Anson Fabozzi Jones FRANK J. FABOZZI, PHD, CFA, CPA, is Professor in the Practice of Finance and Becton Fellow at the Yale School of Management, Editor of the Journal of Portfolio Management, and an Associate Editor of the Journal of Fixed Income. He is on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University. FRANK J. JONES, PHD, is a Professor of Accounting and Finance at San Jose State University. He is also Chairman of the Investment Committee of Private Ocean Wealth Management. Formerly, he was chief investment officer of Guardian Life Insurance Company and vice chairman of the board of the International Securities Exchange. Jacket Photograph: istockphoto THE FRANK J. FABOZZI SERIES A s the financial industry continues to grow in both size and sophistication, so do the instruments found within it. In order to achieve success in today s markets whether you re a seasoned professional or an individual investor you need a firm understanding of the various investment vehicles that can protect a portfolio as well as increase its overall performance. THE HANDBOOK of TRADITIONAL and ALTERNATIVE INVESTMENT VEHICLES Whether you re a seasoned professional or an individual investor, you need to be familiar with the various financial instruments found in today s marketplace if you intend on achieving investment success. Nobody understands this better than the expert author team of Mark Anson, Frank Fabozzi, and Frank Jones. And now, with The Handbook of Traditional and Alternative Investment Vehicles they share their extensive experience in the field of finance with you. Engaging and informative, this practical guide provides a detailed look at a wide array of products that can enhance your investment endeavors. Touching on both traditional and alternative assets, it covers everything from common stock to commodities, and offers strategies that will allow you to use them to enhance your portfolio s performance. Instruments you ll be introduced to include: Traditional Alternative Stocks Hedge Funds Bonds and Structured Credit Products Venture Capital and Private Equity Real Estate Commodities Succeeding in today s volatile market requires careful investment in many different asset classes through multiple investment vehicles. Written in a straightforward and accessible style, The Handbook of Traditional and Alternative Investment Vehicles presents the major principles and methods of investing in established, as well as new, asset classes and discusses the risks and rewards that accompany them. THE HANDBOOK of TRADITIONAL and ALTERNATIVE INVESTMENT VEHICLES MARK J. ANSON, PHD, CFA, CAIA, CPA, JD, is the President and Executive Director of Investment Services at Nuveen Investments. Previously, he was the chief executive officer of Hermes Pensions Management Ltd., as well as the chief executive officer of the British Telecom Pension Scheme the largest pension fund in the UK. Before joining Hermes, Anson was the chief investment officer of the $245 billion California Public Employees Retirement System (CalPERS) the largest pension fund in the United States. Anson is the author or coauthor of various financial books, including the Handbook of Alternative Assets (Wiley). $90.00 USA / $108.00 CAN The expert author team of Mark Anson, Frank Fabozzi, and Frank Jones has extensive experience in the field of finance, and now, with The Handbook of Traditional and Alternative Investment Vehicles, they provide a soup-to-nuts description of the numerous financial instruments that exist in the marketplace. THE HANDBOOK Mixing theory with real-world examples, this reliable resource opens with a detailed look at traditional assets, such as common stock and basic bonds as well as municipal bonds, agency passthrough securities, collateralized mortgage obligations (CMOs), and more specialized structured products in the credit industry. It also covers the fastest growing part of the asset management industry: exchange-traded funds (ETFs). TRADITIONAL and A LTERNATIVE INVESTMENT VEHICLES After a thorough discussion of traditional assets, including real estate and real estate investment trusts (REITs), The Handbook of Traditional and Alternative Investment Vehicles then ventures into the world of alternative assets, offering both a descriptive overview of the many types and styles of hedge funds as well as how to invest in them. The authors also cover the world of private equity dedicating a chapter to each of the four parts of this world: leveraged buyouts, venture capital, mezzanine debt, and distressed debt and also take the time to address commodities, which in recent decades, have developed as an important asset class. Investment Characteristics and Strategies The Handbook of Traditional and Alternative Investment Vehicles goes beyond the spectrum of most finance books by offering professionals in-depth knowledge, strategies, and techniques on a broad range of assets necessary to excel in today s dynamic market. of MARK J. ANSON FRANK J. FABOZZI FRANK J. JONES
The Handbook of Traditional and Alternative Investment Vehicles
The Frank J. Fabozzi Series Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi Real Options and Option-Embedded Securities by William T. Moore Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi The Exchange-Traded Funds Manual by Gary L. Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J. P. Anson The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J. Fabozzi Collateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi Investment Performance Measurement by Bruce J. Feibel The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz Foundations of Economic Value Added, Second Edition by James L. Grant Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy Securities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M. Focardi, and Petter N. Kolm Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi Handbook of Alternative Assets, Second Edition by Mark J. P. Anson Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm, Dessislava A. Pachamanova, and Sergio M. Focardi Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev, Stogan V. Stoyanov, and Frank J. Fabozzi How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell, and Glenn E. Ross Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi Structured Products and Related Credit Derivatives by Brian P. Lancaster, Glenn M. Schultz, and Frank J. Fabozzi Quantitative Equity Investing: Techniques and Strategies by Frank J. Fabozzi, CFA, Sergio M. Focardi, Petter N. Kolm Introduction to Fixed Income Analytics, Second Edition by Frank J. Fabozzi and Steven V. Mann
The Handbook of Traditional and Alternative Investment Vehicles Investment Characteristics and Strategies MARK J. P. ANSON FRANK J. FABOZZI FRANK J. JONES John Wiley & Sons, Inc.
