In most developed countries, the four traditional asset classes are (1) common

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1 Financial Advice and Investment Decisions: A Manifesto for Change. Jarrod W. Wilcox and Frank J. Fabozzi John Wiley & Sons, Inc. Published 2013 by John Wiley & Sons, Inc. APPENDIX A Traditional Asset Classes and Alternative Assets In most developed countries, the four traditional asset classes are (1) common stocks, (2) bonds, (3) real estate, and (4) cash equivalents. In this appendix, we define what an asset class is and review the first three categories of traditional asset classes. We conclude the appendix with a description of alternative assets and discuss whether they represent an alternative asset class. ASSET CLASS DEFINED How do we define an asset class? There are several ways to do so. The first is in terms of the investment attributes that the members of an asset class have in common. These investment characteristics include (1) the major economic factors that influence the value of the asset class and, as a result, correlate highly with the returns of each member included in the asset class; (2) have a similar risk and return characteristic; and (3) have a common legal or regulatory structure. Based on this way of defining an asset class, the correlation between the returns of different asset classes would be low. Kritzman (1999) offers a second way of defining an asset class based simply on a group of assets that is treated as an asset class by asset managers: [S]ome investments take on the status of an asset class simply because the managers of these assets promote them as an asset class. They believe that investors will be more inclined to allocate funds to their products if they are viewed as an asset class rather than merely as an investment strategy. (79) Kritzman then goes on to propose criteria for determining asset class status. 275

2 276 FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE Based on these two ways of defining asset classes, the four major asset classes above can be extended to create other asset classes. From the perspective of a U.S. investor, for example, the four major asset classes listed earlier have been expanded as follows by separating foreign securities from U.S. securities: (1) U.S. common stocks, (2) non-u.s. (or foreign) common stocks, (3) U.S. bonds, (4) non-u.s. bonds, (5) cash equivalents, and (6) real estate. Along with the designation of asset classes comes a barometer to be used to quantify the performance of the asset class the risk, return, and the correlation of the return of the asset class with that of another asset class. The barometer is called the benchmark index, market index, or simply the index. The indexes are also used by investors to evaluate the performance of professional managers hired to manage their assets. COMMON STOCK ASSET CLASSES Common stock is a broad category for an asset class. In practice, common stock is further partitioned into more asset classes. For U.S. common stocks (also referred to as U.S. equities), the following are classified as asset classes in terms of market capitalization and growth versus value characteristics. Market Capitalization The market capitalization of a firm is the total market value of its common stock outstanding. For example, suppose that a corporation has 300 million shares of common stock outstanding and each share has a market value of $60. Then the market capitalization of this company is $18 billion (300 million shares times $60 per share). A firm s market capitalization is commonly referred to as its market cap. Market capitalization is typically classified as follows: Classification Mega cap Large cap Mid cap Small cap Micro cap Nano cap Market Capitalization Greater than $200 billion $10 billion to $200 billion $2 billion to $10 billion $300 million to $2 billion $50 million to $300 million Less than $50 million

3 Traditional Asset Classes and Alternative Assets 277 Growth vs. Value Stocks While a company s market cap is easy to determine given the market price per share and the number of shares outstanding, how does one define value and growth stocks? In broad terms, the stock of a company is considered a growth stock when the company is viewed as having above-average growth prospects (e.g., growing faster in terms of revenue and earnings than the average company in the same industry or the market overall). There is no set definition for classifying a growth stock. Investors and commercial services that create indexes for growth stocks use various measures such as a higher historical growth rate compared to the industry, a better return on equity than the industry, and a superior earnings per share growth rate than the industry. As with a growth stock, the definition varies as to what is a company that is classified as a value stock. For value stocks, the current stock price is critical. Focus is on companies with a low absolute or relative price earnings ratio or above average yield. Other measures used in classifying a stock as a value stock include the price-to-book value and price-to-sales ratios. Bonds For U.S. bonds along with short-term obligations, also referred to as fixed income securities, the following are regarded as asset classes: (1) U.S. government bonds, (2) corporate bonds, (3) U.S. municipal bonds (i.e., state and local bonds), (4) residential mortgage-backed securities, (5) commercial mortgage-backed securities, and (6) asset-backed securities. In turn, several of these asset classes are further segmented by the credit rating (see Appendix D) of the issuer. For example, for corporate bonds, investment-grade (i.e., high credit quality) corporate bonds and noninvestment grade corporate bonds (i.e., speculative quality) are treated as two asset classes. Global Asset Classes For non-u.s. stocks and bonds, the following are classified as asset classes: (1) developed market foreign stocks, (2) developed market foreign bonds, (3) emerging market foreign stocks, and (4) emerging market foreign bonds. The characteristics that market participants use to describe emerging markets is that the countries in this group: Have economies that are in transition but have started implementing political, economic, and financial market reforms in order to participate in the global capital market.

