Chapter 14


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Chapter 14

  1. 1. Chapter 14 Alternative Assets Portfolio Construction, Management, & Protection , 5e, Robert A. Strong Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
  2. 2. <ul><li>“ It is unusual that something as boring as infrastructure—pipelines, toll roads, electricity transmission lines, and airports—becomes the hot new thing but here it is.&quot; </li></ul><ul><li>Mark Weisdorf, CFA </li></ul><ul><li>Managing Director </li></ul><ul><li> JPMorgan Asst Management </li></ul>
  3. 3. Introduction <ul><li>Rapid recent growth in importance </li></ul><ul><ul><li>Pensions and endowments allocation growth: </li></ul></ul><ul><ul><ul><li>5 percent in 2000 </li></ul></ul></ul><ul><ul><ul><li>10 percent in 2008 </li></ul></ul></ul><ul><li>Five Category Groups </li></ul><ul><ul><li>Infrastructure </li></ul></ul><ul><ul><li>Private Equity </li></ul></ul><ul><ul><li>Hedge Funds </li></ul></ul><ul><ul><li>Commodities </li></ul></ul><ul><ul><li>Specialized Real Estate </li></ul></ul>
  4. 4. Infrastructure Investments <ul><li>Prominent alternative asset </li></ul><ul><ul><li>$3.0 trillion in 2006 </li></ul></ul><ul><li>Typically started under government authority and later sold to private investors </li></ul><ul><ul><li>Eliminates managerial burden </li></ul></ul><ul><ul><li>Raises cash for other societal needs </li></ul></ul><ul><ul><li>“ brownfield projects” </li></ul></ul><ul><li>Sometimes businesses provide originates services that are typically offered by government </li></ul><ul><ul><li>“ greenfield projects” </li></ul></ul><ul><ul><li>e.g., high-speed toll road to Washington D.C.’s airport </li></ul></ul><ul><ul><li>Considered to be more risky </li></ul></ul>
  5. 5. Popular Types of Infrastructure <ul><li>Approximately $3 trillion in 2006, including: </li></ul><ul><ul><li>Toll roads & bridges </li></ul></ul><ul><ul><li>Airports and airport trolley systems </li></ul></ul><ul><ul><li>Railway and ferry systems </li></ul></ul><ul><ul><li>Sporting arenas </li></ul></ul><ul><ul><li>Shipping ports </li></ul></ul><ul><ul><li>Electricity transmission </li></ul></ul><ul><ul><li>Water distribution networks </li></ul></ul>
  6. 6. International Aspect of Infrastructure Investment <ul><li>Infrastructure investments: </li></ul><ul><ul><li>Are also called public/private partnerships </li></ul></ul><ul><ul><li>Are necessary and facilitate economic development </li></ul></ul><ul><ul><li>Are found across the globe </li></ul></ul><ul><ul><ul><li>Canada: $C66 </li></ul></ul></ul><ul><ul><ul><li>India: $150 billion </li></ul></ul></ul><ul><ul><ul><li>Europe: €600 billion </li></ul></ul></ul>
  7. 7. Infrastructure Investment Characteristics <ul><li>Long-life </li></ul><ul><li>Cash flows generally stable and inflation linked </li></ul><ul><li>Significant barriers to entry by competitors </li></ul><ul><li>Provides essential community service </li></ul><ul><li>Few substitutes for service </li></ul><ul><li>Typically are highly levered </li></ul><ul><li>Highly illiquid </li></ul>
  8. 8. Infrastructure Investment Options <ul><li>Direct investment </li></ul><ul><ul><li>Requires enormous capital reserves </li></ul></ul><ul><li>Listed funds </li></ul><ul><ul><li>Most popular investment method by individuals </li></ul></ul><ul><li>Unlisted funds </li></ul><ul><ul><li>Offered through investment banks </li></ul></ul><ul><ul><li>Most popular investment methods by pension funds and institutional investors </li></ul></ul>
  9. 9. Advantages of Infrastructure Investment <ul><li>Annual cash flow stream </li></ul><ul><ul><li>Periodic increases to keep up with inflation </li></ul></ul><ul><li>Private management may provide efficiencies unavailable to government </li></ul><ul><li>Low correlation with other assets </li></ul><ul><ul><li>Too new for many long-term studies </li></ul></ul><ul><ul><li>Australian equities and infrastructure: 0.32 </li></ul></ul><ul><ul><ul><li>Zero correlation between non-Australian equities and Australian infrastructure </li></ul></ul></ul>
  10. 10. Hedge Funds <ul><li>No single definition </li></ul><ul><li>Common characteristics </li></ul><ul><ul><li>Low-correlation focused investment funds </li></ul></ul><ul><ul><li>Relatively few investors </li></ul></ul><ul><ul><li>Substantial minimal initial investment </li></ul></ul><ul><ul><li>Investors are limited partners </li></ul></ul><ul><ul><ul><li>Hedge fund is general partner </li></ul></ul></ul><ul><ul><ul><li>The unlimited liability of general partner is used to justify management fees and large proportion of profits </li></ul></ul></ul><ul><ul><ul><li>Consistency of return is typical investment objective </li></ul></ul></ul>
  11. 11. Hedge Fund Demographics <ul><li>Total number of funds is unknown </li></ul><ul><li>Only hedge funds with $30 million in assets or over 15 investors must register with SEC </li></ul><ul><li>Hedge funds publicize success, biasing perceptions in favor of hedge fund investment </li></ul><ul><li>Alfred Jones started first hedge fund in 1949 </li></ul><ul><ul><li>- used short positions to offset risk of equity positions </li></ul></ul><ul><li>In 2008: </li></ul><ul><ul><li>$2 trillion dollars invested </li></ul></ul><ul><ul><li>44% held by individuals </li></ul></ul>
