Alternative Investments

Lecture 1: Introduction to Alternative Assets

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Lecture 1 Overview

1. What is an alternative asset class

2. Types of alternative assets (Hedge Funds, Commodity, Private equity, Real Estate)

3. Asset Allocation

4. Beta versus Alpha drivers

5. Performance, risk and beta/alpha

Anson Handbook of Alternative Investment Assets: Chapter 1 and 2
Bodie Kane Marcus : Section 24.1, 8.2
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WHAT IS AN ALTERNATIVE ASSET
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What is an Alternative Asset Class
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, private
equity, and credit derivatives meet these criteria, we will see that
commodity futures prove to be the exception to these general rules.



5
Types of alternative assets

Hedge funds (purchase of limited partner units)
Commodity (active or passive investing)
Private equity (investing in private companies before their IPOs)
Credit derivatives (purchase of limited partner units, tranche of
special purpose vehicles; or through credit default swaps)
Real estate (purchase of limited partner units, tranche of special
purpose vehicles)

.morelike corporate governance (shareowners vs. shareholders)
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Super Asset Classes
Capital assets
Assets as economic inputs
Assets as a store of value
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Capital Assets
Capital assets are defined by their claim on the future cash flows of
an enterprise. They provide a source of ongoing value. As a result,
capital assets may be valued based on the net present value of their
expected returns.
Modigliani and Miller (1958) demonstrated that the value of the
firm is dependent upon its cash flows. How those cash flows are
divided up between shareholders and bondholders is irrelevant to
firm value.
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Capital Assets
Capital assets, then, are distinguished not by their possession of
physical assets, but rather, by their claim on the cash flows of an
underlying enterprise.
Hedge funds, private equity funds, credit derivatives, and corporate
governance funds all fall within the super asset class of capital assets
because the value of their funds are all determined by the present
value of expected future cash flows from the securities in which they
invest.
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First conclusion
It is not the types of securities in which they invest that
distinguishes hedge funds, private equity funds, credit derivatives,
or corporate governance funds from traditional asset classes.
Rather, it is the alternative investment strategies that they pursue
that distinguishes them from traditional stock-and-bond
investments.
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Assets as economic inputs
Assets can be consumed as part of the production cycle
Physical commodities: grains, metals, energy products, and
livestock. These assets are used as economic inputs into the
production cycle to produce other assets, such as automobiles,
skyscrapers, new homes, and appliances.
These assets generally cannot be valued using a net present value
analysis.
The lack of dependency on future cash flows to generate value is
one of the reasons why commodities have important diversification
potential vis vis capital assets.
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Assets as a store of value
Art is considered the classic asset that stores value. It is not a capital
asset because there are no cash flows associated with owning a
painting or a sculpture. Also not an asset that is used as an economic
input because it is a finished product. Value is somehow subjective.
Gold and precious metals are another example of a store of value
asset (tangible assets)




12
ASSET ALLOCATION
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Asset Classes and Asset Allocation
Asset allocation is the allocation of an investors portfolio across a
number of asset classes. (Sharpe, 1992)
4 main categories of asset classes:
Equity (large capitalised, small, foreign stocks)
Fixed Income (US Treasury, investment grade, high-yield bolds)
Cash
Real Estate
For each asset class there could be sub-classes.
Stocks (e.g. large and small cap, or foreign)
Bonds (e.g. US Treasury, high-yield bonds)

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Strategic versus Tactical Allocations
Strategic Assets Allocation is concerned with long-term asset mix.
For example, the mix is designed to accomplish a long-term goal such
as funding pension benefits or matching long-term liabilities.
Strategic tracking error in the portfolio
Tactical Asset Allocation is short-term in nature.
Take advantage of current market conditions
The goal is to maximise returns
It depends also on capacity to diversify: alternative assets add value
(example, derivatives)
Tactical tracking error
Transaction costs (use swaps/futures)
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Efficient versus Inefficient Asset Classes
The US bond and equity is a semi-strong efficient markets. Price
adjust to public available info rapidly and in unbiased fashion.
What about alternative assets?
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Levels of Asset Allocation
Source: Dahlquist and Harvey (2001)
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Constraint versus Unconstraint Investing
The traditional manager invests against a benchmark
Hedge funds and other alternative investment vehicle allows to
invest away from a benchmark.
18
Asset Allocation versus Trading Strategy
Mutual funds: where to invest (large cap, treasury ?)
Asset Class risk premium
Hedge funds : how they trade
Trading Strategy risk premium
(think about trading mispriced securities !)

