FINANCIAL AND INVESTMENT INSTRUMENTS. Lecture 8: Alternative Investments

Transcription

1 FINANCIAL AND INVESTMENT INSTRUMENTS Lecture 8: Alternative Investments AIMS After this session you should Know the characteristics & properties of mutual funds/unit trusts Know the characteristics & properties of closed-end funds/investment trusts Know the meaning of Net Asset Value Appreciate the general performance of investment companies Know the characteristics & properties of Exchange Traded Funds Know the different types of venture capital Know the characteristics & properties of hedge funds Know the properties of real estate as an asset class Know the properties of commodities as an asset class Required Reading: Investment Analysis and Portfolio Management, 7th edition, Frank K. Reilly and Keith C. Brown (Thomson South-Western, 2003): Chapters 17, Solnik, B. and D. McLeavey (2003), International Investments, 5th ed, Addison Wesley Chapter 8

2 Alternative investments This is a miscellaneous category of investment instruments which includes anything other than equities, bonds or derivatives. In order to increase returns and benefit from diversification fund managers are increasingly interested in a wider set of investment instruments. These alternative investments have a number of similar features: a) Relatively illiquid; b) Uncertainty about current market value; c) limited historical data/information; and d) extensive investment analysis required. Investment companies Pooled investment vehicles are of two types: Mutual funds and closed-end funds Mutual Funds/Unit trusts A mutual fund or unit trust is a type of investment company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities A mutual fund/unit trust is an open ended collective investment. It is open ended because the number of 'units' in each trust will vary according to supply and demand. It is collective because it puts together the money from many different investors for a professional investment manager to manage. Investors buy and sell shares in the mutual fund from the fund itself (or through a broker), rather than through stock exchange. The price that investors pay for mutual fund shares is the fund s per share net asset value (NAV) plus any shareholder fees that the fund imposes at purchase (such as sales loads). Mutual fund shares are "redeemable." This means that when mutual fund investors want to sell their fund shares, they sell them back to the fund at their approximate NAV, minus any fees the fund imposes at that time (redemption fees). When investors buy shares in mutual funds, the fund manager will use the money given to them by unit holders to buy additional securities Mutual funds generally sell their shares on a continuous basis, although some funds will stop selling when, for example, they become too large (Fidelity Magellan) Mutual funds come in many varieties. For example, there are index funds, stock funds, bond funds, money market funds, and more. Each of these may have a different investment objective and strategy and a different investment portfolio. Different mutual funds may also be subject to different risks, volatility, and fees and expenses. All funds charge management fees for operating the fund. Some also charge for their distribution and service costs. Some funds may also impose sales charge or loads when you purchase or sell fund shares. In this regard, a fund may offer different "classes" of shares in the same portfolio, with each class having different fees and expenses.. Charges may be 5% or more at the outset. There is then an annual management fee, typically 1% to 1.5%. A minority of funds have no initial charges, but slightly higher annual charges.

3 Evidence on performance of mutual funds Malkiel (1995)

4 Closed-End Funds/Investment Trusts Closed-End funds or Investment Trusts are companies which invest in the shares of other companies. Like mutual funds/unit trusts, they are collective investments which pool together the money of many investors. This money is then invested in a portfolio (or wide range) of companies which will be more varied than the small investor could achieve on his own. Closed-end funds generally do not continuously offer their shares for sale. Rather, they sell a fixed number of shares at one time (in the initial public offering), after which the shares typically trade on a stock exchange or secondary market The price of closed-end fund shares that trade on a secondary market after their initial public offering is determined by the market and may be greater or less than the shares net asset value (NAV). The price of investment trust shares depends on two factors. The value of the investments held by the trust - the so called 'net asset value' (NAV). The other main determinant of the price of the shares is 'demand and supply'. If an investment trust is in demand (perhaps because investors believe the fund manager is a whizz kid who will double investors money), then the share price may be above the 'net asset value' NAV. In many cases however, Investment Trusts trade at a discount to their 'net asset value' (NAV).