4 278 FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE May expose investors to significant price volatility attributable to political risk and the unstable value of their currency. Have a short period over which their financial markets have operated. Loucks, Penicook, and Schillhorn (2008) describe what is meant by an emerging market as follows: Emerging market issuers rely on international investors for capital. Emerging markets cannot finance their fiscal deficits domestically because domestic capital markets are poorly developed and local investors are unable or unwilling to lend to the government. Although emerging market issuers differ greatly in terms of credit risk, dependence on foreign capital is the most basic characteristic of the asset class. (340) REAL ESTATE Real estate is a valuable part of any well-diversified portfolio. There are five goals for adding real estate to an investment portfolio (Wilson et al., 2005): 1. To achieve absolute returns above the risk-free rate. 2. To provide a hedge against inflation. 3. As a portfolio diversification tool that provides exposure to a different type of systematic risk and return than stocks and bonds. 4. To constitute an investment portfolio that resembles the global investment opportunity set. 5. To deliver strong cash flows to the portfolio through lease and rental payments. The real estate indexes most commonly used to represent the real estate sector are the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI) and four of its components (apartments, offices, retail, and industrial properties). Strategies in real estate investing can be classified into the following styles: core, value added, and opportunistic. Core properties are the most liquid, most developed, least leveraged, and most recognizable properties in a real estate portfolio. These properties have the greatest amount of liquidity but still are not sold quickly relative to traditional investments. Core properties tend to be held for a long period of time to take full advantage of the lease and rental cash flows that they provide. The majority of their

5 Traditional Asset Classes and Alternative Assets 279 returns come from the cash flows instead of value appreciation, and relatively little leverage is applied. Value-added properties include hotels, resorts, assisted care living, low-income housing, outlet malls, hospitals, and the like. These properties tend to require a subspecialty within the real estate market to manage well and can involve repositioning, renovation, and redevelopment of existing properties. Relative to core properties, these properties tend to produce less income and rely more on property appreciation to generate the total return. These properties can also include new properties that might otherwise be core properties except that they are not fully leased, such as a new apartment complex or a new shopping center. A value-added property could also be an existing property that needs a new strategy like a facelift, new tenants, or a new marketing campaign. These properties tend to use more leverage and generate a total return from both capital appreciation and income. Opportunistic real estate moves away from a core income approach to a capital appreciation approach. Often, opportunistic real estate is accessed through real estate opportunity funds, sometimes called private equity real estate (PERE). PERE funds invest in real estate with a high risk and return profile, particularly those properties that require extensive development or are turnaround opportunities. 1 Real Estate Investment Trusts A simple and liquid way to bring real estate into an investor s portfolio is by investing in a real estate investment trust (REIT). REITs are securities listed on major stock exchanges that represent an interest in an underlying pool of real estate properties. Effectively, REITs operate much in the same fashion as mutual funds. They pool investment capital from many small investors, and invest the larger collective pool in real estate properties that would not be available to the small investor. The key advantage of REITs is that they provide access to an illiquid asset class for investors who would not otherwise invest in real property. For now, consider an investment in a REIT as providing a broad exposure to real estate properties that the investor would not otherwise be able to obtain. The three major advantages of investing in REITs are: For federal income tax purposes, a REIT is treated as a pass-through entity if certain IRS requirements are satisfied. Therefore, a REIT avoids double taxation that comes with paying taxes at both the corporate and individual levels and instead is able to avoid corporate income taxation by passing all of its income and capital gains to its shareholders (where the distributions may be subject to taxation at the individual level). 1 See Hahn, Geltner, and Gerardo-Lietz (2005).