Copyright 2011 by John Wiley & Sons, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. ISBN: 978-0-470-60973-6 (cloth); 978-1-118-00868-3 (ebk); 978-1-118-00869-0 (ebk) Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1
MJPA To my wife Mary, my children Madeleine and Marcus, and our two cats, Scout and Fuffy two important members of our family FJF To my wife Donna and my children Patricia, Karly, and Francesco FJJ To my wife Sally for her good humor and patience
Contents Preface About the Authors xiii xv CHAPTER 1 Introduction 1 Risks Associated with Investing 1 Asset Classes 7 Super Asset Classes 11 Strategic vs. Tactical Allocations 13 Efficient vs. Inefficient Asset Classes 14 Beta and Alpha Drivers 15 Financial Instruments and Concepts Introduced in this Chapter 16 CHAPTER 2 Investing in Common Stock 17 Earnings 18 Dividends 22 Stock Repurchases 28 The U.S. Equity Markets 29 Trading Mechanics 31 Trading Costs 37 Financial Instruments and Concepts Introduced in this Chapter 38 CHAPTER 3 More on Common Stock 41 Pricing Efficiency of the Stock Market 41 Stock Market Indicators 42 Risk Factors 46 Tracking Error 49 Common Stock Investment Strategies 54 Financial Instruments and Concepts Introduced in this Chapter 67 vii
viii CONTENTS CHAPTER 4 Bond Basics 69 Features of Bonds 69 Yield Measures and Their Limitations 77 Interest Rate Risk 83 Call and Prepayment Risk 86 Credit Risk 87 Financial Instruments and Concepts Introduced in this Chapter 95 CHAPTER 5 U.S. Treasury and Federal Agency Securities 97 Treasury Securities 97 Federal Agency Securities 104 Financial Instruments and Concepts Introduced in this Chapter 109 CHAPTER 6 Municipal Securities 111 Tax-Exempt and Taxable Municipal Securities 111 Types of Municipal Securities 114 Tax-Exempt Municipal Bond Yields 123 Risks Associated with Investing in Municipal Bonds 125 Build America Bonds 125 Financial Instruments and Concepts Introduced in this Chapter 126 CHAPTER 7 Corporate Fixed Income Securities 127 Corporate Bonds 127 Medium-Term Notes 132 Commercial Paper 134 Preferred Stock 135 Convertible Security 138 Financial Instruments and Concepts Introduced in this Chapter 145 CHAPTER 8 Agency Mortgage Passthrough Securities 147 Mortgages 147 Mortgage Passthrough Securities 151 Types of Agency Mortgage Passthrough Securities 152 Prepayment Conventions and Cash Flows 153 Factors Affecting Prepayment Behavior 159 Prepayment Models 162
Contents ix Yield 162 A Closer Look at Prepayment Risk 164 Trading and Settlement Procedures for Agency Passthroughs 165 Stripped Mortgage-Backed Securities 167 Financial Instruments and Concepts Introduced in this Chapter 170 CHAPTER 9 Agency Collateralized Mortgage Obligations 173 The Basic Principle of CMOs 173 Agency CMOs 174 CMO Structures 174 Yields 199 Financial Instruments and Concepts Introduced in this Chapter 200 CHAPTER 10 Structured Credit Products 201 Private Label Residential MBS 202 Commercial Mortgage-Backed Securities 206 Nonmortgage Asset-Backed Securities 209 Auto Loan-Backed Securities 210 Collateralized Debt Obligations 215 Financial Instruments and Concepts Introduced in this Chapter 222 CHAPTER 11 Investment-Oriented Life Insurance 223 Cash Value Life Insurance 223 Stock and Mutual Insurance Companies 224 General Account vs. Separate Account Products 226 Overview of Cash Value Whole Life Insurance 227 Taxability of Life Insurance 229 Products 230 Financial Instruments and Concepts Introduced in this Chapter 242 CHAPTER 12 Investment Companies 243 Types of Investment Companies 243 Fund Sales Charges and Annual Operating Expenses 248 Advantages of Investing in Mutual Funds 253 Types of Funds by Investment Objective 254 The Concept of a Family of Funds 256 Taxation of Mutual Funds 259
x CONTENTS Structure of a Fund 260 Financial Instruments and Concepts Introduced in this Chapter 260 CHAPTER 13 Exchange-Traded Funds 263 Review of Mutual Funds and Closed-End Funds 263 Basics of Exchange-Traded Funds 264 ETF Mechanics: The ETF Creation/Redemption Process 267 ETF Sponsors 270 Mutual Funds vs. ETFs: Relative Advantages 272 Uses of ETFs 274 The New Generation of Mutual Funds 274 Financial Instruments and Concepts Introduced in this Chapter 276 CHAPTER 14 Investing in Real Estate 277 The Benefits of Real Estate Investing 277 Real Estate Performance 278 Real Estate Risk Profile 280 Real Estate as Part of a Diversified Portfolio 282 Core, Value-Added, and Opportunistic Real Estate 285 Financial Instruments and Concepts Introduced in this Chapter 298 CHAPTER 15 Investing in Real Estate Investment Trusts 299 Advantages and Disadvantages of REITs 299 Different Types of REITs 302 REIT Rules 304 Economics of REITs 306 Financial Instruments and Concepts Introduced in this Chapter 312 CHAPTER 16 Introduction to Hedge Funds 313 Hedge Funds vs. Mutual Funds 313 Growth of the Hedge Fund Industry 315 Categories of Hedge Funds 316 Hedge Fund Strategies 318 Financial Instruments and Concepts Introduced in this Chapter 342 CHAPTER 17 Considerations in Investing in Hedge Funds 343 Hedge Fund Performance 343