5 Closed-end fund shares generally are not redeemable. That is, a closed-end fund is not required to buy its shares back from investors upon request. Some closed-end funds, commonly referred to as interval funds, offer to repurchase their shares at specified intervals. The investment portfolios of closed-end funds generally are managed by professional fund managers Closed-end funds also are permitted to invest in a greater amount of "illiquid" securities than mutual funds. (An "illiquid" security generally is considered to be a security that can t be sold within seven days at the approximate price used by the fund in determining NAV.) Because of this feature, funds that seek to invest in markets where the securities tend to be more illiquid are typically organized as closed-end funds. Closed-end funds come in many varieties. They can have different investment objectives, strategies, and investment portfolios. They also can be subject to different risks, volatility, and fees and expenses. Net Asset Value "Net asset value," or "NAV," of an investment company is the company s total assets minus its total liabilities. For example, if an investment company has securities and other assets worth $100 million and has liabilities of $10 million, the investment company s NAV will be $90 million. Because an investment company s assets and liabilities change daily, NAV will also change daily. NAV might be $90 million one day, $100 million the next, and $80 million the day after. Mutual funds and Unit Investment Trusts (UITs) generally must calculate their NAV at least once every business day, typically after the major U.S. exchanges close. A closedend fund, whose shares generally are not "redeemable" that is, not required to be repurchased by the fund is not subject to this requirement. An investment company calculates the NAV of a single share (or the "per share NAV") by dividing its NAV by the number of shares that are outstanding. For example, if a mutual fund has an NAV of $100 million, and investors own 10,000,000 of the fund s shares, the fund s per share NAV will be $10. Because per share NAV is based on NAV, which changes daily, and on the number of shares held by investors, which also changes daily, per share NAV also will change daily. Most mutual funds publish their per share NAVs in the daily newspapers. A mutual fund's net asset value its price per share. If you see a fund NAV as $14, then you can expect to buy the fund for $14 or sell it for $14. Since mutual funds hold a number of securities, the net asset value must be calculated at the end of day on a daily basis (as opposed to stocks that change prices by the second). NAVs are helpful in tracking a mutual fund's price movement, but NAVs are not the best way to keep track of performance. This is because of mutual fund distributions. Mutual funds are forced by

6 law to distribute at least 90% of its' realized capital gains and dividend income each year. When a fund pays out this distribution, the NAV drops by the amount paid. This is important because an investor may become frightened when they see their fund's NAV drop by $3 even though they haven't lost any money (the $3 was paid out to the shareholder). For a better understanding of mutual fund distributions, click here. Exchange-Traded Funds (ETFs) There are some investment companies, known as exchange-traded funds or ETFs, which are legally classified as open-end companies or UITs. An exchange-traded fund, or ETF, is a type of investment company whose investment objective is to achieve the same return as a particular market index. An ETF is similar to an index fund in that it will primarily invest in the securities of companies that are included in a selected market index. An ETF will invest in either all of the securities or a representative sample of the securities included in the index. For example, one type of ETF, known as Spiders or SPDRs, invests in all of the stocks contained in the S&P 500 Composite Stock Price Index. ishares recreate indexed positions in various global markets. Exchange Traded funds are depository receipts (like ADRs), in which a bank or financial institutions buys a basket of securities (perhaps mimicking a particular index), and then issuing share certificates against these assets. ETFs differ from traditional open-end companies in the following respects: ETFs do not sell individual shares directly to investors, and only issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as "Creation Units." Investors generally do not purchase Creation Units with cash. Instead, they buy Creation Units with a basket of securities that generally mirrors the ETF s portfolio. Those who purchase Creation Units are frequently institutions. After purchasing a Creation Unit, an institution often splits it up and sells the individual shares on a secondary market. This permits other investors to purchase individual shares (instead of Creation Units). Investors who want to sell their ETF shares have two options: (1) they can sell individual shares to other investors on the secondary market, or (2) they can sell the Creation Units back to the ETF. In addition, ETFs generally redeem Creation Units by giving investors the securities that comprise the portfolio instead of cash. So, for example, an ETF invested in the stocks contained in the Dow Jones Industrial Average (DJIA) would give a redeeming shareholder the actual securities that constitute the DJIA instead of cash. Because of the limited redeemability of ETF shares, ETFs are not considered to be and may not call themselves mutual funds. Advantages of Exchange Traded Funds Being similar to stocks, exchange traded funds offer more flexibility than your typical mutual fund. ETFs can be bought and sold throughout the trading day, allowing for intraday trading - which is rare with mutual funds. Traders have the ability to short or buy ETFs on margin.