6 280 FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE Investors in REITs can freely trade the shares of a REIT, making REIT investing both convenient and liquid. Consequently, an investor can add to or trim her or his exposure to real estate quickly and easily through REITs. In fact, a REIT is a marginable security, which means that investors can typically borrow from their broker (up to 50%) to purchase shares in a REIT. The investor receives (at a cost) the professional asset management of real estate properties by the REIT executives. These are real estate professionals who know how to acquire, finance, develop, renovate, and negotiate lease agreements with respect to real estate properties to get the most return for their shareholders. 2 The major disadvantage of REITs comes from being listed on a stock exchange or traded in the over-the-count stock market. As a result, their prices pick up some of the systematic risk associated with the broader stock market. This reduces their diversification benefits, as an investor in a REIT obtains both real estate and stock market exposure. Therefore, REITs are less of a pure play in real estate. They are an imperfect substitute or proxy for direct real estate investing. ALTERNATIVE ASSETS Part of the difficulty of working with alternative asset classes is defining them. Are they a separate asset class or a subset of an existing asset class? Do they hedge the investment opportunity set or expand it? That is, in terms of Markowitz diversification, do they improve the efficient portfolio for a given level of risk? This means that for a given level of risk, do they allow for a greater expected return than by just investing in traditional asset classes? In most cases, alternative assets are a subset of an existing asset class. This may run contrary to the popular view that alternative assets are separate asset classes. However, we take the view that what many consider separate classes are really just different investment strategies within an existing asset class. In most cases, they expand the investment opportunity set, rather than hedge it. Finally, alternative assets are generally purchased in the private markets, outside of any exchange. While hedge funds and private equity that we discuss next meet these criteria, commodity investing proves to be the exception to these general rules. Alternative assets, then, are mostly just alternative investments within an existing asset class. Specifically, most alternative assets derive their value from either the debt or equity markets. For instance, most hedge fund strate- 2 For a further discussion, see Chapter 15 in Anson, Fabozzi, and Jones (2011).

7 Traditional Asset Classes and Alternative Assets 281 gies involve the purchase and sale of either equity or debt securities. Additionally, hedge fund managers may invest in derivative instruments whose value is derived from the equity or debt market. Consequently, returns are often surprisingly correlated with that of the underlying true asset classes. In the following subsections, we will review three types of the best known alternative assets: hedge funds, private equity, and commodities. Hedge Funds There is no legal definition of what a hedge fund is in the U.S. securities law. What can be said is that hedge funds have certain attributes that are common and that the word hedge in hedge funds is misleading. Hedge funds employ a wide range of trading strategies and techniques in seeking to generate a stellar return regardless of the movement of the market. That is, they seek to earn positive absolute returns even in a declining market environment. In contrast, other asset managers usually seek to earn an attractive return relative to a broad asset class benchmark. Hedge fund managers employ portfolio strategies that typically include leverage, short selling, and the use of derivatives. Hedge funds managers are compensated in terms of both a fixed fee based on the market value of assets managed plus a share of the positive return (an incentive fee). In contrast to mutual funds, which are publicly traded investment vehicles, hedge funds are private investment vehicles. In the management of their portfolios, hedge funds tend to employ derivative strategies much more than mutual funds. The use of derivative strategies requires more sophisticated risk management techniques to control risks associated by hedge fund managers due to their greater use of leverage. Although mutual funds may be permitted to short securities by prospectus and there are SEC regulatory restrictions on shorting, they primarily hold long positions. Hedge funds do not have any such restriction on short positions and, in fact, shorting may be the most important aspect of their investment strategy. There are restrictions on leverage employed by mutual funds but none for hedge funds. For example, mutual funds are limited by SEC rules in the amount they may borrow (up to 33% of their net asset base). It is not unusual to find some hedge funds that employ leverage up to 10 times their net asset base. Hedge funds can be classified into four broad buckets: 3 Market directional hedge funds. Managers of these hedge funds pursue a strategy that involves either retaining some systematic risk or are specifically driven by the movements of the stock market. The three 3 For a more detailed discussion of the types of hedge funds, see Chapters 16 and 17 in Anson, Fabozzi, and Jones (2011).

