Alternative Investment Strategies
Sponsored by:
Fact or Myth
• Volatility = Risk?• Diversification provides superior long-term
returns?• All investment opportunities normalize and
revert to the mean?
Is There a Hedge Fund Bubble?
• A trillion dollar industry - a world of 1,000 niches
• Multiple client agendas• Performance oriented culture• Market forces separate the wheat from the
chaff
• Understanding the payoff process and drivers• Forecasting the nominal dollar amount of the payoffs• Measuring the meaning, significance or utility of the payoffs
Long
Debt
Hybrids
Equity
Derivatives
Other
Short Hedged Arbitraged Other The space of opportunities for value investing has expanded enormously and the need for and the availability of flexibility has increased.
Structures
Co
rpo
rate
Ass
et C
lass
es
1
2Value investing emphasizes fundamental analysis of the payoffs from investment opportunities. We divide the analysis of payoffs into three key areas.
Combining Discipline with Flexibility in Value Investing
PricingModels
Return Models
DecisionModels
The toolbox and WAP approach (words, algebra and pictures) facilitates reframing by using decision analysis as the basic “power tool” and the other tools and concepts as “attachments”.
4 Game Theory
Options
The technique of framing and reframing is at the core of the analytic process for dealing with payoffs because it provides flexibility within the discipline of value investing.
Buffett’s bond/company analogy:•stock " company " bond " stock
– or –•bond " company " stock " bond
3
Combining Discipline with Flexibility in Value Investing
5 The wheel is a circular decision tree which puts all the above in the larger context of events and decisions affecting a value investor’s efforts to construct a portfolio based on asset allocation, security selection and structuring strategies
• Value investing as an investment philosophy and strategy emphasizes the return of money over the return on money. • Practitioners of value investing seek to earn at least reasonable returns during “normal” times, preserve principal during disruptive periods, and put money to work during such disruptive periods which ultimately earns abnormal returns. • If money is not lost, the cadence of normal and abnormal returns over time takes advantage of the power of compounding (which Albert Einstein supposedly said was one of the most significant forces in the Universe).
• Effective value investing combines the discipline and commitment of a coherent investment philosophy and strategy with the flexibility of reframing. • Buffett performs reframing, for example, with his bond/company analogy although he does not call it as such.• A conceptual tool box and the WAP approach (words, algebra and pictures) can facilitate reframing and provide multiple perspectives for analyzing the basic components of investment opportunities: understanding the payoff process and drivers, forecasting the nominal dollar amount of the payoffs, and measuring the significance, meaning, or utility of the payoffs.
• Accounting based valuation and the continuing value driver formulation can be used to reframe like Buffett by seeing a stock as partial ownership of a company and then as a bond and then back to a stock.• Another example of reframing is Professor Greenwald's approach of segmenting pricing models to reflect a company's competitive advantage and franchise.• We can compare this segmentation of the company's intrinsic price or value with the segments of the company's capital structure.• The value segments can then be matched with the capital structure segments to help clarify the bet an investor is making.
Customers
The FirmProducts and Input Markets
Capital Markets
Suppliers
Net Operating
Assets(NOA)
Net Financial
Assets(NFA)
Debtholdersor
Debt Issuers
Shareholders
All Stocks and Flows for a FirmNet operating assets employed in operations generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers).
OperatingActivities
FinancingActivities
OR - OE = OIOI - ∆NOA = C - I
C - I - ∆NFA + NFI = d
F = Net cash flow to debtholders and issuersd = Net cash flow to shareholdersC = Cash flow from operationsI = Cash investmentNFA = Net financial assets
NOA = Net operating assetsOR = Operating revenueOE = Operating expensesOI = Operating incomeNFI = Net financial income
Key:
(∆ indicates change)
OE
OR
C
I
F
d
Penman Analytical Framework for Accruals
Customers
The FirmProducts and Input Markets
Capital Markets
Suppliers
Net Operating
Assets(NOA)
Net Financial
Assets(NFA)
Debtholdersor
Debt Issuers
Shareholders
All Stocks and Flows for a FirmNet operating assets employed in operations generate operating revenue (by selling goods and services to customers) and incur operating expenses (by buying inputs from suppliers).