7 Low annual expenses rival the cheapest mutual funds. Disadvantages of ETFs Commissions - like stocks, trading exchange traded funds will cost you. Only institutions and the extremely wealthy can deal directly with the ETF companies (must buy through a broker). Unlike mutual funds, ETFs don't necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolios. Slippage - as with stocks, there is a bid-ask spread, meaning you might buy the ETF for 15 1/8 but can only sell it for 15 (which is basically a hidden charge). Venture Capital Venture capital involves an equity stake in a start-up or relatively young company, which is not listed on a stock market. Venture capital is associated with the private-equity market, but a venture capitalist would typically not only involve supplying equity finance, but would also monitor and advise the start-up company. A venture capitalist is a financial intermediary who would typically raise funds from private equity investors, and then invest these funds in a limited number of start-up companies. The companies would be regularly monitored by the VC and the VC may have a seat of the company s board of directors. The aim of the VC is to ultimately exist the company via a listing on a stock exchange Stage/type of venture capital investment Seed To allow a business concept to be developed, perhaps involving the production of a business plan, prototypes and additional research, prior to bringing a product to market and commencing large-scale manufacturing. Only a few seed financings are undertaken each year by private equity firms. Many seed financings are too small and require too much hands-on support from the private equity firm to make them economically viable as investments. There are some specialist private equity firms which are worth approaching, subject to the company meeting their other investment preferences. Business angel capital should also be considered, as with a business angel on a company s board, it may be more attractive to private equity firms when later stage funds are required. Start-up To develop the company s products and fund their initial marketing. Companies may be in the process of being set up or may have been trading for a short time, but not have sold their product commercially. Although many start-ups are typically smaller companies, there are an increasing number of multi-million pound start-ups. Around half of BVCA members will consider high quality and generally larger start-up propositions. However, there are those that specialise in this stage, subject to the company seeking investment meeting the firm s other investment preferences. Around 15%of companies receiving private equity each year are start-ups.

8 Other early stage To initiate commercial manufacturing and sales in companies that have completed the product development stage, but may not yet be generating profits. This is a stage that has been attracting an increasing amount of private equity over the past few years, accounting for around 20%of the number of financings each year by BVCA members. Expansion To grow and expand an established company. For example, to finance increased production capacity, product development, marketing and to provide additional working capital. Also known as development or growth capital. More UK companies at this stage of development receive private equity than any other, generally accounting for around 50%of financings each year by BVCA members. Management buy-out (MBO) To enable the current operating management and investors to acquire or to purchase a significant shareholding in the product line or business they manage. MBOs range from the acquisition of relatively small formerly family owned businesses to 100 million plus buy-outs. The amounts concerned tend to be larger than other types of financing, as they involve the acquisition of an entire business. They tend to account for around 15%of financings undertaken each year by BVCA member companies. Management buy-in (MBI) To enable a manager or group of managers from outside a company to buy into it. Buy-in management buy-out (BIMBO) To enable a company s management to acquire the business they manage with the assistance of some incoming management. Institutional buy-out (IBO) To enable a private equity firm to acquire a company, following which the incumbent and/or incoming management will be given or acquire a stake in the business. This is a relatively new term and is an increasingly used method of buy-out. It is a method often preferred by vendors, as it reduces the number of parties with whom they have to negotiate. BVCA Report on Investment Activity 2003 Summary of results Private equity investments reached a total of 6.4 billion in 2003, an increase of 16% over 2002, with the number of companies financed reaching almost 1,500 similar to 2002 levels. The technology sector showed encouraging growth with a 50% increase in the amount invested to 0.8 billion. Just under half of all companies invested in were in the technology industries. Fund raising also showed an increase of 14% to 8.9 billion, with more than two-thirds of the funds coming from overseas sources. The vast majority of funds are aimed at management buy-outs.

