FIN206 Topic 8: Managing an alternative asset portfolio

Arbitrage

Arbitrage traders attempt to profit from security mispricing.

Contrarian

Contrarian theory contends that when the majority of investors are bullish, the top is reached. Conversely, if the majority is bearish, the bottom is reached because most investors have already done their selling. It is a contrarian view of the market that when most participants are bullish, the averages should go down; when most are bearish, they should rise.

Agricultural products - grains

Grain futures have been mostly traded on US exchanges, with the CME Group dominating corn and soybean contracts. Other grain products traded on the CME Group include wheat, soybean meal, soybean oil, oats and rice. However, there are a number of regional exchanges in China, Europe, South Africa and now Australia that trade an increasing number of grain futures and options contracts. Of interest in recent years has been the development of ethanol industries in the United States and Brazil. In the United States, the ethanol feedstock is corn while in Brazil the feedstock is sugar. The development of ethanol industries in these countries now means that grain and sugar markets display a correlation with oil and energy markets.

Cash invested

How much cash or 'skin' has management invested in the company? Investors generally regard the fact that the managers have invested a large portion of their net worth in the company as a particularly good indicator of a highly committed management team. Conversely, if the managers have invested little of their own cash in the company, the presumption is that they are less than wholly committed to the company's success.

Single purpose

Infrastructure assets tend to have only one use or purpose — to support other businesses or activities (e.g. an electricity grid or a toll road).

Meats

Like grain futures, meat futures contracts are mainly listed on US exchanges. The CME Group is dominant and the most actively traded contract in meat futures is CME live cattle. Other contracts such as live hogs, frozen pork bellies, feeder cattle, pig and piglet futures are also traded.

Forecast returns

Notwithstanding many contrary claims, it is suggested that forecast returns differ very little throughout the world; irrespective of the location and once all assumptions are equalised (including sovereign risk assumptions, where appropriate). They tend to fall, according to risk, in a range of between 2% and 5% above the general stock exchange index of the country in which the asset is located.

Topic learning outcomes

On completing this topic, students should be able to: • discuss the main characteristics of alternative assets • analyse the different investment styles for managing alternative assets • describe the risks associated with investing in alternative assets • analyse pertinent risk management techniques to manage the risks of investing in alternative assets.

Price return

Price return for a commodity derivative is a function of the change in the spot price for the underlying commodity over the life of the derivative contract. Price return is impacted by basis risk. This basis is the difference between the local cash price of a commodity and the price of the relevant futures contract.

How private equity funds make money

There are four main ways in which private equity funds operating in the buyout area make money. They can: • improve the profitability of the companies bought and sell them at a profit • buy low, when the market has overreacted, and then sell high • break the company up and then sell it off in pieces — some businesses trade at a value less than the sum of their parts; sometimes an area that is underperforming drains resources and management focus and the rest of the business prospers once it is divested • use leverage — borrowing can multiply gains made from any of the above methods — however, this can also increase the risk profile of the company.

Private equity investment funds

Traditionally private equity funds have been organised as limited partnerships, which are controlled by a private equity firm that acts as the general partner. They then obtain funds from investors such as financial institutions, pension (or superannuation) funds and wealthy individuals. There are over 50 private equity fund managers in Australia, but the majority are open only to institutional investors and individuals with $500,000 or more to invest.

Liquidity risk

Two types of liquidity risk are inherent in hedge funds. The first is that a fund may not be able to, or cannot easily, unwind or offset a particular position due to inadequate market depth. The second is the risk that a fund will not be able to meet its future financial obligations resulting from its investments such as margin calls on futures contracts.

Direct investments in senior and subordinated debt

A large institution or superannuation fund would be able to invest directly in senior or subordinated debt issued by a project. In the case of senior debt, this is most common in the form of nominal or CPI bonds issued by the project. The other main form of senior debt — bank debt — is usually syndicated among a number of banks who, typically, hold these investments on the banks' balance sheets.

Leveraged buyouts

A leveraged buyout (LBO) occurs when a group of investors, which may include the current management team or a new management team external to the company, purchases a company (or division of a company that is being divested) by using relatively high levels of debt financing compared with the debt levels of comparable companies. LBOs usually occur in mature businesses that have reached the phase in their life cycle where substantial cash flows are generated and are surplus to the business's operating requirements. The most suitable businesses for a LBO are those operating in product markets with very predictable demand patterns, regardless of the economic conditions (e.g. food, beverages and tobacco). These businesses generate relatively predictable cash flows, enabling the business to be financed by higher levels of debt and lower levels of equity.

