lecture 5

Question 1

 Alternative Investments

Answer 1

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

Question 2

 Gearing

Answer 2

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

Question 3

o Positive geared

Answer 3

 Rent received covers costs e.g. profitable

 Excess income is taxed at the marginal tax rate

Question 4

o Negative geared

Answer 4

 Costs are greater than the rental received

 Loss can be claimed as a tax deduction to offset your income tax payable

Question 5

 Benefits of gearing

Answer 5

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

Question 6

 Risks of gearing

Answer 6

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

Question 7

 Gearing ratio

Answer 7

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

Question 8

 Loan to valuation Ratio

Answer 8

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

Question 9

 Margin Lending – what can go wrong?

Answer 9

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

Question 10

 How to manage LVR

Answer 10

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

Question 11

 If you go over your LVR

Answer 11

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?

Question 12

 Alternative Assets

Answer 12

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

Question 13

 Is there an illiquidity premium?

Answer 13

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

Question 14

 Alternative assets – what to look out for

Answer 14

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?

Question 15

 Endowment Funds

Answer 15

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.

Question 16

 Lessons from endowment funds

Answer 16

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?

Question 17

 Agribusiness in Australia

Answer 17

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

Question 18

 Agribusiness – What to look out for

Answer 18

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

Question 19

 Agribusiness – What can go wrong?

Answer 19

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%

Question 20

 Absolute return strategies

Answer 20

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

Question 21

 Benefits of absolute return strategies

Answer 21

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

Question 22

 ARS – What to look out for

Answer 22

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