Efficient versus Inefficient Asset Classes
Another way to distinguish alternative asset classes is based on the efficiency of the market place. The U.S. public stock-and-bond markets are generally considered to be the most efficient marketplaces in the world. Often, these markets are referred to as “Semi-Strong Efficient.” This means that all publicly available information regarding a publicly traded corporation, both past information and present, is fully digested in that company’s traded securities. Yet inefficiencies exist in all markets, both public and private. If there were no informational inefficiencies in the public equity market, there would be no case for active management. Nonetheless, whatever inefficiencies do exist, they are small and fleeting. The reason is that information is easy to acquire and disseminate in the publicly traded securities markets. Top quartile active managers in the public equity market earn excess returns (over their benchmarks) of approximately 1% a year. In contrast, with respect to alternative assets, information is very difficult to acquire. Most alternative assets (with the exception of commodities) are privately traded. This includes private equity, hedge funds, and credit derivatives. The difference between top quartile and bottom quartile performance in private equity can be as much as 25%. Consider venture capital, one subset of the private equity market. Investments in startup companies require intense research into the product niche the company intends to fulfill, the background of the management of the company, projections about future cash flows, exit strategies, potential competition, beta testing schedules, and so forth. This information is not readily available to the investing public. It is time consuming and expensive to accumulate. Furthermore, most investors do not have the time or the talent to acquire and filter through the rough data regarding a private company. One reason why alternative asset managers charge large management and incentive fees is to recoup the cost of information collection. This leads to another distinguishing factor between alternative investments and the traditional asset classes: the investment intermediary. Continuing with our venture capital example, most investments in venture capital are made through limited partnerships, limited liability companies, or special purpose vehicles. It is estimated that 80% of all private equity investments in the United States are funneled through a financial intermediary. Investments in alternative assets are less liquid than their public markets counterparts. Investments are closely held and liquidity is minimal. Furthermore, without a publicly traded security, the value of private securities cannot be determined by market trading. The value of the private securities must be estimated by book value, appraisal, or determined by a cash flow model.
Constrained versus Unconstrained Investing During the great bull market from 1981 to 2000 the asset management industry only had to invest in the stock market to enjoy consistent, high, double-digit returns. During this heyday, investment management shops and institutional investors divided their assets between the traditional asset classes of stocks and bonds. As the markets turned sour at the beginning of the new millennium, asset management firms and institutional investors found themselves “boxed in” by these traditional asset class distinctions. They found that their investment teams were organized along traditional asset class lines and their investment portfolios were constrained by efficient benchmarks that reflected this “asset box” approach. Consequently, traditional asset management shops have been slow to reorganize their investment structures. This has allowed hedge funds and other alternative investment vehicles to flourish because they are not bounded by traditional asset class lines—they can invest outside the benchmark. These alternative assets are free to exploit the investment opportunities that fall in between the traditional benchmark boxes. The lack of constraints allows alternative asset managers a degree of freedom that is not allowed the traditional asset class shops. Furthermore, traditional asset management shops remain caught up in an organizational structure that is bounded by traditional asset class lines. This provides another constraint because it inhibits the flow of information and investment ideas across the organization.
Asset Location versus Trading Strategy One of the first and best papers on hedge funds by William Fung and David Hsieh show a distinct difference between how mutual funds and hedge funds operate. They show that the economic exposure associated with mutual funds is defined primarily by where the mutual fund invests. In other words, mutual funds gain their primary economic and risk exposures by the location of the asset classes in which they invest. Thus we get large-cap active equity funds, small-cap growth funds, Treasury bond funds, and the like. Conversely, Fung and Hsieh show that hedge funds’ economic exposures are defined more by how they trade. That is, a hedge fund’s risk and return exposure is defined more by a trading strategy within an asset class than it is defined by the location of the asset class. As a result, hedge fund managers tend to have much greater turnover in their portfolios than mutual funds.