Subordinated debt funds

A number of funds have been established to invest in subordinated debt issued by infrastructure projects. These funds provide investors with exposure to subordinated debt issued by a number of projects without the need to invest directly in each project. The returns from these funds are usually based on floating rate return plus a margin, with added value from capital gains on investments due to decreases in the risks in the underlying project.

List the criteria for an asset to be considered an alternative asset.

An asset may be considered an alternative asset if: • it has a limited investment history • it is not usually included in investment portfolios • its return characteristics differ from traditional assets • it requires specialist management skills.

Change of strategy risk

An investor may invest in a fund with a particular strategy because it matches their risk and return requirements and correlations are expected to remain stable. If a manager ceases to follow its promoted strategy, portfolio diversification may be compromised, resulting in increased volatility of return.

Roll yield

As commodity derivatives expire, an investor who wishes to maintain a position for a longer period must close out the expiring contract and open a new one. This process is called 'rolling over the position'. The gains or losses from this transaction are referred to as the roll yield.

Convertible arbitrage

Convertible arbitrage involves purchasing a portfolio of convertible securities or generally convertible bonds and hedging a portion of the equity risk by selling short the underlying common stock. Certain managers may also seek to hedge interest rate exposure under some circumstances. Most managers employ some degree of leverage, ranging from zero to 6:1. The equity hedge ratio may range from 30% to 100%. The average grade of bond in a typical portfolio is BB-, with individual ratings ranging from AA to CCC. However, as the default risk of the company is hedged by shorting the underlying common stock, the risk is considerably better than the rating of the unhedged bond indicates.

Credit risk

Credit risk refers to the risk that a counterparty will fail to fulfil contractual obligations, or to the credit quality of the clearing brokers and the default risk of the counterparties in any kind of over-the-counter (OTC) trades. Counterparty risks, to a large degree, are dependent on the fund's reputation and its capacity to trade with quality organisations.

Distressed securities

Distressed securities are a form of specialist credit that strategies invest in. They invest in, and may sell short, the securities of companies where the security's price has been, or is expected to be, affected by a distressed situation. This may involve reorganisations, bankruptcies, distressed sales and other corporate restructurings. Depending on the manager's style, investments may be made in bank debt, corporate debt, distressed mortgages, positive carry, private placements, trade claims, common stock, preferred stock and warrants. Strategies may be sub-categorised as 'high-yield' or 'orphan equities'. Leverage may be used by some managers. Fund managers may run a market hedge using S&P put options or put options spreads.

Collateral yield

Investors in commodity derivatives need to post collateral. This usually takes the form of short-term government securities which yield the risk-free rate.

Monopoly/oligopoly

Most (but not all) infrastructure is developed under some form of government 'franchise'. For example, a government grants the operator an exclusive franchise to build, own and operate a toll road. In the private sector, a mining company might grant a franchise to build, own and operate a rail link between the mine and port.

Management commitment

Much of the success of a private equity company depends on its managers. Therefore, a potential investor will want to gauge how committed the managers are to the company. There are several factors to use in assessing this including: • percentage ownership: how much of the company is owned by the management team? Ownership of a large portion of the company is an indication of high commitment to the company • compensation incentives: if management is key to the company's success, an investor will want to ensure that the current managers' interests align with those of the shareholders through the company's compensation arrangements.

Energy

Oil futures were introduced in the late 1970s with NYMEX listing West Texas Intermediate (WTI) crude oil futures. Brent Crude Oil contracts were later listed on what is now known as the 'ICE Futures market'. NYMEX energy contracts are among the world's leading price discovery and risk transfer benchmarks for crude oil, natural gas, heating oil and unleaded gasoline. Crude oil is the major feedstock for oil refineries. The most recent entrant to the energy futures platform has been electricity futures. Many of the participants in the electricity market are also expected to be significant players in growing market of emissions trading.

Listed private equity funds

Some private equity funds have listed on the Australian Securities Exchange (ASX). The investment mandates and approach of these funds are similar to their non-listed counterparts. The difference is that they source the equity component of their capital structure from the market. One advantage of the listed structure over an unlisted vehicle is that the listing of the stock provides liquidity to investors who can trade in and out of the stock as desired. Another benefit is that it provides the ability for smaller investors who may not be in a position to fund $500,000 minimum individual investments to invest in the private equity sector. Their funds can be structured as: • direct investment • fund-of-fund.

What are the two (2) main benefits of alternative investments?