OperatingActivities
FinancingActivities
OR - OE = OIOI - ∆NOA = C - I
C - I - ∆NFA + NFI = d
F = Net cash flow to debtholders and issuersd = Net cash flow to shareholdersC = Cash flow from operationsI = Cash investmentNFA = Net financial assets
NOA = Net operating assetsOR = Operating revenueOE = Operating expensesOI = Operating incomeNFI = Net financial income
Key:
(∆ indicates change)
OE
OR
C
I
F
d
Penman Analytical Framework for Accruals
“Operating” and “Financing” Activities – All Stocks and Flows
Operating Activities
• (C - I) = OI - ∆NOA– operations generate operating income and free cash flow is
the part that remains after reinvesting some of it in net operating assets
– if investment in NOA > OI, free cash flow is negative– if investment in NOA < OI, free cash flow is positiveFinancing Activities
• (C - I) = ∆NFA - NFI + d OR (C - I) = NFE - ∆NFO + d – explains the disposition of free cash flow from operating
activities (above), i.e. free cash flow and net financial income(expense) increase (decrease) net financial assets (obligations) and increase (decrease) payout of net dividends
• CV = (NOPLAT (1-g / ROIC)) / (WACC – g)
• NOPLAT = OI = 177• ROIC = RNOA = OI / NOA = 177 / 1,325 = 13.3%• Assume WACC = 10% and g = 3%• CV = (177 (1 – 0.03/0.133)) / (0.10 – 0.03) = 1,958• Equity value = CV – NFO = 1,958 – 300 = 1,658
• (NOPLAT (1-g / ROIC)) = NOPLAT – NOPLAT (g/ROIC) = OI - ∆NOA
• ∆NOA represents the amount of OI (or NOPLAT) required to invest back into the business in order to achieve the assumed growth rate of OI (or NOPLAT)
• In this case, ∆NOA = 177 (0.03/0.133) = 40 vs. actual ∆NOA = 70• Need to analyze changes in OA and OL items to better understand economic and
growth opportunities (if ∆NOA applied to projects where ROIC > WACC, firm creates additional value and vice versa)
• Dupont analysis can yield insight into value drivers and wealth creation (destruction)
Continuing Value (McKinsey) Model for Valuing Equity
(2) NOPLAT = Net operating profit less adjusted taxes
(2)
DuPont Analysis - Break-down of Value Drivers
Level 1
Earnings = Comprehensive incomeCSE = Common shareholders’ equityOI = Operating income (after tax)NOA = Net operating assetsNFE = Net financial expenseNFO = Net financial obligations
ROCE = Earnings/CSE= RNOA + (FLEV x SPREAD)
NFOCSE
SPREAD = RNOA - NBC
RNOA = OI/NOA= ROOA + (OLLEV x OLSPREAD)
FLEV =
NFENFO
NBC =RNOA
PM = OI/Sales
Sales PM Other items PM
Gross marginratios
Expense ratios Other OI/Sales ratios
Individual asset and liability turnovers
Borrowing cost drivers
ROCE = Return on common equityRNOA = Return on net operating assetsROOA = Return on operating assetsNBC = Net borrowing costsOLLEV = Operating liability leverageOLSPREAD = Operating liability leverage spreadFLEV = Financial leverageSPREAD = Operating spreadPM = Operating profit marginATO = Asset turnover
Financialstatementline items:
Ratios:
Level 3
Level 2 ATO = Sales/NOA
(1) Adapted from Penman, Financial Statement Analysis and Security Valuation, 2nd Edition, 2004
Level 1
Earnings = Comprehensive incomeCSE = Common shareholders’ equityOI = Operating income (after tax)NOA = Net operating assetsNFE = Net financial expenseNFO = Net financial obligations
ROCE = Earnings/CSE= RNOA + (FLEV x SPREAD)
NFOCSE
SPREAD = RNOA - NBC
RNOA = OI/NOA= ROOA + (OLLEV x OLSPREAD)
FLEV =
NFENFO
NBC =RNOA
PM = OI/Sales
Sales PM Other items PM
Gross marginratios
Expense ratios Other OI/Sales ratios
Individual asset and liability turnovers
Borrowing cost drivers
ROCE = Return on common equityRNOA = Return on net operating assetsROOA = Return on operating assetsNBC = Net borrowing costsOLLEV = Operating liability leverageOLSPREAD = Operating liability leverage spreadFLEV = Financial leverageSPREAD = Operating spreadPM = Operating profit marginATO = Asset turnover
Financialstatementline items:
Ratios:
Level 3
Level 2 ATO = Sales/NOA
(1) Adapted from Penman, Financial Statement Analysis and Security Valuation, 2nd Edition, 2004
Correlation of Returns by Strategy1994-2005
0.13
0.28
0.21
0.45
0.45
Bond Arb.
