1. Introduction to Alternative Investments

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Dr. Denis Schweizer Associate Professor of Finance John Molson School of Business, Concordia UniversityMailing address: 1455 de Maisonneuve Boulevard West, Montreal, Quebec H3G 1M8Office: MB 11.305 Telephone: +1(514)-848-2424, ext. 2926Fax: +1(514)-848-4500E-mail: [email protected]

1. Introduction

Investment Analysis



Page 2Investment AnalysisDenis Schweizer

People

Prof. Dr. Denis Schweizer

Associate Professor of Finance

Office: MB 11.305

Office Hours: Thursday 13:00 – 14:00

Telephone: +1 (514)-848-2424, ext. 2926

E-mail: [email protected]

Since 08/2014 Associate Professor of FinanceConcordia University

09/20011 – 01/2012 Visiting Scholar New York University

Since 04/2011 Investment Committee MemberUniversal Bank, Germany

04/2010 – 11/2012 Board member

Source for Alpha AG, Switzerland

08/2008 – 07/2012 Assistant Professor of Alternative Investments WHU – Otto Beisheim School of Management

06/2005 – 06/2008 Research AssistantEuropean Business School (EBS)

04/2003 – 04/2005 Mathematics Johann Wolfgang-Goethe University

10/1999 – 10/2004 Business Administration Johann Wolfgang-Goethe University




Learning Outcome Statement

Differences between active and passive investments

Understanding of the different types of market efficiency

Understanding of market anomalies and risk premiums

The usage of Fama-French-Factors for performance evaluation purposes

Differentiation of traditional and alternative investments




Agenda

I. Active versus Passive Investing

II. Anomalies and Risk Premiums

II. Differences between Alternative and Traditional Asset Classes




What People Think of Active Fund Managers

Active fund managers enjoy a strong marketingedge over passive managers

Many attain celebrity status and their opinions on what the market is doing are highly sought after bythe media

Great faith is often placed in their abilities, and

what they do is often portrayed as glamorous

Some fund managers are paid seven figure salariesand bonuses and are often aggressively headhuntedby rival groups

Above all, active fund managers are usually

perceived to be “interesting” For instance, John Paulson, a well known hedge

fund manager, received $ 3,7 bn. in 2008 forshorting the mortgage market




What People Think of Passive Fund Managers

Passive fund managers are seen as the “nerds” ofthe investment business

Their performance objective is only to match

an index

All they ever talk about is tax efficiency, costminimization, diversification, asset allocation andbuy and hold investing. Where is the fun in that?

Passive fund managers claim to have no specialinsights into what the market is going to do. Theyhave no clever strategy that they intend to employto “beat the market” by a large margin, often

recommending investors “stay the course” and holda diversified portfolio through thick and thin

Above all, passive fund managers are usually

perceived to be “boring”




Active Funds were Underperforming in Eight

out of Nine Style Categories

Active funds versus index

Why is the disadvantage for small caps lower?

Growth Blend Value

102 funds

Large Category average 17.89%

Cap Index benchmark 19.92%

(S&P 500 growth)

Index advantage +203BP

63 fundsCategory average 18.14%

Mid Index benchmark 19.52%

Cap (Russel mid-cap growth)


33 funds

Category average 17.12%Small Index benchmark 13.01%Cap (Russel 2000 growth)

Index advantage -411BP

126 funds

Category average 15.60%

Index benchmark 17.55%

(S&P 500)




(Russel mid-cap)


22 funds

Category average 12.99%Index benchmark 13.73%(S&P 600 growth)


129 funds

Category average 13.37%


(S&P 500 value)




(Russel mid-cap value)


23 funds

Category average 11.74%Index Benchmark 12.91%

(Russel 2000 value)





Active Funds were Underperforming in 82.9% of

the Time

“Using Morningstar’s fund

database, we examined theperformance of more than 2,000active U.S. equity funds during the

15-year period from July 1, 1998 to June 28, 2013. Result: only 25.6%of the active funds currently inexistence outperformed theirbenchmarks.” (S&P Indices versus Active Funds Scorecard)

Source: Ferri and Benke (2013) A Case for Index Fund Portfolios




Active Funds Did Not Outperform on Average

10 10.18

19.22

5.8

9.03

21.43

12.35

15.27

22.4

0

5

10

15

20

25

Growth Fund Core Funds Value Funds

Large-Cap Mid-Cap Small-Cap

Average annual percentage of active funds that beat their S&P Benchmark

Source: S&P Indices versus Active Funds Scorecard (SPIVA) 10-year average ending in 2012




Seeking Explanations… Are Actively Managed

Funds just Less Risky?

Risk/return profiles of passive and active investments

Source: TAM Asset Management, Inc, “Investment Policy Guidelines & Strategies Within the Context of The Prudent Investor Rule”

14,50%

16,90%

12,70%

17,80%

0,00%

2,00%

4,00%

6,00%

8,00%

10,00%

12,00%14,00%

16,00%

18,00%

20,00%

Return Standard Deviation

Average annual returns and standard deviations for the S&P500and 7,125 U.S. domestic mutual funds (1991-2001)

S&P 500 Average Active Mutual Fund




Seeking Explanations… Are Active Funds

Performing Better in Downturns?

52%

63%

71%

0%

10%

20%

30%

40%

50%

60%

70%

80%

2001 96-01 91-01

U.S. equity mutual funds outperformedby the S&P500 Index

71%

59%

69%

0%

10%

20%

30%

40%

50%

60%

70%

80%

2001 96-01 91-01

European equity mutual fundsoutperformed by the MSCI Europe

Index




Seeking Explanations… Are There some

Consistent Outperformers?