The two main benefits of alternative investments are: • reduced risk through diversification • relatively higher risk-weighted returns.

Risks specific to hedge funds

There are a number of risks that are considered to be specific to hedge funds: • gap and liquidity risk • change of strategy risk • human risk • market impact risk • mark-to-market risk.

Direct investment

These are funds that take a direct equity stake in the underlying company or project. They have a management team that makes decisions as to where to invest.

Direct equity investment

This option is available only for large institutional investors and superannuation funds. Advantages of direct equity investment The advantages of direct equity investment are: • no management fees payable to a third party • access to unlisted equity. Disadvantages of direct equity investment The disadvantages of direct equity investment are: • investor needs expertise and resources to assess investment • investment is not available in small parcels • investment is illiquid.

Term

Where an asset is contracted to be handed back to the franchising government at the end of a period, the term is self-defined. However, for some assets (e.g. a power station) the term will be assessed on the basis of the expected operating life. Clearly, the longer the assumed life of the asset, the greater is the present value.

What are the broad categories of commodities you can invest in?

- Base metals • precious metals • energy (oil & gas) • agriculture • electricity.

Human risk

A hedge fund is only as good as its managers and traders. The human factor is therefore critical. Funds often have a low transparency therefore investors are heavily reliant on their fund managers. Thus, adequate incentive structures are necessary to retain quality staff. The departure of a key staff member might affect the pursuit of a manager's strategy and capabilities. Human risk is exacerbated in funds with a single manager. However, funds with two or more managers tend to have far lower key person risk.

Macro

A selection of HF strategies is classified as 'directional' as distinct from 'market neutral' (i.e. non directional) strategies. Macro HFs may be global asset allocators (i.e. global macro strategies) or may specialise in emerging markets or just short selling (e.g. tactical traders). Macro involves investing by making leveraged bets on anticipated price movements of stock markets, interest rates, foreign exchange and physical commodities. Macro managers employ a 'top-down' global approach, and may invest in markets using any instruments to participate in expected market movements. These movements may result from forecasted shifts in world economies, political fortunes or global supply and demand for resources, both physical and financial. Exchange-traded and over-the-counter derivatives are often used to magnify these price movements.

Evaluating investee companies

As with any investment, due diligence is extremely important when considering a direct private equity investment in an investee company. Private equity investors need to be especially careful due to: • reduced disclosure requirements • limited availability of information • expected liquidity constraints that make early exit difficult • higher expected risk profile of these investments. Key considerations include: • the prospects for market success • a review of operations • reviews of financial and legal issues.

Illiquidity

As with infrastructure, venture capital requires 'patient capital'. Investors must be prepared to develop the investment to a stage where it is either sufficiently large to command a premium on listing on a stock exchange, or alternatively attract a trade buyer. All these factors suggest that venture capital is a very high-risk investment which would not, superficially, appear attractive. However, because venture capital is at the extreme end of the risk spectrum, it commands a very high-risk premium and as a consequence, successful venture capital investments can be extremely rewarding.

Asset class generic risks

Asset class generic risks are: • market/economic risk • political risk • environmental risk. Generic risks spread across the class: • Will the economic environment in which the asset operates be appropriate? • Will there be continuing political support? (Remember infrastructure assets generally depend on government franchise) • What will be the long-run environmental impact? In all assessment of risk it is important to recognise that infrastructure assets are illiquid and involve patient capital and it is therefore frequently difficult to correct initially incorrect risk assessments.

Asset-specific risks

Asset-specific risks are: • design risk • construction risk • operations risk. Asset-specific risks go to the economics of the project: • Will it be designed correctly? • Will construction be on time and on budget and if not, what compensation or damages will the builder meet? • Will it operate according to plan? • What liabilities exist for failure to operate (e.g. contaminated water, electricity and gas outages)?

Why invest in alternative investments?

Consideration of any investment rests on the value that it adds to an existing portfolio. Any proposed investment is assessed according to characteristics such as the return, risk and correlation with other asset classes. Proponents of alternative investments argue they often have high return, low risk and low correlation in the range of traditional investments being employed; such as shares, bonds and property. If an alternative investment exhibits strong return, low risk and low correlation, it has the potential to improve the efficiency of a portfolio of traditional assets. Alternative assets also tend to be more expensive than traditional assets. It is usual for hedge funds and private equity funds to charge performance fees in addition to a standard retainer fee. For example, a hedge fund fee of 2% retainer plus 20% of any profit is typical. In addition, a hedge fund of funds may charge an additional 1% flat fee plus another 10% of profits. All asset classes should always be assessed on the basis of value added after the deduction of fees and taxes. Alternative assets such as private equity and infrastructure are long duration assets and require a long investment horizon. They are relatively illiquid and therefore must offer an additional return (known as the illiquidity premium) to compensate investors for locking away their capital.