0.68
0.18
0.66
0.66
0.37
0.39
Event Driven
0.3
0.21
0.35
0.33
0.21
0.08
0.36
Mkt. Neut.
0.42
-0.02
0.59
0.65
0.41
0.29
0.67
0.22
Emerg. Mkts
0.39
0.17
0.78
All
0.13
0.12
0.42
0.86
Global Macro
0.31Global Macro
0.31Bond Arb.
0.94Event Driven
0.57All
0.33Mkt. Neutral
0.58Long/Short
0.59Emerg. Mkts
0.51
0.16
Long/ Short
0.06
Multi strategy
0.56Risk Arb.
0.12Multi strategy
Distress.
200420022000199819961994
300
250
200
150
100
50
Index, 1994=100
All DistressedEmerging Mkts Event Driven
Hedge Fund Returns by Strategy
200420022000199819961994
300
250
200
150
100
50
Index, 1994=100
Risk Arb Global MacroLong/Short Equity Mkt Neutral
Hedge Fund Returns by Strategy
Correlation of Strategies with Broad Hedge Index Returns
20032001199919971995
1.0
0.7
0.5
0.2
-0.0
-0.3
18 month rolling correlation
Risk Arb Global Macro Long/Short
20032001199919971995
1.0
0.7
0.4
0.0
-0.3
-0.6
18 month rolling correlation
Bond Arb Distressed Emerg. Mkts
Correlation of Strategies with Broad Hedge Index Returns
Why Invest in Hedge Funds• Absolute Performance - Hedge Funds attempt to produce
consistent absolute returns regardless of the market direction. • Focus on Risk Management - Hedge Fund Managers focus on
preserving capital by carefully managing investment risks.• Hedge Fund Managers often heavily invested in their own
funds• Greater Diversification - Funds of Hedge Funds add a further
dimension of risk management, investor discipline and access to a diversified portfolio.
• Lower Volatility - The combined focus on absolute performance, risk management and diversification lead to a low volatility of performance.
Comparative Risk Adjusted Returns(January 1990-February 2005)
MSCI World Index
S&P 500
Hedge Funds
HY BondsLehman Agg. Bond Index
Gov't Bonds1-5Yr
90 Day T-Bill
0%
4%
8%
12%
16%
0% 2% 4% 6% 8% 10% 12% 14% 16%Risk (Standard Deviation)
Annualized Return
Historical Hedge Fund Performance (1990- Feb 2005)
20042002200019981996199419921990
8
6
4
2
0
Jan 1990 = 1
Lehman Brothers Agg. Bond Index
Hedge Fund Composite S&P 500
Historically, Hedge Funds have Outperformed both Equity and Bond Indices.