  12. 12. Hedge Fund Classifications <ul><li>Nondirectional/Directional Strategy </li></ul><ul><ul><li>Anticipated changes in the underlying market does not impact choices in nondirectional strategies </li></ul></ul><ul><li>Arbitrage/Relative Value strategy </li></ul><ul><ul><li>Assumes the “mispriced” securities will move towards their normal relationship </li></ul></ul><ul><ul><li>Merger arbitrage may result in selling shares of acquiring firm and buying those of acquired firm </li></ul></ul><ul><ul><li>Convertible arbitrage may result in selling shares and buy convertibles bonds to earn interest income </li></ul></ul><ul><ul><ul><li>“ may” because one has to consider current price and perceived value of both positions </li></ul></ul></ul>
  13. 13. 130/130 Strategy <ul><li>A long/short strategy </li></ul><ul><ul><li>Buying undervalued stocks and selling overvalued stocks </li></ul></ul><ul><li>Within a given portfolio, sell short the 30% considered to be overvalued and invest the proceeds in the 30% considered to be undervalued. </li></ul><ul><li>For every $1 originally invested, there now is another $0.60 worth of positions taken </li></ul><ul><ul><li>The proportions could be any number greater than 100 </li></ul></ul><ul><ul><ul><li>110/110 or 120/120, but not 120/110 </li></ul></ul></ul>
  14. 14. Hedge Fund-of-Funds <ul><li>Portfolio of hedge funds </li></ul><ul><li>Lower initial investment than individual funds </li></ul><ul><li>Higher management fees </li></ul><ul><ul><li>Pay fees to fund managers and Fund-of-fund managers </li></ul></ul>
  15. 15. Commodities <ul><li>Now a widely-used investment class </li></ul><ul><li>Primary advantage: Low correlation with equity investments </li></ul><ul><ul><li>Over 1994-2008 period, the correlation with the Wilshire 5000 Index has been between 0.02 and 0.10, depending on index </li></ul></ul><ul><li>Primary disadvantage: Returns typically do not outpace inflation </li></ul><ul><ul><li>May outpace inflation during short periods </li></ul></ul><ul><ul><li>In 2008: Oil and wheat hit record high prices </li></ul></ul>
  16. 16. Commodities (cont’d) <ul><li>Some institutional investors use futures markets </li></ul><ul><li>Seek price gain, not the commodity itself </li></ul><ul><li>Others invest in farmland, almond groves, and vineyards where assets will be produced </li></ul><ul><li>“Price bubbles” </li></ul><ul><ul><li>Farmland, ethanol, and all commodities </li></ul></ul>
  17. 17. Private Equity <ul><li>Acquisition of a significant portion of a company, develop the company’s value, and sell it to the investment community </li></ul><ul><ul><li>There always is a clear exit strategy consisting of receiving cash </li></ul></ul><ul><li>Unlike the entrepreneur, and private equity investor has a target selling date </li></ul><ul><ul><li>Both are willing to put forth the time and effort needed to influence corporate decisions </li></ul></ul>
  18. 18. Private Equity Investments in 2006 61% 8.4% Endowment Funds 36% 4.4% Corporate Funds Expect a Significant Increase in Allocation over 2007-2009 period Private Equity Portfolio Allocation
  19. 19. Forms of Private Equity <ul><li>Venture Capital </li></ul><ul><ul><li>New companies or new ideas </li></ul></ul><ul><ul><ul><li>High revenue growth, limited net income </li></ul></ul></ul><ul><li>Corporate Finance/Buyout </li></ul><ul><ul><li>Established firm investment </li></ul></ul><ul><ul><ul><li>Help them take advantage of competitive advantage </li></ul></ul></ul><ul><li>Mezzanine Financing </li></ul><ul><ul><li>Provision of second-mortgage financing </li></ul></ul><ul><ul><ul><li>May convert to equity </li></ul></ul></ul><ul><li>Distressed Firm Financing </li></ul><ul><ul><li>Cash infusion when firm is unable to make debt payments </li></ul></ul>
  20. 20. J Curve <ul><li>Pattern of returns from private equity investment to cash event </li></ul><ul><li>Typically lose money in first four or five years </li></ul><ul><li>Eventually, return turns positive, resulting in annual returns in the 25 percent range </li></ul><ul><li>Over 1992-2007 period, the U.S. venture capital market earned a 19.65 percent annualized rate of return </li></ul><ul><ul><li>The S&P 500 earned 11.19% over the same period </li></ul></ul><ul><li>Given the risks, it is wise to own a “portfolio” of private equity investments! </li></ul>
  21. 21. Opportunistic Real Estate <ul><li>High-risk, developed property investment </li></ul><ul><ul><li>Generally have a specific purpose </li></ul></ul><ul><ul><li>Examples include golf courses, churches, bowling alley, hotels, student housing projects, single-family homes </li></ul></ul><ul><li>Opportunistic real estate opportunities may arise from: </li></ul><ul><ul><li>Severe regional economic conditions (bankruptcy of city’s primary employer) </li></ul></ul><ul><ul><li>Natural disasters (Hurricane Katrina) </li></ul></ul><ul><ul><li>Systematic problems (Subprime mortgage problems) </li></ul></ul><ul><li>Opportunistic real estate investors focus more on price appreciation </li></ul><ul><ul><li>Income streams are smaller, more volatile, and inconsistent </li></ul></ul><ul><ul><li>Traditional real estate investors are more concerned with current income </li></ul></ul><ul><li>Less than 1 percent of public institutional investment assets </li></ul>