19
BETA VS ALPHA DRIVERS
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Historical Context
1980s and 1990s: equity expansion, annual return of S&P of 17% per
year. US Treasury return 9.83%.
Long-term Implied risk premium (over 10-year US Treasury) :
the risk premium implied by stock market valuations and forecasts of
earnings in relation to current market value.
The expected risk premium that a long-term investor must earn to hold
equities over government bonds.
The realised risk premium exceeded implied risk premium (the
equity premium puzzle !)
21
Expected and Realised Equity Risk Premium : the roaring 1990s
Source: Anson
22
Alpha versus Beta Drivers
Beta drivers capture financial market risk premiums in an efficient
manner.

Alpha drivers seek pockets of excess returns often without regard to
benchmarks.
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Alpha versus Beta in terms of asset allocation
Strategic Asset Allocation
Beta or market risk of the portfolio/fund
is not design to beat the market
Passive fund management (e.g. pension fund funding)
Requires periodical adjustments(monthly, trimester).

Tactical Asset Allocation
Alpha part of the portfolio
It seeks extra return
Active fund management (i.e. market not in line with fundamental
economic valuations)
Requires more trading
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Large-Cap Active Equity Manager
Weekly Returns (2000-2004). Beta=1 , R-squared=0.99 (follows ups and downs of the
index).
They just replicate the index. The claim to be active!!!!
This is a beta driver, not an alpha driver

Source: Anson
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Look at some passive S&P Index Managers!
Source: Anson
Over the period 2000-20004 active fund managers
underperformed passive managers by 276 basis points.
They just got higher fees!!!
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Active vs. Beta Drivers andalternative investments
In institutional portfolios there are both components. BUT, alpha is
attached to beta.
In institutional portfolios investors start from strategic benchmarks
to establish the policy risk. Generally, the active part of the portfolio
is still in traditional asset classes.
In new investment models, alpha is independent of beta. It is
outside the benchmark. It is in alternative investments.
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Types of Alpha Drivers
Absolute return strategies
No reference to a benchmark, low correlation
long and short positions are traded
Market segmentation
Only trade in selected markets (e.g. avoid low rated tranches of
securities, avoid below investment grade)
Concentrated portfolios
With diversification you minimise the probability to outperformance
Typical example: corporate bond funds
Nonlinear return distributions
Exhibit option like payoffs with a kinked distribution
Examples: merger arbitrage, event driven, fixed income arbitrage



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The blur separation between Alpha and Beta Drivers
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Example of an Institutional Portfolio
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A nice mix.Equity Alpha-Beta Portfolios (40/60)
Why equity?
31
A nice mixFixed Income Alpha-Beta Portfolio (25/75)
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PERFORMANCE, RISK AND BETA/ALPHA
33
Time-weighted vs. Dollar-weighted returns
Two common ways to measure average portfolio return:
1. Time-weighted returns
The geometric average is a time-weighted average.
Each periods return has equal weight.


2. Dollar-weighted returns
Internal rate of return considering the cash flow from or to investment
Returns are weighted by the amount invested in each period:





( ) ( )( ) ( )
n
n
G
r r r r + + + = + 1 ... 1 1 1
2 1
( ) ( ) ( )
n
n
r
C
r
C
r
C
PV
+
+
+
+
+
=
1
...
1 1
2
2
1
1
34
Dollar-weighted Return (IRR):
Dollar-Weighted Return
-$50 -$53
$2
$4+$108
% 117 . 7 ;
) 1 (
112
) 1 (
2
) 1 (
53
50
2 1 1
=
+
+
+
=
+
+ r
r r r
35
Time-Weighted Return
% 66 . 5
53
2 53 54
% 10
50
2 50 53
2
1
=
+
=
=
+
=
r
r
The dollar-weighted average is less than the time-weighted
average in this example because more money is invested in year
two, when the return was lower.
r
G
= [ (1.1) (1.0566) ]
1/2
1 = 7.81%
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Comparing returns
The simplest and most popular way to adjust returns for risk is to compare the
portfolios return with the returns on a comparison universe.
The comparison universe is a benchmark composed of a group of funds or
portfolios with similar risk characteristics, such as growth stock funds or high-
yield bond funds.
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Return must be adjusted for risk. What is the
return per unit of risk?

