Analyse alternative investments Flashcards
Intro: , what they are and their properties
Alternative assets, by their nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management, these inefficiencies can enhance returns and will reduce the risk through diversification. However, these investments are less regulated and can be illiquid at times meaning an investor cannot simply exit out of them whenever they please.
Another important aspect of private equity that defines it as a unique investment category is that it is not perfectly correlated with the other traditional asset classes (U.S. and non-U.S. stocks, U.S. bonds) or alternative asset classes
investment risk is worth the reward.
Hedge Fund charateristics
Unregulated
Managers can employ leverage through futures, options and repurchase agreements and charge performance-based fees.
Low correlation with equity market allowing for diversification benefits
Limited partnerships – with restricted withdrawals (investors are private, banks, pension funds and insurance companies.)
Rarely are limited partners given a list of portfolio holdings
Trading strategies
Directional Trading: based on speculation of market direction in multiple asset classes. Both model-based systems and subjective judgment are used to make trading decisions.
Relative Value: focus on spread relationships between pricing components of financial assets. Market risk is kept to a minimum. Many managers use leverage to enhance returns.
Specialist Credit: based on credit sensitive securities. Funds in this strategy conduct high due diligence to identify relatively inexpensive securities.
Stock Selection: combine long and short positions, primary in equities, to exploit under and overvalued securities. Market exposure can vary substantially.
“A risk-neutral manager can be endogenously risk-averse and decrease leverage following poor-performance
Equity market neutral strategies
However, equity market neutral strategies also attempt to limit the fund’s overall volatility exposure by taking offsetting risk positions on the long and short side, which might involve derivative positions. Absent leverage, these portfolios are expected to produce returns of 2 to 4 percent above the risk-free rate, which has led some investors to refer to them as absolute return strategies.
10,000 active funds managing $3 trillion in 2016
What is private equity
Ownership interest in an asset that is not traded publicly on the market
Fund new or established firms looking to change their organizational structure or have financial problems.
Considered long-term positions due to illiquid nature
Higher return high risk but good source of diversification, more volatile as shown by high standard deviation.
The majority of private equity activity involves leveraged buyouts of established profitable and cash generative companies with solid customer bases, proven products and high-quality management.
Return pattern and Alpha
Alpha – how well the stock outperformed the benchmark
Partners at PE firms must generate substantial aplha to compensate investors for risk, fees management etc. Yang finds that on average investors may just break-even net of costs associated with PE.
The return pattern known as the “J-curve effect”
― Average annual returns for these investments tend to be quite high over time ― The initial years of a new private equity commitment usually produce negative returns
Firs years of private equity
the initial years of a new private equity commitment usually produce negative returns. This is because the organizational expenses incurred by the fund’s general partner are drawn from invested capital, as well as the fact that the less-successful investments in the portfolio tend to be recognized quickly and written down. However, as the better-performing investments increase in value over time and are sold at a profit, the returns to the private equity fund tend to increase dramatically.
Real estate
Includes private commercial RE equity (e.g. ownership of a building), private commercial RE debt (e.g. directly issued loans or mortgages on commercial property), public RE equity (e.g. REITs), and public RE debt investments (e.g. mortgage-backed securities)
Pro and cons of real estate
Offers steady income
Offers capital appreciation
Diversifies portfolio
Can be bought with leverage
Cons
Is usually illiquid
Influenced by highly local factors
Requires big initial capital outlay
May require active management and expertise
How to invest in REIT
The most popular way to invest in a REIT is to buy shares that are publicly traded on an exchange. The shares trade like any other security traded on an exchange such as stocks and makes REITs very liquid and transparent. Income from REITs is earned through dividend payments and appreciation of the shares.
Why alternative assets
Morgan Stanley have stated that over the last 25 years having an allocation to alternatives has enhanced returns and reduced risk for investors.
Most alternative investment teams have thorough due diligence that requires heavy quantitative analysis, business and operation review the approval of funds then ongoing investment and operation monitoring.
Venture Capital
typically involves investing in or providing financing to start up or early-state companies with high growth potential and represents a small portion of the private equity market.
Interests are growing
Growth of investment from endowment funds focusing on long term view
Disenchantment with public markets (agency problem, diversified naïve investors, increased costs, regulation, etc.)
Black Rock
A traditional “60/40” allocation to equities and bonds may no longer be enough to meet long-term investment goals. Alternatives can help to lower volatility, enhance returns and broaden diversification of a portfolio
Private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020
Alpha
Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole.”
Alpha ratio is useful to determine excess returns on an investment. Beta ratio shows the correlation between the stock and the benchmark that determines the overall market, usually the Standard & Poor’s 500 Index. Sharpe ratio helps determine whether the investment risk is worth the reward.