Long/Short Equity
Emerging Mkts
S&P 500
MSCI World Index
Distressed Securities
Event Driven
Hedge Fund Composite
Relative Value
Convertible Arb
Merger Arb
Equity Market Neutral
Fixed Income Arb
Lehman Agg. Bond
0%
4%
8%
12%
16%
20%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%Risk (Standard Deviation)
Composite Risk Adjusted Performance Risk vs. Reward Analysis of Hedge Fund Strategies (1990-2005)
Annualized Return
Historical Hedge Fund Asset Growth
20042000199819951990
1200
1000
800
600
400
200
0
US$ Billions
1000
600
350
190
50
Looming Risks to Fixed Income
• Rising interest rates – Telegraphed by the Fed
• Increasing default rates – Default rates abnormally low last 4 years
• Undue pressure to chase yield – Spreads are the lowest in modern history
Impact of Losses on Overall Return
$800,922.68 -11.88%$1,134,225.00 6.50%2001
$908,900.00 -9.11%$1,065,000.00 6.50%2000
$623,918.77 -22.10%$1,207,949.63 6.50%2002
$1,000,000.00 $1,000,000.00
$1,459,142.30
$1,370,086.66
$1,286,466.35
Value of Investment
S&P 500Hypothetical Fixed Return
63.88%
10.88%
28.70%
Annual Return
$1,459,142.30 6.50%2005
$890,348.05 6.50%2004
$802,983.45 6.50%2003
Value of Investment
Annual Return
The Importance of Protecting the Downside
Demonstrated Impact of Alternative Investments
22
6
1516 18
9
19
1114
7
20
1014
9
17
11 1115
2824
37
4245
48
9
0
10
20
30
40
50
60
Hedge Funds Venture Capital Private Equity Energy &Natural
Resources
Private/PublicEquity Real
Estate
FY 2000
FY 2001
FY 2002
FY 2003
FY 2004
Alternative Strategies Asset Mix Trends for Endowments
Percent
23
41 4250 50 47
13
1520
21 24 29
17
1514
13 10 8
9
23
129
5 419 15 12 9 7 4
5
23
2 5
3
0%
20%
40%
60%
80%
100%
> $1B $500M - $1B $100M -$500M
$50M -$100M
$10M - $50M $0M - $10M
Dom. Equities Fixed Income Intl. Equities
Short Term Securities/Cash Alternatives Hedge Funds
Allocations by Asset Classes
17.8
7.8 12
.2
10.1
37.6
16.8
11.7
7.2 12
.2
4.7
22.9
14.7
11.5
7.1 11
.0
4.2
0
10
20
30
40
50
DomesticEquities
DomesticBonds
AbsoluteReturn
ForeignEquities
PrivateEquities
Real Assets 10 YearPerformance
Yale ReturnsActive BenchmarkPassive Benchmark
Yale Performance Relative to Benchmarks (10 Years)
Active Benchmarks:Domestic Equity: Frank Russell Median Manager, U.S. EquityFixed income: Frank Russell Median Manager, Fixed IncomeAbsolute Return: CSFB CompositeForeign Equity: Frank Russell Median Manager Composite, Foreign EquityPrivate Equity: Cambridge Associates CompositeReal Assets: NCREIF and Cambridge Associates Composite
Passive Benchmarks:Domestic Equity: Wilshire 5000Fixed income: Lehman Brothers U.S. Treasury IndexAbsolute Return: 1-year Constant Maturity Treasure +6%Foreign Equity: 50% MSCI EAFE Index, 50% MSCI EM IndexPrivate Equity: University Inflation +10%Real Assets: University Inflation +6%
$<1B
–12
.5
$100
M -
500M
–8.
9
Yal
e R
etu
rns
–16
.8
4.6% CAGR Difference Between Domestic Bonds and Absolute Performance.
Asset Allocations
3.53.2Cash18.86.3Real Estates14.55.5Private Equity14.815.6Foreign Equity26.115.1Absolute Return7.417.5Fixed Income
14.836.8Domestic Equity
Yale University
(%)
Educational Institutions
(%)
Sources of Hedge Funds’ $66 billion of Institutional Money – 2003 Q4
Other7%
Private Plans22%
Endowments and
Foundations53%
Public Plans18%
Institutional Investors’ Top Concerns About Hedge Funds
Fees13%
Transparency15%
Headline risk38%
Impact of capital flows on returns
34%
Institutional Investors’ Views on Impact of Capital Flows on Returns
No impact24%
Significantly negative
43%
Slightly negative
33%
What is a Hedge Fund?