8 282 FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE principal types of hedge funds in this category are equity long/short funds, equity market timing funds, and short-selling funds. Corporate restructuring hedge funds. The managers of these hedge funds seek to take advantage of significant corporate transactions. Examples of such transactions are a merger, an acquisition, or a bankruptcy. The portfolio holdings of these funds are concentrated in a few stocks. The manager must evaluate not only whether the corporation is under or overvalued, but also the probability that the corporate transaction will be completed. Convergence trading hedge funds. These funds pursue strategies that typically involve the word arbitrage. The meaning of arbitrage in these strategies is far different from the definition used in financial economics for pricing assets and derivatives. Some practitioners refer to this form of arbitrage as risk arbitrage, which is an odd term given the true economic meaning of arbitrage. In general, the bet made by managers of these hedge funds is that two similar securities that have dissimilar market prices will converge to the same value over some investment horizon. The hedge funds that fall into this category are statistical arbitrage, fixed income arbitrage, relative value arbitrage, and convertible arbitrage hedge funds. Equity market neutral strategies also fall into this category. Opportunistic hedge funds. True to their name, the strategies employed by managers of hedge funds that fall into this category are designed to take advantage of whatever opportunities present themselves. Global macrohedge funds, global tactical asset allocation hedge funds, and multistrategy hedge funds are the three most popular types of opportunistic hedge funds. In addition, there are funds of hedge funds in which the manager invests the fund s capital in other hedge funds using a tactical asset allocation strategy. This strategy involves reallocating capital across hedge fund strategies when the manager projects that certain hedge fund strategies will outperform others. The drawback of this way to invest in hedge funds is the large fees. An investor has to typically pay a management fee plus profit sharing fees to the hedge fund of funds managers over-and-above the management and incentive fees that must be paid to underlying hedge fund managers. Although this makes it difficult for managers of fund of hedge funds to outperform some of the more aggressive individual hedge fund strategies, is does potentially provide for better risk control by having a diversified portfolio of hedge funds.

9 Traditional Asset Classes and Alternative Assets 283 Private Equity As with hedge funds, there is no legal definition of private equity. A useful broad definition is one suggested by Megginson (2004): a professionally managed pool of money raised for the sole purpose of making actively managed direct equity investments in private companies and with a well defined exit strategy (sale or IPO) (19). Here private companies means companies that are not listed on any exchange and therefore cannot raise capital via the public stock market. Private equity strategies can be divided into the following types: venture capital, buy-outs, and growth capital. Below we focus on the most popular type, venture capital. 4 Venture capital is the supply of equity financing to start-up companies that do not have a sufficient track record to attract investment capital from traditional sources (e.g., the public markets or lending institutions). Entrepreneurs who develop business plans require investment capital to implement those plans. Typically, these start-up companies lack tangible assets that can be used as collateral for a loan and are unlikely to generate positive earnings for several years. Venture capitalists provide these firms that have unproven or untested goods or services with capital by acquiring a senior equity stake while a firm remains private. Venture capitalists raise the funds they invest from investors and then quite often take an active role in the firm by either serving in an advisory capacity or as a director on the firm s board. Venture capitalists earn fees two ways: management fees and a percentage of the profits earned by the venture fund. Management fees can range anywhere from 1% to up to 4%. Management fees are used to compensate the venture capitalist while looking for attractive investment opportunities for the venture fund. The vehicles used in venture capital investing are: Limited partnerships Limited liability companies Corporate venture funds Venture capital fund of funds In the United States, the limited partnership vehicle is the predominant form of venture capital investing. Generally formed with an expected life of 10 years with an option to extend for another one to five years, a limited partnership is managed by a general partner who has day-to-day responsibility for managing the venture capital fund s investments. The limited 4 For a further discussion, see Chapters 18 and 19 in Anson, Fabozzi, and Jones (2011).

