Table of Contents
The Frank J. Fabozzi Series
Title Page
Copyright Page
Dedication
Preface
About the Authors
CHAPTER 1 - Introduction
RISKS ASSOCIATED WITH INVESTING
ASSET CLASSES
SUPER ASSET CLASSES
STRATEGIC VS. TACTICAL ALLOCATIONS
EFFICIENT VS. INEFFICIENT ASSET CLASSES
BETA AND ALPHA DRIVERS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 2 - Investing in Common Stock
EARNINGS
DIVIDENDS
STOCK REPURCHASES
THE U.S. EQUITY MARKETS
TRADING MECHANICS
TRADING COSTS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 3 - More on Common Stock
PRICING EFFICIENCY OF THE STOCK MARKET
STOCK MARKET INDICATORS
RISK FACTORS
TRACKING ERROR
COMMON STOCK INVESTMENT STRATEGIES
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 4 - Bond Basics
FEATURES OF BONDS
YIELD MEASURES AND THEIR LIMITATIONS
INTEREST RATE RISK
CALL AND PREPAYMENT RISK
CREDIT RISK
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 5 - U.S. Treasury and Federal Agency Securities
TREASURY SECURITIES
FEDERAL AGENCY SECURITIES
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 6 - Municipal Securities
TAX-EXEMPT AND TAXABLE MUNICIPAL SECURITIES
TYPES OF MUNICIPAL SECURITIES
TAX-EXEMPT MUNICIPAL BOND YIELDS
RISKS ASSOCIATED WITH INVESTING IN MUNICIPAL BONDS
BUILD AMERICA BONDS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 7 - Corporate Fixed Income Securities
CORPORATE BONDS
MEDIUM-TERM NOTES
COMMERCIAL PAPER
PREFERRED STOCK
CONVERTIBLE SECURITY
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 8 - Agency Mortgage Passthrough Securities
MORTGAGES
MORTGAGE PASSTHROUGH SECURITIES
TYPES OF AGENCY MORTGAGE PASSTHROUGH SECURITIES
PREPAYMENT CONVENTIONS AND CASH FLOWS
FACTORS AFFECTING PREPAYMENT BEHAVIOR
PREPAYMENT MODELS
YIELD
A CLOSER LOOK AT PREPAYMENT RISK
TRADING AND SETTLEMENT PROCEDURES FOR AGENCY PASSTHROUGHS
STRIPPED MORTGAGE-BACKED SECURITIES
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 9 - Agency Collateralized Mortgage Obligations
THE BASIC PRINCIPLE OF CMOs
AGENCY CMOs
CMO STRUCTURES
YIELDS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 10 - Structured Credit Products
PRIVATE LABEL RESIDENTIAL MBS
COMMERCIAL MORTGAGE-BACKED SECURITIES
NONMORTGAGE ASSET-BACKED SECURITIES
AUTO LOAN-BACKED SECURITIES
COLLATERALIZED DEBT OBLIGATIONS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 11 - Investment-Oriented Life Insurance
CASH VALUE LIFE INSURANCE
STOCK AND MUTUAL INSURANCE COMPANIES
GENERAL ACCOUNT VS. SEPARATE ACCOUNT PRODUCTS
OVERVIEW OF CASH VALUE WHOLE LIFE INSURANCE
TAXABILITY OF LIFE INSURANCE
PRODUCTS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 12 - Investment Companies
TYPES OF INVESTMENT COMPANIES
FUND SALES CHARGES AND ANNUAL OPERATING EXPENSES
ADVANTAGES OF INVESTING IN MUTUAL FUNDS
TYPES OF FUNDS BY INVESTMENT OBJECTIVE
THE CONCEPT OF A FAMILY OF FUNDS
TAXATION OF MUTUAL FUNDS
STRUCTURE OF A FUND
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 13 - Exchange-Traded Funds
REVIEW OF MUTUAL FUNDS AND CLOSED-END FUNDS