Contents xi Is Hedge Fund Performance Persistent? 345 A Hedge Fund Investment Strategy 347 Selecting a Hedge Fund Manager 354 Financial Instruments and Concepts Introduced in this Chapter 360 CHAPTER 18 Investing in Capital Venture Funds 361 The Role of a Venture Capitalist 362 The Business Plan 367 Venture Capital Investment Vehicles 374 The Life Cycle of a Venture Capital Fund 378 Specialization within the Venture Capital Industry 380 Stage of Financing 382 Historical Performance 386 Financial Instruments and Concepts Introduced in this Chapter 388 CHAPTER 19 Investing in Leveraged Buyouts 389 A Theoretical Example of a Leveraged Buyout 389 How LBOs Create Value 392 LBO Fund Structures 402 Profile of an LBO Candidate 406 Venture Capital vs. Leveraged Buyouts 408 Risks of LBOs 410 Financial Instruments and Concepts Introduced in this Chapter 411 CHAPTER 20 Investing in Mezzanine Debt 413 Overview of Mezzanine Debt 413 Examples of Mezzanine Financing 418 Mezzanine Funds 421 Venture Capital and the Distinction Between Mezannine Financing and Different Forms of Private Equity 423 Advantages of Mezzanine Debt to the Investor 424 Advantages to the Company/Borrower 425 Negotiations with Senior Creditors 426 Market Performance 428 Financial Instruments and Concepts Introduced in this Chapter 429 CHAPTER 21 Investing in Distressed Debt 431 Vulture Investors and Hedge Fund Managers 432
xii CONTENTS Distressed Debt Is an Inefficient and Segmented Market 432 Distressed Debt and Bankruptcy 434 Distressed Debt Investment Strategies 438 Risks of Distressed Debt Investing 450 Market Performance 452 Financial Instruments and Concepts Introduced in this Chapter 453 CHAPTER 22 Investing in Commodities 455 Gaining Exposure to Commodities 457 Commodity Prices Compared to Financial Asset Prices 462 Economic Rationale 463 Commodity Futures Indexes 471 Financial Instruments and Concepts Introduced in this Chapter 485 APPENDIX A Arithmetic Mean vs. Geometric Mean 487 APPENDIX B Measures of Risk 491 Range and Location 491 Moments of the Distribution 494 INDEX 499
Preface T he financial industry has grown tremendously in terms of size and sophistication over the last 30 years. The great bull stock market that began in the early 1980s combined with the birth of enormous computing power led to a growth in the financial markets that no one could have predicted. So, it was a bit of a daunting task to produce a one-volume handbook to the financial instruments that exist in the global marketplace. At the outset of this book, we decided to take a pragmatic approach mixing a little theory with a lot of real world examples. As authors, we thought it better to provide you with a user-friendly reference guide than to provide you with a theoretical treatise. Not that we are beyond being academic indeed we have all been professors at one point in our careers. However, we thought a better approach would be to dazzle the reader less with our academic credentials and instead, to provide a more descriptive textbook. In this book we provide a soup to nuts approach to describing the various financial instruments there are in the marketplace. We start with the basics: commons stock and basic bonds. We then move on to municipal bonds, agency passthrough securities, collateralized mortgage obligations, and the more specialized structured products in the credit industry. We also cover the fastest growing part of the asset management industry: exchangetraded funds. Over the past decade, exchange-traded funds have grown at a cumulative average growth rate of over 40% per year stronger growth than the alternative asset market. This brings us to the next part of the book. We provide an in depth review of the major segments of the alternative asset market. We start with real estate and then move on to publicly traded real estate investment trusts. We then venture into the world of hedge funds, providing both a descriptive overview of the many types and styles of hedge funds as well as providing a how to guide to investing in these vehicles. We also cover the world of private equity dedicating a chapter to each of the four parts of the private equity world: leveraged buyouts, venture capital, mezzanine debt, and distressed debt. Last, we include commodities. Over the last 20 years, commodities have developed as an investable asset class. xiii