Chapter 8
Alternative Investments
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Introduction
In this chapter we discuss:
Common features of alternative investments.
Different types of alternative investments.
Risk and return features of alternative investments.
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Alternative Investments — Features
The common features of alternative investments include:
Illiquidity
Difficulty in determining current market values.
Limited historical risk and return data.
Extensive investment analysis required.
A liquidity risk premium
Segmentation risk premium
Alternative assets are assets not traded on exchanges.
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Alternative Investments — 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.
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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.
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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.
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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.
Only management fees can be considered a portfolio management incentive fee.
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Exchange Traded Funds (ETFs)
They are shares of a portfolio, not of an individual company.
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 companies, unit investment trusts and grantor trusts.
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ETFs — Advantages
ETFs have the following advantages:
Diversification
Trading similarly to a stock
Transparency
Cost effectiveness
Management of their risk augmented by futures and options contracts on them.
Avoidance of significant premiums or discounts to NAV
Tax savings from payment of in-kind redemption
Immediate dividend reinvestment for open-end ETFs.
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ETFs — Disadvantages
ETFs have the following disadvantages:
Only a narrow-based market index tracked in some countries
Intraday 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.
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ETFs — Types
ETFs can be grouped under the following categories:
Broad domestic market index
Style
Sector or industry
Country or region
Fixed Income
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ETFs — Risks
Listed are the major risks faced by ETFs:
Market Risk
Asset class/sector risk
Trading Risk
Tracking error risk
Derivatives risk
Currency risk
Country risk
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ETFs — Applications
Following are some suggested applications:
Implementing asset allocation
Diversifying sector/industry exposure
Gaining exposure to international markets
Equitizing cash
Managing cash flows
Completing overall investment strategy
Bridging transitions in fund management
Managing portfolio risk
Applying relative value, long/short strategies
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Real Estate
In many countries, real estate is a common investment vehicle for pension funds and life insurance companies.
Characteristics include:
Each property is immovable
Basically indivisible and unique
Not directly comparable to other properties
Illiquid
Bought and sold intermittently in a generally local marketplace.
High transaction costs and market inefficiencies.
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Forms of Real Estate Investment
There are several forms of real estate investment:
Free and clear equity
Leveraged equity
Mortgages
Aggregation vehicles
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Real Estate — Valuation Approaches
The following four approaches are used worldwide:
The Cost Approach
The Sales Comparison Approach
The Income Approach
The 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.
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Real Estate — Valuation Approaches
Cost Approach:
The cost of replacing the building in its present form.
Sales Comparison Approach:
An adjusted value from a benchmark of comparable sales.
Hedonic price estimate from a regression model
Income Approach:
Capitalized net operating income.
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Real Estate — Valuation Approaches
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.
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Venture Capital — Stages
Venture capital financing is done in many stages:
Seed-stage financing
Early stage financing
Start-up
First-stage
Formative stage financing
Later stage financing
Second-stage
Third-stage
Mezzanine
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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.
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Venture Capital — Characteristics
Some of the characteristics are common to alternative investing, but many are unique:
Illiquidity
Long-term commitment required
Difficulty in determining current market values
Limited historical risk and return data
Limited information
Entrepreneurial/management mismatches
Fund manager incentive mismatches
Lack of knowledge of how many competitors exist
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Venture Capital — Characteristics
Some of the characteristics are common to alternative investing, but some are unique:
Vintage cycles
Extensive operations analysis and advice may be required.
The challenges to venture capital performance measurement are:
The difficulty in determining precise valuations
The lack of meaningful benchmarks
The long-term nature of any performance feedback.
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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.
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Hedge Funds
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 returns
Having a legal structure that avoids some government regulations
Have option-like fees, including a base management fee and an incentive fee proportional to realized profits.
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Hedge Funds
The net performance of a hedge fund can be calculated by subtracting its fees from its gross performance.
Hedge funds can be classified as:
Long/short
Market neutral
Global macro
Emerging market funds
Managed futures funds
Event driven
Distressed securities funds
Risk arbitrage in M&A
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Fund of Funds — Advantages
Availability to the small investor
Access to funds closed to new investors
Diversification
Managerial expertise
Due diligence process
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Fund of Funds — Disadvantages
High fees
Little evidence of persistence performance
Absolute return loss through diversification
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Hedge Funds — Risks
The unique risks include:
Liquidity risk
Pricing risk
Counterparty risk
Credit risk
Settlement risk
Short squeeze risk
Financing squeeze risk.
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Hedge Funds
High leverage is often present in hedge funds as part of the trading strategy. It is an essential part of some strategies in which the arbitrage return is so small that leverage is needed to amplify the part.
The biases present in performance reporting:
Self selection bias
Instant history bias
Survivorship bias on return and risk
Smoothed pricing on infrequently traded assets
Option-like investment strategies
Fee structure-induced gaming
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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.
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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.
Are similar to venture capital investments because they are:
Illiquid
Require a long investment horizon
Require intense investor participation/consulting
Offer the possibility of alpha because of mispricing.
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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.
These give the investors exposure to the commodity components of the country’s production and consumption.
The return on a collateralized futures position comes from the change in the futures price plus the interest income on risk-free government securities.
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Commodity Markets
and Commodity Derivatives
These are attractive to investors because commodities may have negative correlation with stock and bond returns and 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.
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Commodity Markets and Commodity Derivatives — Risks
The risks of managed futures can be managed as follows:
Liquidity monitoring
Through diversification
Volatility dependent allocation
VaR
Risk budgeting on various levels
Limits on leverage
Use of derivatives
Care in model selection