BASICS OF EXCHANGE-TRADED FUNDS
ETF MECHANICS: THE ETF CREATION/REDEMPTION PROCESS
ETF SPONSORS
MUTUAL FUNDS VS. ETFS: RELATIVE ADVANTAGES
USES OF ETFs
THE NEW GENERATION OF MUTUAL FUNDS
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 14 - Investing in Real Estate
THE BENEFITS OF REAL ESTATE INVESTING
REAL ESTATE PERFORMANCE
REAL ESTATE RISK PROFILE
REAL ESTATE AS PART OF A DIVERSIFIED PORTFOLIO
CORE, VALUE-ADDED, AND OPPORTUNISTIC REAL ESTATE
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 15 - Investing in Real Estate Investment Trusts
ADVANTAGES AND DISADVANTAGES OF REITs
DIFFERENT TYPES OF REITS
REIT RULES
ECONOMICS OF REITs
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 16 - Introduction to Hedge Funds
HEDGE FUNDS VS. MUTUAL FUNDS
GROWTH OF THE HEDGE FUND INDUSTRY
CATEGORIES OF HEDGE FUNDS
HEDGE FUND STRATEGIES
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 17 - Considerations in Investing in Hedge Funds
HEDGE FUND PERFORMANCE
IS HEDGE FUND PERFORMANCE PERSISTENT?
A HEDGE FUND INVESTMENT STRATEGY
SELECTING A HEDGE FUND MANAGER
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 18 - Investing in Capital Venture Funds
THE ROLE OF A VENTURE CAPITALIST
THE BUSINESS PLAN
VENTURE CAPITAL INVESTMENT VEHICLES
THE LIFE CYCLE OF A VENTURE CAPITAL FUND
SPECIALIZATION WITHIN THE VENTURE CAPITAL INDUSTRY
STAGE OF FINANCING
HISTORICAL PERFORMANCE
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 19 - Investing in Leveraged Buyouts
A THEORETICAL EXAMPLE OF A LEVERAGED BUYOUT
HOW LBOs CREATE VALUE
LBO FUND STRUCTURES
PROFILE OF AN LBO CANDIDATE
VENTURE CAPITAL VS. LEVERAGED BUYOUTS
RISKS OF LBOs
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 20 - Investing in Mezzanine Debt
OVERVIEW OF MEZZANINE DEBT
EXAMPLES OF MEZZANINE FINANCING
MEZZANINE FUNDS
VENTURE CAPITAL AND THE DISTINCTION BETWEEN MEZANNINE FINANCING AND DIFFERENT ...
ADVANTAGES OF MEZZANINE DEBT TO THE INVESTOR
ADVANTAGES TO THE COMPANY/BORROWER
NEGOTIATIONS WITH SENIOR CREDITORS
MARKET PERFORMANCE
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 21 - Investing in Distressed Debt
VULTURE INVESTORS AND HEDGE FUND MANAGERS
DISTRESSED DEBT IS AN INEFFICIENT AND SEGMENTED MARKET
DISTRESSED DEBT AND BANKRUPTCY
DISTRESSED DEBT INVESTMENT STRATEGIES
RISKS OF DISTRESSED DEBT INVESTING
MARKET PERFORMANCE
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
CHAPTER 22 - Investing in Commodities
GAINING EXPOSURE TO COMMODITIES
COMMODITY PRICES COMPARED TO FINANCIAL ASSET PRICES
ECONOMIC RATIONALE
COMMODITY FUTURES INDEXES
Financial Instruments and Concepts Introduced in this Chapter (in Order of Presentation)
APPENDIX A - Arithmetic Mean vs. Geometric Mean
APPENDIX B - Measures of Risk
Index
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
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
Preface
The 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: exchange-traded 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.