9 Highlights Worldwide investment In 2003 investments were made in 1,493 companies worldwide compared to 1,459 in 2002, an increase of 2%. Worldwide investment by UK private equity firms increased 16% in 2003 to 6,357 million from 5,466 million in The average financing across all stages of investment increased to 4.3 million in 2003 from 3.8 million in In the UK alone, the number of companies financed increased by 7% to 1,274, although investment in the UK decreased by 9% in 2003 to 4,074 million from 4,480 million in The UK now represents just 64% of the total amount invested, down from 82% in Investment in overseas companies more than doubled in 2003 to 2,283 million from 986 million in 2002, although the number of companies financed overseas fell 17% to 219. Investment in the USA increased five times to 292 million. Investment in Continental Europe more than doubled to 1,972 million. 70% of the amount invested overseas was at the MBO/MBI stages, up from 65% in 2002, whilst total early stage fell from 11% to 4%. The expansion stages increased to 26% from 24%. UK investment The number of companies financed at the start-up stage increased 12% to 185 from 165 in 2002, representing 2% of the total investment amount at 73 million, down from 99 million in The average start-up financing was 0.4 million in 2003, compared to 0.6 million in Investment in other early stage companies fell just 3% to 190 million from 196 million in The number of companies financed at this stage increased from 233 to 242. The average financing at this stage was 0.8 million, the same as in Over half of all companies backed were in the total expansion stage category. These are businesses that required funds for working capital, new plant, acquisitions, etc. Excluding those that also benefited from secondary purchases and the refinancing of bank debt, 582 companies were financed, up by 2% from the 568 financed in Expansion stage investment fell by 57% to 477 million in 2003 from 1,118 million in The average amount received by an expanding company fell from 2.0 million in 2002 to 0.8 million in Secondary purchase investments increased by 48% to 344 million in 49 companies and refinancing bank debt investments increased 92% to 46 million in 14 companies. The amount invested in management buy-outs (MBOs) decreased 10%, with 2,395 million invested in 2003, compared to 2,659 million invested in The number of companies financed at this stage increased to 168 companies from 150 companies in This gives an average MBO financing of 14.3 million, compared to 17.7 million in The number of management buy-ins (MBIs) in the UK increased by 17% (34 companies) with 549 million invested, up 3 ½ times from 2002, giving an

10 average MBI financing of 16.1 million compared to just 5.2 million in Overall UK VC Performance by Investment Stage (Current Year & Longer Term Return (% p.a.)) No. of Funds 2003 Three Years Five Years Ten Years Early Stage Development Mid MBO Large MBO Generalist Total UK Non-UK Technology Non-Technology Comparable Indices FTSE-All Share FTSE Small Cap Source BVCA 1002 Real Estate/Property Real estate investments include land, buildings, warehouses, offices, car-parks, retail space and represent a tangible investment. Arts, antiques, timber are other tangible investments. There are several forms of real estate: a) free and clear equity (full ownership rights); leveraged equity, which includes ownership rights but subject to a debt (mortgage); c) Mortgage Loans are a type of debt instrument. A mortgage is a pledge of real estate ownership rights to another party as security for debt owed to that party. Investors can invest in mortgages, and in the event of default, the investor would acquire the property being mortgaged; d) Aggregation vehicles are open-ended or closed-end investment vehicles designed specifically for investments in real estate. Real Estate characteristics are that is it immoveable, and of limited divisibility: it is unique ; Because of its uniqueness, properties are only approximately comparable with other properties; real estate investments are illiquid, due to their immobility and indivisibility; properties are sold locally or regionally, rather than nationally or internationally. Transactions costs are high. Valuing Real Estate: Three Approaches 1) Replacement cost approach. How much would it cost to replace the building in its present form? However need to appraise the value of the land, and the market value of a building could differ from its construction costs, because of local externalities. 2) Sales Comparison Approach. Market value is estimated relative to a comparable property somewhere else. Hedonic price estimation imputes a rating on various property characteristics.

