liquidation)Chapter 11 (reorganization)


Distressed Securities/Bankruptcies

Investment characteristics:IlliquidRequire a long investment horizonRequire intense investor participation/consultingOffer the possibility of alpha because of mispricing.


Commodity Markets and Commodity Derivatives

These investments complement investment opportunities offered by shares of corporations that extensively use these as raw materials in their production processes.Several indirect ways of commodity investing:

Futures contractsBonds indexed on some commodity priceStocks of companies producing the commodities.


Commodity Markets and Commodity Derivatives (2)

These are attractive to investors because1) commodities may have negative correlation

with stock and bond returns 2) A desirable positive correlation with inflation.In the case of commodity-linked securities, the investor can receive some income rather than depending solely on commodity price changes.


Managed Futures

Commodity trading advisers (CTAs) offer managed futures funds that take positions in exchange traded derivatives on commodities and financials.A passive investor would typically invest through a collateralized position in a futures contract. A collateralized position in futures is a portfolio in which an investor takes a long position in futures for a given amount of underlying value and simultaneously invests the same amount in government securities, such as Treasury bills.


Collateralized Futures —Example

Assume that the futures price is currently $100. If $100 million is added to the fund, the manager will take a long position in the futures contract for $100 million of underlying value and simultaneously buy $100 million worth of Treasury bills (part of this will be deposited as margin). If the futures price drops to $95 the next day, the futures position will be marked to market, and the manager will have to sell $5 million of the Treasury bills to cover the loss. Conversely, if the futures price rises to $105, the manager will receive a marked-to-market profit of $5 million, which will be invested in additional Treasury bills. Discuss the sources of total return from such an investment.


Answer

The total return on the collateralized futures position comes from the change in futures price and the interest income on the Treasury bills.


Commodity Markets and Commodity Derivatives - Risks

The risks of managed futures can be managed as follows:

Liquidity monitoringThrough diversificationVolatility dependent allocationVaRRisk budgeting on various levelsLimits on leverageUse of derivativesCare in model selection


The Example of Gold

Former international monetary assetOffers protection in case of a major disruptionGold often allows investors to diversify against the kinds of risks that affect all stock markets simultaneously (depression,…)There are many gold-linked investments, such as gold mining stocks, gold-linked bonds.

Documents

SolMcL 6e ch08 [唯讀] - Stanford Universityweb.stanford.edu/class/msande247s/2008/eighth week...Title Microsoft PowerPoint - SolMcL_6e_ch08 [唯讀] Author YTF Created Date 7/23/2008