In summary, our goal in this book is not to display our command of the arcane nomenclature associated with the financial markets, but instead, to provide the reader with a thoughtful guide to financial instruments. If you pull this book down from your bookshelf from time to time to consult how the market works for a particular financial instrument, we consider this a successful effort.
Mark J. P. Anson
Frank J. Fabozzi
Frank J. Jones
About the Authors
Mark Anson is the Chief Investment Officer and Managing Partner for Oak Hill Investments, a wealth advisory firm serving high net worth clients. Prior to joining OHIM, Mark was President and Executive Director of Investment Services at Nuveen Investments, an asset management firm with $150 billion assets under management. Prior to Nuveen, Mark served as Chief Executive Officer of Hermes Pensions Management Ltd., an institutional asset management company based in London, where he was also the Chief Executive Officer of the British Telecom Pension Scheme, the largest pension fund in the United Kingdom and the sole owner of Hermes. Prior to joining Hermes, he served as the Chief Investment Officer of the California Public Employees’ Retirement System, the largest pension fund in the United States. Mark is the former Chairman of the Board of the International Corporate Governance Network. He also has served on the advisory boards for the New York Stock Exchange, NYSE/Euronext, MSCI-Barra, The Dow Jones-UBS Commodity Index, and the International Association of Financial Engineers. Currently, he is a member of the Board of Governors of the CFA Institute and the SEC Advisory Committee to SEC Chairwoman Mary Schapiro. He has published over 100 research articles in professional journals, has won two Best Paper Awards, is the author of four financial textbooks including the Handbook of Alternative Assets, which is the primary textbook used for the Chartered Alternative Investment Analyst program, and sits on the editorial boards of several financial journals. Mark earned a B.A. in Economics and Chemistry from St. Olaf College, a J.D. from Northwestern University School of Law, and a Masters and a Ph.D. in Finance from Columbia University Graduate School of Business, all with honors. In addition, Mark has earned the Chartered Financial Analyst, Chartered Alternative Investment Analyst, Certified Public Accountant, Certified Management Accountant, and Certified Internal Auditor professional designations.
Frank J. Fabozzi, Ph.D., CFA, CPA is Professor in the Practice of Finance in the Yale School of Management. Prior to joining the Yale faculty, he was a Visiting Professor of Finance in the Sloan School at MIT. Frank is a Fellow of the International Center for Finance at Yale University and on the Advisory Council for the Department of Operations Research and Financial Engineering at Princeton University. He is the editor of the Journal of Portfolio Management and an associate editor of the Journal of Fixed Income and the Journal of Structured Finance. He is a trustee for the BlackRock family of closed-end funds. In 2002, Frank was inducted into the Fixed Income Analysts Society’s Hall of Fame and is the 2007 recipient of the C. Stewart Sheppard Award given by the CFA Institute. He has authored numerous books in investment management and structured finance. Frank earned a doctorate in economics from the City University of New York in 1972 and earned the designation of Chartered Financial Analyst and Certified Public Accountant.
Frank J. Jones is a Professor of Finance and Accounting at San Jose State University. He is also the Chairman of the Investment Committee of Private Ocean Wealth Management, a wealth management advisory firm serving high net worth clients. Frank served on the Board of Directors of the International Securities Exchange for 10 years until 2010 where he was alternately Chairman and Vice-Chairman and was on the Executive Committee, IPO Committee, and Finance and Audit Committee. Prior to returning to academia, he was the Executive Vice President and Chief Investment Officer of the Guardian Life Insurance Company; President of the Park Avenue Portfolio, a mutual fund company; Director of Global Fixed Income Research and Economics at Merrill Lynch and Company; and Senior Vice President at the New York Stock Exchange. Frank has been on the Graduate Faculty of Economics at the University of Notre Dame; an Adjunct Professor of Finance at the New York University Stern School of Business; and a Lecturer at the Yale University School of Management. He is on the Editorial Board of the Journal of Investment Management. He received a Doctorate from the Stanford University Graduate School of Business and a Masters of Science in Nuclear Engineering from Cornell University. He is the author of several books, chapters in books, and articles in investments and finance.