11 3) Income Aproach. Estimates the value of the property by assessing the annual rental income that could be obtained in perpetuity. The appropriate discount rate may be obtained from a similar property s income stream and market value. Hedge Funds Private equity is only one of several different types of alternative asset class, alongside others including hedge funds. Hedge funds use a variety of investment strategies to seek to exploit inefficiencies in markets, and according to some estimates have grown in number from as few as 300 in 1990 to anything up to 5,000 today, managing some $200 billion to $400 billion. A hedge fund is effectively an unregulated investment pool which may invest variously. Because they are free from regulatory and disclosure requirements and often small hedge funds can be extremely flexible in their investment options and change their portfolio faster than larger regulated vehicles. Hedge fund investing originally involved managers taking positions in individual securities which were either long or short on the basis of their views on the valuation of that security. Because these funds took long and short positions in individual securities, they were able to hedge market risk. But over the years the term hedge fund has come to encompass a wide variety of alternative investment strategies. Taxonomy of hedge fund strategies Trading strategies (based on speculation about market direction in multiple asset classes). Relative value strategies arbitrage focused on the spread relationships between pricing components of financial assets (may involve minimal market risk but often requires leverage to enhance returns). Specialist credit strategies (involves lending to credit sensitive issuers, for example, firms in or near bankruptcy, following a high level of due diligence work identifying mispriced securities: vulture funds: distressed securities investing) Stock selection (combinations of long and short positions, normally in equities, aiming to exploit under and overvalued securities): pairs trading market neutral Funds of funds allows smaller investors to invest in hedge funds. A fund that invests a a number of hedge funds, and sell shares to the public. Hedge funds tend to target significantly higher returns than funds managed in a more conventional manner. A number of factors may help them to do so: they are focused on their own areas of expertise, tending to avoid risks outside those areas; they operate on a performance fee structure which, it is argued, attracts successful managers and incentivises them; and hedge fund managers will often have their own money invested in the fund. Moreover, there tends to be very little correlation between the performance of one type of hedge fund and another (in contrast to active fund managers), and between most hedge funds and market indices. Investment in one or more hedge funds (or a carefully constructed fund of funds) can therefore generate superior risk-adjusted returns, which

12 are uncorrelated with the remainder of a typical institutional investor s portfolio. However, the selection of funds is crucial, and must take place on the basis of careful research, since as is also true of private equity funds the dispersion of returns for hedge funds is much wider than for conventional active management, as are the sources of competitive advantage, risk and return. There has historically been caution about hedge fund investing on the part of institutions, with high net worth individuals providing the primary client-base for most hedge funds. There has been limited understanding of the different styles of hedge fund and the risk diversification and return enhancement potential they can provide; fees tend to be high, and charged on a performance basis; and the positions taken by a hedge fund manager are likely to be significantly different to the consensus a very different set of characteristics to those with which many institutional investors tend to be comfortable. Moreover, there are significant capacity constraints, with many high-profile funds closing to investors very soon after opening. There has recently been increased interest in the asset class from institutions often seeking to allocate a small proportion of their portfolio to it, perhaps by investing in a fund of funds. Many of the larger financial institutions are now setting up their own funds, both to retain their talented management staff, and to attempt to meet the demand for hedge fund investment from existing and new clients. Commodities Commodities are a tangible investment instrument, though most investors would invest in commodity futures, rather than incur the storage costs associated with the physical products. Futures contracts exist on agricultural products; energy products, and metals.

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