Sharpe Index
Risk Adjusted Performance: Sharpe
r
p
= Average return on the portfolio
r
f
= Average risk free rate
P
=Standard deviation of portfolio return
o
( )
P f
P
r r
o

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Treynor Measure
Risk Adjusted Performance: Treynor
r
p
= Average return on the portfolio
r
f
= Average risk free rate

p
= Weighted average beta for portfolio (systematic risk instead of total risk)
( )
P f
P
r r
|

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Risk Adjusted Performance: Jensen
Jensens Measure
p
= Alpha for the portfolio (over the CAPM prediction)
r
p
= Average return on the portfolio

p
= Weighted average Beta
r
f
= Average risk free rate
r
m
= Average return on market index portfolio
o
( )
P P f P M f
r r r r o |
(
= +

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Information Ratio
Information Ratio = o
p
/ o(e
p
)
The information ratio divides the alpha of the portfolio by the nonsystematic risk.
Nonsystematic risk could, in theory, be eliminated by diversification.
o(e
p
) = standard deviation of the non-systematic risk of portfolio = tracking error


It shows efficiency (comparison)and consistency (there is volatility, so low sigma, high IR)!

Example: if IR is 0.25 then the strategy/investment delivered 0.25% in excess returns of
every unit of risk taken




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Tracking Error
Remember the regression of the index model:

Where
o
p
= intercept , is the portfolio expected excess return when the market excess return is
zero

p
= the slope, is the portfolios sensitivity to the index (systematic risk)
e
p
= average of the firm-specific components =
1

=1


The portfolio variance is :
Total risk= Systematic risk + Idiosyncratic risk (Firm-specific)


Tracking error represents the added risk taken in an effort to beat the market.




) ( ) ( ) ( t e t R t R
P M p P P
+ + =| o
) (
2 2 2 2
p M P P
e o o | o + =
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The effect of diversificationgive us the beta component
Variance of the equally weighted portfolio of firm-specific components:


When n gets large,
2
(

)becomes negligible and firm specific risk is

diversified away.



2
2
2 2
1
1 1
( ) ( ) ( )
n
P i
i
e e e
n n
o o o
=
| |
= =
|
\ .

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M
2

Measure
Developed by Modigliani and Modigliani
Create an adjusted portfolio (P*)that has the same standard
deviation as the market index (just move on the CAL, buy T-bills
as Rf securities)
Because the market index and P* have the same standard
deviation, their returns are comparable:
2
* P M
M r r =
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M
2

Measure: Example

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M
2

Measure: Example
Managed Portfolio: return = 35% standard deviation = 42%
Market Portfolio: return = 28% standard deviation = 30%
T-bill return = 6%
P* Portfolio:
30/42 = .714 in P and (1-.714) or .286 in T-bills
The return on P* is (.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed
portfolio underperformed.

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It depends on investment assumptions
1) If the portfolio represents the entire risky investment ,
then use the Sharpe measure.

2) If the portfolio is one of many combined into a larger
investment fund, use the Jensen o or the Treynor
measure. The Treynor measure is appealing because it
weighs excess returns against systematic risk.

Which Measure is Appropriate?
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Portfolio Performance: example
Is Q better than P?
1)Look at alphas
2) Draw the graph, why beta in the x-axis?
3) The slope is T
p


4) If we mix with T-bill, P is better !

P
P
M P P
T T T
|
o
= =
2
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Portfolio Performance: another example
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Portfolio Performance: another example (contd)
Q is more aggressive than P (beta 1.40 is higher). But P is better diversified (st.dev 1.95<8.98).
If P or Q represents the entire investment, Q is better because of its higher Sharpe measure and
better M
2
.
If P and Q are competing for a role as one of a number of subportfolios, Q also dominates because
its Treynor (5.40) measure is higher.
If we seek an active portfolio to mix with an index portfolio, P is better due to its higher information
ratio (/(e)).


50
Modigliani and Miller (1958), The Cost of Capital, Corporate Finance,
and the Theory of Investment, American Economic Review
Sharpe W. (1992), Asset Allocation: Management Style and
Performance Measurement, Journal of Portfolio Management, 18 (2)
References