Asset Class Risk Premiums versus Trading Strategy Risk Premiums Related to the idea of trading strategy versus investment location is the notion of risk premiums. You cannot earn a return without incurring risk. Traditional investment managers earn risk premiums for investing in the large-cap value equity market, small-cap growth equity market, high-yield bond market; in other words, based on the location of the asset markets in which they invest. Conversely, alternative asset managers also earn returns for taking risk, but the risk is defined more by a trading strategy than it is an economic exposure associated with the systematic risk contained within broad financial classes. For example, hedge fund strategies such as con- vertible arbitrage, statistical arbitrage, and equity market neutral can earn a “complexity” risk premium. These strategies buy and sell similar securities expecting the securities to converge in value overtime. The complexity of implementing these strategies results in inefficient pricing in the market. Additionally, many investors are constrained by the long-only constraint—their inability to short securities. This perpetuates inefficient pricing in the marketplace which enables hedge funds to earn a return.
vOVERVIEW OF THIS BOOK
This book is organized into six parts. The first part provides a framework to consider alternative assets within a broader portfolio context. Specifically, in Chapter 2 we expand on the concept of strategic versus tactical asset allocation and the use of beta drivers versus alpha drivers to achieve these goals. The second part of this book reviews hedge funds. Chapter 3 begins with a brief history on the birth of hedge funds and an introduction to the types of hedge fund investment strategies. Chapter 4 provides some practical guidance as to how to build a hedge fund investment program. Chapter 5 is devoted to conducting due diligence, including both a qualitative and quantitative review. In Chapter 6 we analyze the return distributions hedge funds and begin to consider some risk management issues. In Chapter 7 we expand the discussion of hedge fund risks and highlight some specific examples of hedge fund underperformance. In Chapter 8 we review the regulatory framework in which hedge funds operate. Chapter 9 provides an introduction to hedge fund benchmarks and how these benchmarks can impact the asset allocation decision to hedge funds. In Chapter 10, we consider the fees charged by hedge fund managers— a key point of contention between hedge fund managers and their clients. Last, in Chapter 11 we conclude on a humorous note as we go through a top ten list of hedge fund quotes and accompanying anecdotes. Part Three is devoted to commodity and managed futures. We begin with a brief review in Chapter 12 of the economic value inherent in commodity futures contracts. Chapter 13 describes how an individual or institution may invest in commodity futures, including an introduction to commodity future benchmarks. Chapter 14 considers commodity futures within a portfolio framework, while Chapter 15 examines the managed futures industry. See Lars Jaeger, Managing Risk in Alternative Investment Strategies (London: Financial Times/Prentice Hall, 2002). What Is an Alternative Asset Class? Part Four covers the spectrum of private equity. In Chapter 16 we provide an introduction to venture capital, while Chapter 17 is devoted to leveraged buyouts. In Chapters 18 and 19 we show how two different forms of debt may be a component of the private equity marketplace. In Chapter 20 we review the economics associated with private equity investments, and in Chapter 21 we consider some issues with respect to private equity benchmarks. In Chapter 22, we review some new trends in the private equity market place. Part Five is devoted to credit derivatives. In Chapter 23 we review the importance of credit risk, and provide examples of how credit derivatives are used in portfolio management. In Chapter 24 we review the collateralized debt obligation market. Specifically, we review the design, structure and economics of collateralized bond obligations and collateralized loan obligations. In Chapter 25 we consider a new form of asset backed security—the collateralized fund obligation. Finally, we devote Chapter 26 to corporate governance as an alternative investment strategy. Throughout this book we attempt to provide descriptive material as well as empirical examples. In each chapter you will find charts, tables, graphs, and calculations that serve to highlight a specific point. Our goal is both to educate the reader with respect to these alternative investment strategies as well as provide a reference book for data and research. Along the way we also try to provide a few anecdotes about alternative investing that, while providing some humor, also demonstrate some of the pitfalls of the alternative asset universe.
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