Systems, processing and legal risk

Due to the specific and complex nature of the trades undertaken by hedge funds, systems and processing risk is higher for these funds than for those traditional investment funds which invest in shares or bonds on a long-term basis. A systems breakdown has the potential to cause significant damage to overall risk management. Technical problems in clearing a trade may result in time delays and extra costs. Legal and political risks are usually mentioned only in relation to funds investing in emerging markets. Most investors conduct very detailed due diligence on fund operations covering issues including, but not limited, IT systems, disaster recovery, compliance regime, processes, risk audits and outsourced service providers.

Equity hedge

Equity hedge investing consists of a core holding of long equities hedged at all times with short sales of stocks and/or stock index options. Some managers maintain a substantial portion of assets within a hedged structure and commonly employ leverage. Where short sales are used, hedged assets may be comprised of an equal dollar value of long and short stock positions. Other variations use short sales unrelated to long holdings and/or puts on the S&P 500 index and put spreads. Conservative funds mitigate market risk by maintaining market exposure from zero to 100%. Aggressive funds may magnify market risk by exceeding 100% exposure and, in some instances, maintain a short exposure. In addition to equities, some funds may have limited assets invested in other types of securities.

Equity market neutral

Equity market neutral investing seeks to profit by exploiting pricing inefficiencies between related equity securities and thus neutralising exposure to market risk by combining long and short positions. Typically, but not in all cases, the strategy is based on quantitative models for selecting specific stocks with equal dollar amounts comprising the long and short sides of the portfolio. One example of this strategy is to build portfolios made up of long positions in the strongest companies in several industries and taking corresponding short positions in those showing signs of weakness. Another variation is investing in long stocks and selling short index futures. During the GFC there were market neutral hedge funds that delivered positive returns in 2008 as a result of the zero market exposure. This strategy has a very low volatility due the low equity exposure and is often geared to enhance returns.

Equity non-hedge funds

Equity non-hedge funds are predominantly 'long' equities although they have the ability to hedge with short sales of stocks and/or stock index options. These funds are commonly known as 'stock-pickers'. Some funds employ leverage to enhance returns. When market conditions warrant, managers may implement a hedge in the portfolio. Funds may also opportunistically short individual stocks. The important distinction between equity non-hedge funds and equity hedge funds is equity non-hedge funds do not always have a hedge in place. In addition to equities, some funds may have limited assets invested in other types of securities.

Event-driven

Event-driven is also known as 'corporate life cycle' investing. This involves investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganisations, recapitalisations and share buybacks. Instruments include long and short common and preferred stocks, as well as debt securities and options. Leverage may be used by some managers. Fund managers may hedge against market risk, for example, by purchasing S&P put options or put option spreads.

Fund of hedge funds

Fund of hedge funds (FOHFs) are pooled vehicles investing in a number of hedge funds. Some FOHFs focus on a single strategy and others pursue multiple strategies. With the explosion in the number of hedge funds globally, keeping track of the better ones is a complex task. Given the time and expertise required in conducting due diligence on managers and making strategy allocations, many investors have turned to FOHFs. Another major difficulty is that most hedge funds are located in the United States, the United Kingdom or Europe. Other than structured products, FOHFs have been the predominant offering to retail investors. FOHFs are generally accepted as the less risky route to accessing investments of this nature as a result of their diversification.

Political risk

Hedge funds and other market participants were affected by the decision in many countries to place a ban on short selling during the global financial crisis. This made it difficult for some funds to execute their strategies during this period. Rightly or wrongly, hedge funds are often blamed for volatility in financial markets and are then targeted for potential regulatory backlash.

Hedge funds

Hedge funds are a managed pool of funds that utilise various trading strategies to exploit market inefficiencies and hedge underlying risk. Originally, the purpose of hedge funds was to give investment managers the ability to hedge their exposure to downward movements in equities by combining long and short positions that allow them to profit in otherwise falling markets. Today hedge funds are used not only to offset the risks involved in the traditional asset allocation within an investment portfolio, but also to pursue higher returns with a greater risk appetite. There are essentially two common elements that characterise most hedge funds. Their aim is: • for absolute, rather than relative, performance. Whereas a traditional fund manager would seek to outdo the market average on the upside and experience smaller losses on the downside, hedge fund managers seek returns that are not necessarily related to the direction of the market • to attempt to profit from a more astute understanding of the market. Hedge funds thrive on the market's temporary errors. They do not so much 'price' investments as assess the validity of the pricing of investments.

