lecture 5 Flashcards
Alternative Investments
o Provide exposure to securities whose performance is not highly correlated with traditional stocks and bonds
E.g. Commodities, global real estate
o Alternative strategies provide exposure to managers who invest in stocks and bonds in non-traditional ways
E.g. absolute return strategies, gearing
o Investors can acquire alternative assets strategies directly and indirectly
Gearing
o Use of borrowed money to invest in assets (will increase in capital value)
o Provides a means of diversification
o Suitable for people with: Aggressive risk profiles Strong, secure cash flows Higher incomes Long term investment horizon – need to be able to survive short term volatility
o A margin loan is secured against the value of the shares being purchased
Daily fluctuations in value of stocks / managed funds changes risk of loan
o Interest expense on a loan for investing in income producing assets will be a deductible expense
o Positive geared
Rent received covers costs e.g. profitable
Excess income is taxed at the marginal tax rate
o Negative geared
Costs are greater than the rental received
Loss can be claimed as a tax deduction to offset your income tax payable
Benefits of gearing
o Expanded opportunities for portfolio exposure
Diversified therefore volatility is reduced
o Tax benefits
Interest payments / other claimed as deductions against taxable income
o Magnify gains
Net gains from investments outweighs costs of borrowing
Risks of gearing
o Magnify losses potentially
E.g. more money to play with, more money to use
o Assets prices drop and/or market moves
unfavourably
o Ability to service debt impacted by changes to income / interest rates
o Only works with growth assets
o Additional costs will be incurred (brokerage, lender fees and charges)
o May need to have full personal insurance
o Need to be fairly liquid
o Involves frequent and careful monitoring
Gearing ratio
o Amount of debt in relation to current market value of asset purchased with debt
o Gearing ratio = borrowed funds/investor’s contribution
o Investors contribution = MV of asset – borrowed funds
Loan to valuation Ratio
o Set at beginning of loan -> change as market value of portfolio changes
o Amount of debt expressed as % of the total asset value
o LVR = Borrowed funds / Asset Valuation
o Need to stay around the set figure
Margin Lending – what can go wrong?
o Debt x debt
Taking out a margin loan and a home loan to invest in index funds
o Centralized control – no individual planning by advisers
o One size fits all – similar SOAS: Not consistent with S945
How to manage LVR
o Don’t borrow too much
o Ensure underlying assets are diversified
o Make regular interest payments
o Re-invest income from investments or use It to pay off interest rather than withdrawing
If you go over your LVR
o Will receive a margin call
o Give the lender more security e.g. buy more shares or add other shares
o Pay off the loan
With cash or by selling shares
Is it a good time to sell?
Alternative Assets
o E.g. hedge funds, private equity, infrastructure and commodities
o Excess returns
Liquidity?
Or tend to have high levels of unsystematic risk?
o Uncorrelated with mainstream asset classes of shares and bonds
Diversified
o Reduce risk exposure
Is there an illiquidity premium?
o Difficult to isolate illiquidity premium from other risk premia
o Voluntary nature of hedge fund reporting
o Risk of illiquid assets is difficult to measure
Return profiles of alternatives are not normally distributed
Standard deviation is poor measure
o Who undertakes valuation of assets
Alternative assets – what to look out for
o Reduce diversifiable risk but exposes investors to other risks
Operational (different structural issues / tax issues)
Governance (variance in governance structure)
liquidity disclosure risks (not representative and transparency is not as vigilant)
o Valuation risk
Valuation method which gives them the best value
Infrastructure is valued by an independent valuer
Is there a lag in valuation?
Where does the market data come from, and what is the coverage?
Endowment Funds
o Non-taxable vehicles established to contribute towards the future funding requirements of the university
Come from legacies, gifts and investment returns
Long-term investment horizon
U.S. endowment funds hold 54% in alternative assets
o Keys to success
Careful in-terms of management (person is poached and picking exports)
Performance based pay
Avoid funds of funds – don’t know who the underlying investment manager is
Focus on ‘equity like’ asset classes (e.g. liquidity from illiquid assets)
• Bond’s pay interest, real estate produces rent, e.g.
Lessons from endowment funds
o For long term investments
Superannuation funds, SMSF’S
o How do you determine which asset classes are the least efficiently priced?
o Do you have the resources/ skills to monitor fund managers?
Agribusiness in Australia
o Alternative strategy and asset known as an inflation alternative
Hedge against inflation since food prices are linked to inflationary trends
o Opportunities
Grains, beef, dairy, trees, olives, almonds
o Tax benefits
R&D tax incentives
o Diversification
o Less impacted by economic slowdowns (food is relatively inelastic to income)
o Invest directly via agricultural assets (land, livestock, crops)
o Indirectly via managed funds
MF’s provide liquidity benefits but correlated with equity markets
Agribusiness – What to look out for
o Funds can use a broad definition of agricultural stocks depending on use of SICS, GICS, NAICS
o Don’t need 100% in agribusiness fund to be diverse
o Exposed to other risks
Drought, bests, disease, fire, political risks, commodity price volatility
Agribusiness – What can go wrong?
o Great southern founded in 1987
o Prior to collapse lost 2.2b
Lack of independence and expertise of the agricultural experts
Reliance on tax benefit as main selling point
When ATO changed the tax treatment, investor interest fell
Commission was up to 10%
Absolute return strategies
o Have different return and risk profile
o Independent from traditional benchmark indexes
o Have flexibility to seek to protect capital during bear markets
Not constrained to particular asset classes
o Focus in generating a positive risk-adjusted return stream over time
Benefits of absolute return strategies
o Traditional benchmarks constrain the investment universe that a fund manager can work with
No restriction -> a fund manager can effectively address bear market risk
o E.g. A portfolio manager whos mandate is to stay fully invested in the asset class, will not be able to avoid a negative result
o ARS can be added to a portfolio of traditional funds
Improve diversification
Allow for overall reduction in risk
ARS – What to look out for
o Reputation of fund manager (skills and experience)
o Institutional risk management controls and procedures
o Alignment of interests – performance based pay
Two and twenty – performance rather than FUM
Calculation period – longer the better to reward
long-term performance rather than short term gains
Target/trigger/hurdle/water mark
• Is the trigger relative or absolute?
• If trigger is 8% and fund return 10%, performance fees are payable on full 10% as trigger is met
• Hurdle same, payable is 2%
o Transparency
Taken with grain of salt
Chosen information reported