CHAPTER 1
Introduction
There is a wide range of financial instruments. The most general classification of financial instruments is based on the nature of the claim that the investor has on the issuer of the instrument. When the contractual arrangement is one in which the issuer agrees to pay interest and repay the amount borrowed, the financial instrument is said to be a debt instrument . In contrast to a debt instrument, an equity instrument represents an ownership interest in the entity that has issued the financial instrument. The holder of an equity instrument is entitled to receive a pro rata share of earnings, if any, after the holders of debt instruments have been paid. Common stock is an example of an equity claim. A partnership share in a business is another example.
Some financial instruments fall into both categories in terms of their attributes. Preferred stock, for example, is an equity instrument that entitles the investor to receive a fixed amount of earnings. This payment is contingent, however, and due only after payments to holders of debt instrument are made. Another hybrid instrument is a convertible bond, which allows the investor to convert a debt instrument into an equity instrument under certain circumstances. Both debt instruments and preferred stock are called fixed income instruments.
In this chapter, we’ll provide some basics about financial instruments, the general types of risks associated with investing, and characteristics of asset classes.
RISKS ASSOCIATED WITH INVESTING
There are various risks associated with investing and these will be described throughout the book. Here we will provide a brief review of the major risks associated with investing.
Total Risk
The dictionary defines risk as “hazard, peril, exposure to loss or injury.” With respect to investing, investors have used a variety of definitions to describe risk. Today, the most commonly accepted definition of risk is one that involves a well-known statistical measure known as the variance and is referred to as the total risk. The variance measures the dispersion of the outcomes around the expected value of all outcomes. Another name for the expected value is the average value.
In applying this statistical measure to the returns for a financial instrument, which we refer to as an asset for our discussion here, the observed returns on that asset over some time period are first obtained. Appendix A explains how returns for an asset are calculated. From those observed returns, the average return (which is the average or mean value) can be computed and using that average value, the variance can be computed. The square root of the variance is the standard deviation.
Despite the dominance of the variance (or standard deviation) as a measure of total risk, there are problems with using this measure to quantify the total risk for many of the assets we describe in this book. The first problem is that since the variance measures the dispersion of an asset’s return around its expected value, it considers the possibility of returns above the expected return and below the average return. Investors, however, do not view possible returns above the expected return as an unfavorable outcome. In fact, such outcomes are viewed as favorable. Because of this, it is argued that measures of risk should not consider the possible returns above the expected return. Various measures of downside risk, such as risk of loss and value at risk, are currently being used by practitioners.
The second problem is that the variance is only one measure of how the returns vary around the expected return. When a probability distribution is not symmetrical around its expected return, then another statistical measure known as skewness should be used in addition to the variance. Skewed distributions are referred to in terms of tails and mass. The tails of a probability distribution for returns is important because it is in the tails where the extreme values exist. An investor should be aware of the potential adverse extreme values for an investment and an investment portfolio. The statistical measures important for understanding risk, skewness and kurtosis, are explained in Appendix B.
Diversification
One way of reducing the total risk associated with holding an individual asset is by diversifying. Often, one hears financial advisors and professional money managers talking about diversifying their portfolio. By this it is meant the construction of a portfolio in such a way as to reduce the portfolio’s total risk without sacrificing expected return. This is certainly a goal that investors should seek. However, the question is, how does one do this in practice?
Some financial advisors and the popular press might say that a portfolio can be diversified by including assets across all asset classes. (We’ll explain in more detail what we mean by an asset class below.) Although that might be reasonable, two questions must be addressed in order to construct a diversified portfolio. First, how much of the investor’s wealth should be invested in each asset class? Second, given the allocation, which specific assets should the investor select?