Example: Private equity acquisition and disposal of Myer

In March 2006, a consortium comprising Newbridge Capital and the Myer family purchased the chain of Myer department stores from the listed Coles Myer group. The parent company of Newbridge Capital, Texas Pacific Group, provided funding for the transaction. The bid was worth in excess of $900 million. In November 2009 the private equity consortium exited the investment via a sharemarket listing.

Venture capital

In its narrow definition, venture capital is an investment made into a company which is in the early stages of developing a product or service. These companies are almost invariably operating at a loss and have highly unpredictable cash flows. The capital is used to ascertain whether the product has a viable market and to develop the product further. This phase involves quite substantial business risk because the company is seeking to develop unproven technologies or products. In Australia, about 18% of private equity capital is invested in venture capital. This is consistent with international trends of about 20%.

High capital cost and long payback

Infrastructure assets are 'patient' capital in that initial development involves high upfront capital costs and extended payback over the asset's life. It can also involve costly redevelopment and ongoing maintenance.

Terminating

Infrastructure assets tend to have a natural or imposed time limit on operation. Thus a toll road is handed back to the government at the end of a period or an electricity generator reaches the end of its useful life.

The impact of tax

Infrastructure returns are heavily distorted by taxation; therefore, any evaluation of infrastructure investments must incorporate this perspective. Unlike most listed equities, infrastructure investments typically have high gearing ratios and experience income tax losses for a significant part of their early life. Infrastructure investments typically pay low or no dividends throughout the early stages of their operation. Finally, infrastructure is highly capital intensive and is therefore affected by any changes to the depreciation rules.

Investing in private equity

Institutional investors who wish to invest in private equity can choose to invest directly or through a private equity investment fund. Investing directly requires a high degree of manager involvement in the investee company. Investing through a private equity fund is the more common path.

Investing in commodities

Investment in commodities primarily takes place through derivative contracts. Both futures and options are available on commodities through a number of global exchanges. Commodity options are generally options on futures. Futures contracts can either be cash settled or physically delivered. The vast majority of commodity futures and options contracts around the world are deliverable at expiry. Contract deliverability ensures that the futures and options commodity markets remain true to the underlying physical market. In established exchanges, the percentage of deliveries is very small when compared with total volume traded and open positions. For example, deliveries made against the grain contracts on the Chicago Board of Trade (CBOT) — which is also a CME Group Exchange — account for less than 3% of total volume traded in any given year

Discount rate

It is usual to apply a 'real' rather than a nominal discount rate, making an assumption for long-term inflation. Although, in general, the greater the inflation assumption used, the lower is the present value, and thus, in some cases, the more conservative the evaluation (e.g. toll roads, electricity distribution and airports). Inflation assumptions are part of the revenue profile and so it is not unusual to apply different (lower) inflation assumptions for revenue forecasts. However, it is important to note the gearing of finance for infrastructure investments. Most infrastructure tends to have a high level of gearing (i.e. debt financing) and thus the risk profile of the investment will have to be adjusted to take variables such as inflation, and by extension interest rates, into account.

Managed futures funds

Managed futures funds are investment entities that take long or short positions in exchange-traded commodity derivatives and/or financial derivatives such as futures, options and warrants. Managed futures funds operate in the futures and options markets. Their returns are not generally positively correlated to the traditional asset classes (i.e. bonds and stocks) and are therefore a potential source of further portfolio diversification for investors. As a major part of the fund's portfolio is invested in the money market (e.g. only deposits of 3-5% of effective value are required on most domestic futures contracts), the level of short-term interest rates can significantly affect performance. Managed futures funds are investment strategies that seek to generate returns solely through the trading (long and short positions) of futures contracts. This includes the active trading of futures on commodities (e.g. metals, grains) and financial contracts (e.g. fixed income, foreign exchange, equity indices) performed by commodity trading advisers.

Transitional

Many infrastructure assets tend to evolve to more traditional asset types over time, as cash flows stabilise and/or as management seeks to expand the asset out of its single-purpose niche. Thus, as traffic flows stabilise on a toll road, it comes to resemble, for example, an inflation-indexed bond, while at the other end of the scale a single-purpose utility may seek to diversify to develop complete business.