• The term "hedge fund" is not formally defined by federal securities laws
• The term usually refers to an investment entity that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act.
The Origin of Hedge Funds
• The first hedge funds appeared in the 1950s, and were characteristically long/short equity funds that engaged in fundamental hedging strategies.
Investors in Hedge Funds
• Hedge funds generally sell interests in private offerings to “accredited investors.”
• Accredited investors are individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth and most institutions with $5 million in assets.
Likely Impact of Registration of Hedge Fund Advisors
• If hedge fund advisers were compelled to register under the Advisors Act– The SEC would be authorized to collect
information about the activities of hedge fund advisers and hedge funds,
– It would increase the minimum investment requirement for direct investments as registered advisers are generally prohibited from charging performance fees unless investors have $750,000 invested with the adviser or have a net worth of $1.5 million.
Hedge Fund Index 10 Yr Returns
Global Macro Distressed Long/Short Equity
Event Driven CSFB/Tremont Hedge Index
15.0
14.0
13.0
12.0
11.0
% Annualized Return (93-04)
5.0
4.5
4.0
3.5
3.0
2.5
% Annualized Std. Dev.
Hedge Fund Index 10 Yr Volatility
Equity MktNeutral
Risk Arb. Multi-Strat.
Convert.Arb.
Fixed Inc.Arb
0.55
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
Beta
Hedge Fund Indices Beta
Emerg.Mkts
CSFB/ Tremont
Hedge Index
Distressed Event Driven
Long/ShortEquity
2.2
2.0
1.8
1.6
1.4
1.2
1.0
Sharpe Ratio
Hedge Fund Indices Sharpe Ratio
Equity Mkt. Neutral
Convt. Arb.
MultiStrat.
Event Driven
Distressed
Flattening Yield Curve
20Y10Y7Y5Y3Y2Y1Y6M3M1M
6
5
4
3
2
1
0
Percent
March 31, 2004
September 30, 2004
March 31, 2005
Examples of Hedge Fund Trades• Long/Short Equity - Preserving Gains:
– Stock A is owned at $5.00 a share and the shares increase in value to $15.00 per share, the fund can preserve its gains and limit its losses by selling the shares and purchasing calls at $17.00 for $2.00. The Fund has therefore locked in an $8.00 profit and limited it’s loss to $2.00.
• Convertible Arbitrage:– Company A’s common stock trades at $10.00 per share; they have
convertible bonds convertible at $10.00 and pay a 6% coupon. – The Convertible Bond Fund Manager purchases $1mm bonds and
sells short $1mm shares at $10.00. – The Fund will now collect the 6% coupon plus the interest on the
short rebate (e.g., a broker rate) of 1.5%.– The manager has generated an annualized return of 7.5%.
Global Futures MarketNotional Amounts
040302010099989796959493929190
20
15
10
5
0
800
600
400
200
0
US$ trillions US$ billions
Interest Rate (L)
Equity Index (R)
Currency (R)
Global Options MarketNotional Amounts
040302010099989796959493929190
25
20
15
10
5
0
140
120
100
80
60
40
20
0
US$ trillions US$ billions
Interest Rate (L)
Equity Index (L)
Currency (R)
Interest RatesFed Funds Rate and the 10-year Treasury
200320022001200019991998199719961995199419931992
10
8
6
4
2
0
Percent
Fed Funds Rate10-Year Government Bond
20042003200220012000
-2.0
-2.5
-3.0
-3.5
-4.0
-4.5
-5.0
130
120
110
100
90
80
70
U.S. Trillions Jan 2000 = 100
Trade Deficit and US Dollar
Yen/Dollar (R)
Euro/Dollar (R)
Cumulative Trade Deficit Since 1985 (L)
$4.8 trillions as of 2004Q3
Lower Dollar, Higher Oil Price
Crude Oil
Trade-weighted dollar
20042003200220012000
200
180
160
140
120
100
80
60
145
136
127
118
109
100
91
82
Jan 2000 = 100 Jan 2000 = 100
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