Some investors who focus only on one asset class such as common stock argue that such portfolios should also be diversified. By this they mean that an investor should not place all funds in the stock of one company, but rather should include stocks of many companies. Here, too, several questions must be answered in order to construct a diversified portfolio. First, which companies should be represented in the portfolio? Second, how much of the portfolio should be allocated to the stocks of each company?
Prior to the development of portfolio theory by Harry Markowitz in 1952,1 while financial advisors often talked about diversification in these general terms, they never provided the analytical tools by which to answer the questions posed here. Markowitz demonstrated that a diversification strategy should take into account the degree of correlation (or covariance) between asset returns in a portfolio. The correlation of asset returns is a measure of the degree to which the returns on two assets vary or change together. Correlation values range from −1 to +1.
Indeed, a key contribution of what is now popularly referred to as “Markowitz diversification” or “mean-variance diversification” is the formulation of an asset’s risk in terms of a portfolio of assets, rather than the total risk of an individual asset. Markowitz diversification seeks to combine assets in a portfolio with returns that are less than perfectly positively correlated in an effort to lower the portfolio’s total risk (variance) without sacrificing return. It is the concern for maintaining expected return while lowering the portfolio’s total risk through an analysis of the correlation between asset returns that separates Markowitz diversification from other approaches suggested for diversification and makes it more effective.
The principle of Markowitz diversification states that as the correlation between the returns for assets that are combined in a portfolio decreases, so does the variance of the portfolio’s total return. The good news is that investors can maintain expected portfolio return and lower portfolio total risk by combining assets with lower (and preferably negative) correlations. However, the bad news is that very few assets have small to negative correlations with other assets. The problem, then, becomes one of searching among a large number of assets in an effort to discover the portfolio with the minimum risk at a given level of expected return or, equivalently, the highest expected return at a given level of risk. Such portfolios are called efficient portfolios.
The recent financial market crisis has taught an important lesson about constructing efficient portfolios and what to expect from them. Specifically, when constructing a portfolio based on the historical correlations observed, there is no assurance that those correlations may not adversely change over time, particularly in stressful periods in financial markets. By “adversely change” it is meant that correlations that may be considerably less than one when designing a diversified portfolio might move closer to one. This is because during such times there are typically massive sell offs of all assets because of the concerns of a systemic threat to the financial markets throughout the world.
Systematic vs. Unsystematic Risk
The total risk of an asset or a portfolio can be divided into two types of risk: systematic risk and unsystematic risk. William Sharpe defined systematic risk as the portion of an asset’s variability that can be attributed to a common factor.2 It is more popularly referred to as market risk. Because in the models developed to explain how total risk can be partitioned, the Greek letter beta was used to represent the quantity of systematic risk associated with an asset or portfolio, the term “beta” or “beta risk” has been used to mean market risk.
Systematic risk is the minimum level of risk that can be attained for a portfolio by means of diversification across a large number of randomly chosen assets. As such, systematic risk is that which results from general market and economic conditions that cannot be diversified away. For this reason the term undiversifiable risk is also used to describe systematic risk.
Sharpe defined the portion of an asset’s return variability (i.e., total risk) that can be diversified away as unsystematic risk. It is also called diversifiable risk, unique risk, residual risk, idiosyncratic risk, or company-specific risk. This is the risk that is unique to a company, such as an employee strike, the outcome of unfavorable litigation, or a natural catastrophe.
EXHIBIT 1.1 Systematic and Unsystematic Portfolio Risk
How diversification reduces unsystematic risk for portfolios is illustrated in Exhibit 1.1. The vertical axis shows the standard deviation of a portfolio’s total return. The standard deviation represents the total risk for the portfolio (systematic plus unsystematic). The horizontal axis shows the number of holdings of different assets (e.g., the number of common stock held of different companies). As can be seen, as the number of asset holdings increases (assuming that the assets are less than perfectly correlated as discussed below), the level of unsystematic risk is almost completely eliminated (that is, diversified away). The risk that remains is systematic risk. Studies of different asset classes support this. For example, for common stock, several studies suggest that a portfolio size of about 20 randomly selected companies will completely eliminate unsystematic risk leaving only systematic risk.