Market and leverage risk

Market risk represents the risk of adverse movements in investment markets. Holding any security that creates exposure to movements in the prices of a security or market creates such risk. Although the resulting market risks are not peculiar to hedge funds, because of the leverage employed in certain strategies, they can be higher than those applying to a traditional investment fund. Leverage is essential to HFs but there should be a distinction between net leverage and gross leverage. Gross leverage, or exposure, is the sum of long and short positions while net leverage or exposure is the long positions minus the short positions. Strategies with large gross exposure (i.e. aggregated long and short positions) may face liquidity risks. It was the blatant disregard for gross leverage and the associated risks that caused the HF meltdown in 2008. In 2006, in the height of the bull market, more than half of HFs were levered up more than 2×. By December 2012, net leverage was around 53%.

Commodity pricing and returns

Markets for commodities have evolved individually and are generally distinct from financial markets. If there is no central published pricing mechanism, there is no reference price to use for independent price discovery in derivative transactions. For example, there is no clear reference price for malting barley — prices are determined through bilateral negotiation. The more commodities become standardised by grade and quality, the greater the transparency in market pricing which, in turn, helps reduce transaction costs and leads to the development of robust financial markets. Iron ore, once a strictly bilateral market with no published prices beyond the parties to a contract, has started a journey toward open market pricing. Iron ore derivatives will soon follow. Returns from commodities are generated from the following sources: • price return • collateral yield • roll yield.

Merger (risk) arbitrage

Merger (risk) arbitrage — sometimes called risk arbitrage — involves investment in event-driven situations such as leveraged buyouts, mergers and hostile takeovers. Normally, the stock of an acquisition target appreciates while the acquiring company's stock decreases in value. These strategies generate returns by purchasing the stock of the company being acquired, and in some instances, selling short the stock of the acquiring company. Managers may employ the use of equity options as a low-risk alternative to the outright purchase or sale of common stock. Most merger arbitrage funds hedge against market risk by purchasing S&P put options or put option spreads.

Participants

Participants in commodity markets include producers, consumers, speculators, fund managers as well as retail investors and even sovereign wealth funds. Many professional market participants work for large commodity corporations such as gold producers, grain handling cooperatives and wool factories. They understand the fundamental aspects of the physical product as well as the associated financial products. Hedging the price, grade and deliverability risk inherent in a commodity business comprises the bulk of transactions in futures and options contracts. Fund managers have become increasingly active participants in the commodity markets. The inclusion of commodities as an asset class in the portfolio adds diversification to the fund. In general, commodities have a negative correlation to financial assets. When equity prices fall, the holding of commodity assets can help to offset the magnitude of the fall in portfolio value. However, a significant event such as the global credit crisis usually leads to a strongly positive correlation among all asset classes and prices all move in one direction (i.e. down).

Gap and liquidity risk

Potentially, the most dangerous risk for hedge funds is the possibility of a liquidity squeeze in moving markets. Many trading and hedging models and programs imply symmetric price movements which cease to function effectively when price jumps or gaps occur from sharp market declines or government interventions. A dynamic hedge works only as long as both sides of the trade can be adjusted at any time and at fair prices. During a market decline, supply can dominate demand to such a large extent that some instruments have no bid whatsoever or can be sold only at a large discount. Another liquidity problem referred to as 'margin at risk', results from highly leveraged positions. When markets move in the wrong direction, additional variation margin calls have to be satisfied and this may put strain on a fund's liquidity. Also, there is a certain degree of inherent risk from very illiquid positions such as exotic OTC derivatives or distressed securities. If many investors want to redeem simultaneously, cash reserves may not be sufficient and some illiquid positions may have to be liquidated, resulting in large losses. Since the GFC, investors are much more aware of liquidity risk both in terms of a fund's investments as well the fund itself. Hedge funds have reacted to these concerns and, in general, liquidity issues are a major issue considered by the fund manager when investing.

What are alternative investments?

Preceding topics considered a range of 'traditional' investments. There is, however, a wide range of investments that are not regarded as traditional that can also be added to investor portfolios to improve the diversification and the risk-return profile. These are collectively referred to as 'alternative investments'. It should be noted that the classification of asset classes in the funds management industry is subjective. For example, some investors differentiate alternative assets (private equity, hedge funds, commodities etc.) from 'real assets' (e.g. direct property, infrastructure, timberland and agricultural assets). It should also be noted that today's alternative could become tomorrow's traditional investment. One could argue that infrastructure is now more at home in a mainstream asset portfolio than an alternative asset portfolio.