10 284 FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE partners have no role in management of the fund and they do not bear any liability beyond their committed capital. Although at the inception of the fund the partner must commit to a specific investment amount, the limited partners do not contribute money to the fund until the general partner requests an amount up to the initial capital commitment (i.e., makes a capital call). The general partner typically gives one to two months notice of when it intends to make additional capital calls on the limited partners when it has identified a start-up company in which to invest. The general partner can make capital calls up to the amount of the limited partners initial commitments. Similar to the limited partnership, in a limited liability company (LLC) all items of net income or loss as well as capital gains are passed through to the LLC s shareholders. Typically an LLC has a life of 10 years with possible options to extend for another one to five years. The LLC s managing director acts like the general partner of a limited partnership, being responsible for allocating the LLC s committed capital to selected start-up companies. Both a limited partnership and an LLC pool investor capital into a central fund from which to make venture capital investments, with the legal form selected depending upon the type of investor sought. For raising capital from a large number of passive and relatively uninformed investors, the limited partnership vehicle is the preferred vehicle; if the intent is to raise capital from a small group of knowledgeable investors, the LLC is the preferred vehicle. A venture capital fund of funds is a vehicle that invests in other venture capital funds, with the management team selecting the best venture capitalists rather than investing directly in start-up companies. The advantages of this are threefold: (1) the investor benefits from broad exposure to a diverse range of venture capitalists; (2) the investor receives the expertise of the management team in selecting the best venture capitalists; and (3) the investor may obtain access to venture capitalists whose funds may be closed to individual investors. Of course, as with fund-of-hedge funds, the drawback of this structure is the management fee (ranging from 0.5% to 2% of the net assets managed) and possibly an incentive fee charged by the fund s manager. There is considerable specialization in the venture capital space. While some venture capital firms classify themselves by geography or industry, by far the most distinguishing characteristic of venture capital firms is the stage of financing. Some venture capitalists provide first stage, or seed capital while others wait to invest in companies that are further along in their development. Still other venture capital firms come in at the final round of financing before the IPO. There are five discrete stages of venture capital

11 Traditional Asset Classes and Alternative Assets 285 financing: angel investing, seed capital, early stage capital, late stage expansion capital, and mezzanine financing. 5 Commodity Investments As explained at the outset of this section, most alternative asset classes are really alternative investment strategies within an existing asset class. This statement applies to hedge funds and private equity, for example. However, it does not apply to commodities. Investment in this asset class can be achieved through various products. Some investors take passive positions in physical commodities and earn the risk premium that is associated with this asset class. Other investors actively trade both physical commodities and commodity derivatives and generate a rate of return that is both a function of the risk premium embedded in this asset class and the trading skills of the manager. There are several ways for an investor to obtain economic exposure to commodity assets. The most obvious way is for an investor to purchase the underlying commodity to gain economic exposure. However, actual ownership of physical commodities can be problematic because storage and transportation costs associated with direct investments in commodities make this an unattractive alternative for most investors. A second way to gain exposure to commodities is to own the securities of a firm that derives a significant part of its revenues from the purchase and sale of physical commodities. For instance, purchasing shares of Exxon Mobil Corporation might be considered a pure play on the price of oil since three fourths of Exxon Mobil s revenues are derived from the exploration, refining, and marketing of petroleum products. However, this pure play might not work because part of the value of the stock in Exxon Mobil is dependent on the movement of the general stock market. As a result an investment in the stock of any company will result in exposure to systematic (market) risk as well as firm-specific risk. Moreover, there are other operating risks associated with an investment in any company. Perhaps the easiest way to gain exposure to commodities is through commodity derivative contracts such as commodity futures, commodity swaps, and commodity forward contracts. Futures contracts offer several advantages. First, these contracts are traded on an organized exchange. Therefore, they share the same advantages as stock exchanges: a central marketplace, transparent pricing, clearinghouse security, uniform contract size and terms, and daily liquidity. Most importantly, there is minimal counterparty risk. Second, the purchase of a futures contract (i.e., taking a long position) does not require automatic delivery of the underlying commodity. 5 For a further discussion, see Chapter 22 in Anson, Fabozzi, and Jones (2011).

12 286 FINANCIAL ADVICE & INVESTMENT DECISIONS: A MANIFESTO FOR CHANGE An offsetting futures position can be initiated that will close out the position of the initial futures contract. In this way, an investor can gain exposure to commodities without worrying about physical delivery. In fact, only about 1% of all commodity futures contracts result in the actual delivery of the underlying commodity. Commodity swaps and commodity forward contracts perform the same economic function as commodity futures contracts. However, because commodity swaps and forward contracts are custom made for the individual investor, these contracts are less liquid. Typically, if an investor wishes to terminate a commodity swap or forward position prior to maturity, the investor will negotiate with the counterparty who sold the swap or forward contract to the investor. Since these contracts are between two parties without an exchange, they expose an investor to counterparty risk. Another straightforward way to invest in a commodity is through an exchange-traded fund (ETF). A commodity ETF may provide exposure to one commodity or a group of commodities. Finally, an investor can gain exposure to the commodity markets is through a commodity-linked note. In its simplest form, a commodity-linked note is an intermediate-term debt instrument whose value at maturity will be a function of the value of an underlying commodity futures contract or basket of commodity futures contracts.