The relationship between the movement in the price of an asset and the market can be estimated statistically. There are two products of the estimated relationship that investors use. The first is the beta of an asset. Beta measures the sensitivity of an asset’s return to changes in the market’s return. Hence, beta is referred to as an index of systematic risk due to general market conditions that cannot be diversified away. For example, if an asset has a beta of 1.5, it means that, on average, if the market changes by 1%, the asset’s return changes by about 1.5%. The beta for the market is one. A beta that is greater than one means that systematic risk is greater than that of the market; a beta less than one means that the systematic risk is less than that of the market. Brokerage firms, vendors such as Bloomberg, Yahoo! Finance, and online Internet services provide information on beta for common stock.
The second product is the ratio of the amount of systematic risk relative to the total risk. This ratio, called the coefficient of determination or R-squared, varies from zero to one. A value of 0.8 for a portfolio means that 80% of the variation in the portfolio’s return is explained by movements in the market. For individual assets, this ratio is typically low because there is a good deal of unsystematic risk. However, as shown in Exhibit 1.1, through diversification the ratio increases as unsystematic risk is reduced.
Inflation or Purchasing Power Risk
Inflation risk, or purchasing power risk, is the potential erosion in the value of an asset’s cash flows due to inflation, as measured in terms of purchasing power. For example, if an investor purchases an asset that produces an annual return of 5% and the rate of inflation is 3%, the purchasing power of the investor has not increased by 5%. Instead, the investor’s purchasing power has increased by 2%.
Different asset classes have different exposure to inflation risk. As explained in later chapters, there are some financial instruments specifically designed to adjust for the rate of inflation.
Credit Risk
The typical definition of credit risk is that it is the risk that a borrower will fail to satisfy its financial obligations under a debt agreement. The securities issued by the U.S. Department of the Treasury are viewed as free of credit risk. (Whether this remains true in the future will depend on the U.S. government economic policies.) An investor who purchases an asset not guaranteed by the U.S. government is viewed as being exposed to credit risk. Actually, there are several forms of credit risk: default risk, downgrade risk, and spread risk. We describe these various risks in Chapter 4 and we will see that the definition of credit risk given above is for that of default risk.
Liquidity Risk
When an investor wants to sell an asset, he or she is concerned whether the price that can be obtained is close to the true value of the asset. For example, if recent trades in the market for a particular asset have been between $40 and $40.50 and market conditions have not changed, an investor would expect to sell the asset in that range.
Liquidity risk is the risk that the investor will have to sell an asset below its true value where the true value is indicated by a recent transaction. The primary measure of liquidity is the size of the spread between the bid price (the price at which a dealer is willing to buy an asset) and the ask price (the price at which a dealer is willing to sell an asset). The wider the bid-ask spread, the greater the liquidity risk.
Exchange Rate or Currency Risk
An asset whose cash flows are not in the investor’s domestic currency has unknown cash flows in the domestic currency. The cash flows in the investor’s domestic currency are dependent on the exchange rate at the time the payments are received from the asset. For example, suppose an investor’s domestic currency is the U.S. dollar and that the investor purchases an asset whose payments are in euros. If the euro depreciates relative to the U.S. dollar at the time a euro payment is received, then fewer U.S. dollars will be received.
The risk of receiving less of the domestic currency than is expected at the time of purchase when an asset makes payments in a currency other than the investor’s domestic currency is called exchange rate risk or currency risk.
ASSET CLASSES
In most developed countries, the four major asset classes are (1) common stocks, (2) bonds, (3) cash equivalents, and (4) real estate. Why are they referred to as asset classes? That is, 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
• 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.
• Risk and return characteristics that are similar.