Features of commodities

Precious metals: • more like a financial market, easy to invest in full • range of derivatives available • central banks have a large influence on the gold market • investing to any significant extent in the physical market can be difficult, with high warehousing and insurance costs. Oil & gas: • good range of futures and options to invest in • storage and transportation very difficult • large basis risk between many different grades and tradeable derivatives. Agriculture: • underdeveloped derivatives market for many agricultural commodities • storage always difficult • large basis risk due to grades and locations of physical, relative to tradeable derivatives • hard to invest beyond a year. Electricity: • growing derivative market • cannot store • regional nature. Base metals: • curve risk makes options very difficult • storage and transport of physical • can only invest for 27 months • market dominated by producers.

Relative value arbitrage

Relative value arbitrage attempts to take advantage of relative pricing discrepancies between instruments including equities, debt, options and futures. Managers may use mathematical, fundamental or technical analysis to determine mis-valuations. Securities may be mispriced relative to the underlying security, related securities, groups of securities or the overall market. Many funds use leverage and seek opportunities globally. Relative value strategies are sometimes called risk controlled strategies. They fall into two main groups, namely, convergence arbitrage and equity market neutral. Arbitrage strategies include dividend arbitrage, pairs trading, options arbitrage and yield curve trading. Pairs trading, for example, is when a manager goes long one stock and short another, usually in the same sector. An example would be to buy shares in ANZ Bank and to short-sell the same amount of shares in Westpac. In this case the manager has a view that ANZ has a set of attributes that will lead to it out-performing Westpac. Assuming the manager's analysis is correct, if the market goes up ANZ would be expected to rise by more than Westpac. Conversely, if the market goes down ANZ would be expected to fall less than Westpac. In both cases the manager will profit. It is important to note that, in this case, the investor will have close to no market exposure and so returns will be driven purely by the manager's stock-picking skills.

Softs

Softs is the most diverse agricultural category. It covers a range of contracts including sugar, coffee, cocoa, orange juice, potatoes, cotton, raw silk, flax and dairy products. The New York Board of Trade (NYBOT) is the leading exchange in this area, with three of the four highest volume contracts. Its main contracts are Sugar No. 11, Coffee 'C' and Cotton No. 2. European exchanges are also active in this area, with coffee, sugar and cocoa traded on NYSE Euronext LIFFE (London) and white sugar traded on NYSE Euronext Paris.

Mark-to-market risk

Some illiquid positions cannot easily and objectively be valued since there are no active price makers in the market for many of these instruments on a daily or weekly basis. Consequently, there are times when the true value of an investment cannot be clearly determined. To counter this the Financial Accounting Standards Board in the United States has issued a standard on fair value measurement, which provides a process to follow in looking value illiquid assets. This does not solve the problem but does, at least, provide a standardised process for funds to follow.

Fund-of-fund private equity

Some of the listed private equity funds use a fund-of-fund structure. That is, they invest across a range of specialist private equity managers. They hope to gain access to individual managers who are good at certain types of private equity. For example, one manager might be very good at early stage venture capital, whereas another might be good at buyouts of mature companies. It is rare for one manager to be good at everything. By diversifying across managers, they also hope to smooth returns from these often high-risk and volatile investments.

Expansion capital

The expansion phase has lower risk than the start-up phase as it primarily involves exploiting established and proven technologies and generating earnings growth through expansion of the market for the product or service. The requirements for expansion capital usually relate to the financing of specific projects, providing a quantum leap in a company's operating performance.

PE exit strategies

The key component of most private equity transactions is the exit strategy. Common exit strategies include: • trade sale — sell the asset to another company that is looking to get into the industry or, if already in the industry, is looking to expand. Despite the high profile of big private equity floats, the majority of private equity exits take place through trade sales. • initial public offer (IPO) — float the business on a stock exchange • recapitalise — if the value of the asset has increased it may be possible to borrow against that value. The extra funds raised can then be used to make distributions to investors/limited partners • secondary buyout — where one private equity firm sells to another.

Market impact risk

The larger the fund, the more difficult it is to enter and exit positions without impacting on the market, and timely execution becomes possible only at high transaction costs. Strategies that work for smaller investments will not necessarily work with large and market-moving positions. As funds grow these risks increase and diversification between managers becomes more critical. This risk is very dependent on the asset class in which the fund is investing. For example, merger arbitrage based on US stocks is very different to investing in the same strategy in smaller emerging markets.