• A common legal or regulatory structure.
Based on this way of defining an asset class, the correlation between the returns of two different asset classes—the key statistical measure for successful diversification—would be low.
Mark Kritzman 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.
3 He writes:
some 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. (p. 79)
Kritzman then goes on to propose criteria for determining asset class status which includes the attributes that we mentioned above and that will be described in more detail in later chapters.
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.
Common stocks and bonds are commonly further partitioned into more asset classes. For U.S. common stocks (also referred to as U.S. equities), asset classes are based on market capitalization and style (growth versus value).
The market capitalization of a firm, commonly referred to as “market cap,” is the total market value of its common stock outstanding. For example, suppose that a corporation has 400 million shares of common stock outstanding and each share has a market value of $100. Then the market capitalization of this company is $40 billion (400 million shares times $100 per share). The categories of common stock based on market capitalization are mega-cap (greater than $200 billion), large cap ($10 billion to $200 billion), mid-cap ($1 billion to $10 billion), small cap ($300 million to $1 billion), micro-cap ($50 million to $300 million), and nano-cap (less than $50 million).
While the market cap of a company is easy to determine given the market price per share and the number of shares outstanding, how does one define “value” and “growth” stocks? We describe how this done in Chapter 3.
For U.S. bonds, also referred to as fixed income securities, the following are classified 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 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.
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.
• 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 describe what is meant by an emerging market as follows:
4 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. (p. 340)
The asset classes above are referred to as traditional asset classes. Other asset classes are referred to as nontraditional asset classes or alternative asset classes. They include hedge funds, private equity, and commodities and are discussed later.
Real Estate
Before we discuss alternative asset classes, we provide a brief digression to consider where real estate belongs in our classification scheme. Real estate is a distinct asset class, but is it an alternative asset class? There are three reasons why we do not consider real estate to be an alternative asset class.
First, real estate was an asset class long before stocks and bonds became the investment of choice. In fact, in times past, land was the single most important asset class. Kings, queens, lords, and nobles measured their wealth by the amount of property that they owned. “Land barons” were aptly named. Ownership of land was reserved only for the wealthiest of society. However, over the past 200 years, our economic society changed from one based on the ownership of property to the ownership of legal entities. This transformation occurred as society moved from the agricultural age to the industrial age. Production of goods and services became the new source of wealth and power.
Stocks and bonds evolved to support the financing needs of new enterprises that manufactured material goods and services. In fact, stocks and bonds became the “alternatives” to real estate instead of vice versa. With general acceptance of owning equity or debt stakes in companies, it is sometimes forgotten that real estate was the original and primary asset class of society. In fact, it was less than 30 years ago that in the United States real estate was the major asset class of most individual investors. This exposure was the result of owning a primary residence. It was not until around 1983 that investors began to diversify their wealth into the “alternative” assets of stocks and bonds.
Second, given the long-term presence of real estate as an asset class, models have been developed based on expected cash flows for valuing real estate.
Finally, real estate is not an alternative to stocks and bonds—it is a fundamental asset class that should be included within every diversified portfolio. The alternative assets that we describe in this book are meant to diversify the stock-and-bond holdings within a portfolio context.
What Is an Alternative Asset Class?
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? Are they listed on an exchange or do they trade in the over-the-counter market?
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 meet these criteria, commodity futures prove to be the exception to these general rules.
Alternative assets, then, are 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 strategies 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.
SUPER ASSET CLASSES
Although we have defined the general attributes of an asset class, it would help clarify alternative assets if we first define a super asset classes. There are three super asset classes: capital assets, assets that are used as inputs to creating economic value, and assets that are a store of value.5
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 discounted cash flow models; that is, models that compute the present of the expected cash flow from a capital asset.
Corporate financial theory demonstrates that the value of the firm is dependent on its cash flows. How those cash flows are divided up between shareholders and bondholders in a perfect capital market is irrelevant to firm value.6 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 and private equity funds, for example, 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 assets in which the fund manager invests.