Features of managed futures funds

The main features of managed futures funds are: • the use of derivative instruments to obtain a leveraged exposure to equities, bonds, currencies and commodities • enlarged economic exposure arising from the high leverage of derivatives such as futures and options • highly flexible investment positions, as they operate in highly liquid markets and instruments • pursuing speculative gains, rather than seeking to hedge underlying long-term positions • high transparency and liquidity relative to hedge funds • risk-return characteristics different from those of equity or bonds funds, even though the underlying investments may be in those asset classes.

Metals

The metals market can be divided into precious and base or non-precious metals. The New York Mercantile Exchange (NYMEX), now part of the CME Group, and Tokyo Commodities and Metals Exchange (TOCOM) house the largest metals futures contracts. The London Metals Exchange (LME) is often incorrectly included in metals futures trading volumes; however, LME trading is not in futures contracts but in spot and forward delivery. The LME does not have standardised maturity dates for its contracts. The date is specified when the contract is entered into and delivery can be on any specified day within three months of entering the contract.

Trend-following

The trend-following and technical approaches use analytical programs that analyse price trends and initiate trades based on the pattern of those trends. The technical approach analyses trading action within markets, in order to discern what a market is likely to do next. A simple technical method is comparing the current market price to the average market price over the recent past (called the moving average). So the technical analyst tries to predict 'what' will happen, ignoring the 'why.' This is in contrast to traditional investment processes that use fundamental analysis to better understand the 'why' of market behaviour.

Valuation of PE companies

Valuation of PE companies is a difficult task. In Australia PE managers typically adhere to a set of valuation guidelines published by the Australian Venture Capital Association (AVCAL). Companies are commonly valued by one or more of the following methodologies: • earnings multiple • historical cost • price of recent investment • discounted cash flow (DCF) • listed price • net assets. The two most common methods are earnings multiple and historical cost.

Returns of infrastructure

When considering infrastructure investment in the past, it was generally anticipated that returns derived would be of two types: those that were debt-related and those where returns derived from holding the underlying equity. This appears, increasingly, to no longer be the case. In recent infrastructure investments, debt returns have been treated as simple capital market subsets of the corporate debt and fixed interest markets, rather than taking on their own characteristics. Increasingly, the debt has been structured to be marketable and has been syndicated among participating Australian and international banks, designed to tap into the US private placement market or constructed to meet the requirements of the Australian corporate bond market. In contrast, infrastructure equity has quickly developed unique characteristics. It is now common practice to evaluate infrastructure equity on the basis of discounted cash flow (DCF) over a selected term with a selected terminal value. In considering returns from infrastructure equity, the three important aspects to be considered are the discount rate, the term and a terminal value.

Performance measurement

the principal measure used for the performance of unlisted investments is a compound annual cash-to-cash percentage internal rate of return (IRR) to the investor — net of costs. Using the percentage IRR as a measure and, given sufficient historical data to allow significant conclusions to be drawn, it may be possible to compare performance: • of fund managers against their peers • of funds against asset category averages • of one asset category against another • against external benchmarks such as equity indices. Given acceptance of the validity of the IRR as a measure, a significant objective of a venture capital fund is to sustain the compound IRR ahead of listed equity returns by a predetermined margin over an extended period. Because the majority of unlisted investments can take several years to mature, it can be a considerable time before cash-to-cash IRR statistics are available.

Some of the reasons why volatility is high in commodity markets:

• difficulty of storage (agriculture or electricity) • difficult to predict and control production due to weather (agriculture, electricity and possibly for metals — mines being flooded) • supply interruption possible (political instability for metals, oil or agriculture) • underdeveloped markets (electricity and agriculture particularly) • delivery constraints (electricity, possibly gas) • low proportion of world production available to trade leverages (price action in agriculture).

Hedge fund defining characteristics

• the focus on absolute (not relative) returns: preserving capital is often an important element of this, as is non-correlation with traditional equity and bond markets • greater flexibility to invest across any asset class or market, including less liquid instruments — although most still must define what their strategy is and the universe of opportunities they will target • the ability to go short as well as long, thus enabling arbitrage or hedged positions, as well as being less dependent on broad market movements • the ability to employ leverage, through borrowings or via derivatives • the ability to make extensive use of derivative instruments, both over-the-counter and exchange-traded • a reward via a performance fee structure and managers typically have a significant component of their own wealth invested in the funds • restricted fund transparency, as they may operate outside the scope of mandatory disclosure and government regulation • limited or low liquidity: investors are often required to give notice of their intention to redeem their investments as a consequence of the less liquid nature of the strategy's underlying investments.