Consequently, we can conclude that it is not the types of assets in which they invest that distinguish alternative asset classes such as hedge funds and private equity funds from traditional asset classes. Rather, it is the alternative investment strategies that are pursued by the managers of these asset classes that distinguish them from traditional asset classes such as stocks and bonds.
Assets that Can be Used as Economic Inputs
Certain assets can be consumed as part of the production cycle. Consumable or transformable assets can be converted into another asset. Generally, this class of asset consists of the 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 the traditional discounted cash flow approaches used for common stocks and bonds. For example, a pound of copper, by itself, does not yield an economic stream of revenues. Nor does it have much value for capital appreciation. However, the copper can be transformed into copper piping that is used in an office building or as part of the circuitry of an electronic appliance.
While consumable assets cannot produce a stream of cash flows, this asset class has excellent diversification properties for an investment portfolio. In fact, the lack of dependency on future cash flows to generate value is one of the reasons why commodities have important diversification potential vis-à-vis capital assets.
Assets that Are 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. Consequently, art cannot be valued using a discounted cash flow analysis. It is also not an asset that is used as an economic input because it is a finished product. Instead, art requires ownership and possession. Its value can be realized only through its sale and transfer of possession. In the meantime, the owner retains the artwork with the expectation that it will yield a price at least equal to that which the owner paid for it.
There is no rational way to gauge whether the price of art will increase or decrease because its value is derived purely from the subjective (and private) visual enjoyment that the right of ownership conveys. Therefore, to an owner, art is a store of value. It neither conveys economic benefits nor is used as an economic input, but retains the value paid for it.
Gold and precious metals are another example of a store-of-value asset. In the emerging parts of the world, gold and silver are a significant means of maintaining wealth. In these countries, residents do not have access to the same range of financial products that are available to residents of more developed economies. Consequently, they accumulate their wealth through a tangible asset as opposed to a capital asset.
However, the lines between the three super classes of assets can become blurred. For example, gold can be leased to jewelry and other metal manufacturers. Jewelry makers lease gold during periods of seasonal demand, expecting to purchase the gold on the open market and return it to the lessor (i.e., owner of the gold) before the lease term ends. The gold lease provides a stream of cash flows that can be valued using discounted cash flow analysis.
Precious metals can also be used as a transformable/consumable asset because they have the highest level of thermal and electrical conductivity among the metals. Silver, for example, is used in the circuitry for most telephones and light switches. Gold is used in the circuitry for televisions, cars, airplanes, and computers.
STRATEGIC VS. TACTICAL ALLOCATIONS
Alternative assets should be used in a tactical rather than strategic allocation. Strategic allocation of resources is applied to fundamental asset classes such as equity, fixed income, cash, and real estate. These are the basic asset classes that should be held within a diversified portfolio.
Strategic asset allocation is concerned with the long-term asset mix. The strategic mix of assets is designed to accomplish an investor’s long-term goal. For trustees of defined benefit pension plans, the long-term goal is to meet the long-term liabilities. Risk aversion is considered when deciding the strategic asset allocation, but current market conditions are not. In general, policy targets are set for strategic asset classes, with allowable ranges around those targets. Allowable ranges are established to allow flexibility in the management of the investment portfolio.
Tactical asset allocation is short-term in nature. This strategy is used to take advantage of current market conditions that may be more favorable to one asset class over another. The goal of funding long-term liabilities has been satisfied by the target ranges established by the strategic asset allocation. The goal of tactical asset allocation is to maximize return.
Tactical allocation of resources depends on the ability to diversify within an asset class. This is where alternative assets have the greatest ability to add value. Their purpose is not to hedge the fundamental asset classes, but rather to expand them. Consequently, alternative assets should be considered as part of a broader asset class.
EFFICIENT VS. INEFFICIENT ASSET CLASSES