Continuous outperformance by some fund managers?

Source: Frank Russell Australia, data by Morningstar

25%

10%

0% 0%0%

5%

10%

15%

20%

25%

30%

1997 1989 1999 2000

What percentage of the top 25% of the equity mutual funds in 1997 belonged tothe top quartile in the subsequent year?




Passive and Active Investment Strategies of

Investment Funds

40%

60%

Breakdown of funds for institutionalinvestors

Passive Active

Individuals hold 47.9% of the market in 1980 and only 21.5% in 2007

This decline is matched by an increase in the holdings of open-end mutual funds, from4.6% to 32.4%

10%

90%

Breakdown of publicly offered

Passive Active




Why Underperformance? - Efficient Markets

Three forms of informational market efficiency

Given that the semi-strong form holds,asset managers cannot obtain a“competitive advantage” in terms of

information gathering and insight

derivation. Their performanceobjective is only to match an index.

Is this deliberate mediocrity

bordering on negligence?

Asset managers can hence onlysystematically beat the market if they

obtain insider information Insider trading is illegal in most

countries!

Strong form:

• All available

information is

fully reflected

in the currentprice

• Prices follow a

random walk

and not even

insiders can

predict share

pricedevelopment

Semi-strong

form:

• All publicly available

information is

fully reflected

in the current

price

• Fundamental

analysis isuseless

Weak form:

• All infor-

mation on

past price

behavior is

fully reflected

in share prices• Technical

analysis is

useless




What Is an Efficient Market? (1/2)

Standard and Poor’s Indexfor a five-year period orplaying a coin-tossinggame for five years?

Random Walk - stock

price change unpredictably Actually stock prices

follow a “submartingale”:

Expected price ispositive over time

Positive trend andrandom around thetrend




What Is an Efficient Market? (2/2)

What could you do if you

find a significant positiveautocorrelation?

Which asset classes couldhave a positiveautocorrelation?




Cumulative Abnormal Returns Before Minority

Buyout Attempts: Target Companies




Stock Price Reaction to CNBC Reports




Why Underperformance?

Simple Mathematics

Even if markets are not efficient, the average perfor-mance of all investors will equal the market return

The market return is the weighted average of passivereturns plus active returns

If the index funds have the same pre-fee return asthe market, then the average active investor will

also have the same pre-fee return

This is a zero sum game, the average return of allactive investors before costs is necessarily going toequal the average return of the market

A trading gain for one active investor must be aloss for another one

Active investment is usually more expensive than

passive investment so active funds, as a group, will do worse than index funds after fees

No amount of trading or research will change that.Some will outperform, but as a group they will

underperform

E i f I di id l M l F d Al h




Estimates of Individual Mutual Fund Alphas,

1993 - 2007

The performance of mutual managers is broadly consistent with market efficiency

Most mutual managers do not do better than the passive strategy

There are, however, some notable superstars:

Peter Lynch, Warren Buffett, John Templeton, George Soros etc.




What to Do?

US public stock-and-bond markets are generally considered to be the mostefficient marketplaces in the world (semi-strong efficiency)

Information in the public market is easy to acquire, in contrast to alternative

assets, where information is often very difficult to acquire

Differences between the top quartile and bottom quartile performance in relatedPrivate Equity / Hedge Fund strategies can be as much as 25% - whereas thedifference is about 1 to 5% for the traditional asset classes

Finding the “talent” or “skill” gains importance!




The Cost of Active Investing

Investors spend 0.67% of the value of all NYSE, Amex, and NASDAQ stocks each year

trying to beat the market

If the expected real return on U.S. equity is roughly 6.7%, the society's capitalized cost ofprice discovery is about 10% of the current value of the equity market – conservativeestimation

Average annual Hedge Fund fee of4.26% and 6.52% for Funds ofHedge Funds

Hedge Fund fees on US equity rose2.8 billion in1996 to 25 billion in

2007 Hedge Funds absorb two-thirds of

the reduction in the other costs ofinvesting

Source: French (2008) JoFSource: French (2008) JoF




The Cost of Active Investing (cont.)

The cost of active investing is 7 billion in

1980, 30.5 billion in 1993, and 101.8billion in 2006

Thus, in 2006 investors searching forsuperior returns in the US stock marketconsume more than 330 $ in resources forevery man, woman, and child in the

United States The market is willing to pay on average

0.67% over time – which is time persistent

Why is the market willing to pay

Hedge Fund managers these high

fees? What is the economic role of Hedge

Funds?

What might happen when nobody is

willing to invest actively?

Source: French (2008) JoF




Agenda







Are Share Prices Driven by Fundamental Data?

Price Chart EM TV (re-named to Constantin Medien AG)

D t d A li i Fi i l M k t




Documented Anomalies in Financial Markets

(Incomplete Selection)

Size Effect (Small Firm Effect) Small companies (in terms of market capitalization) have shown higher risk-adjusted returns

P/E-(M/B-)Effect

Companies with comparably low P/E-Ratio (low Market to Book Ratio), commonly known as

value stocks, have shown higher returns

Dividend Yield-Effect

The stock return increases with the dividend yield

January Effect/Turn of the Year-Effect

„Past“ research : Stock returns in January are higher compared to all other month

Contemporary research: End of year rally

End-of-Month-Effect

First month halves bring higher returns than the second

Change of Exchange Segment Effect

Change of market segment or newly listing in an equity index shows price effects




Returns for 10 Size-Based Portfolios, 1926 – 2012

Ret rns for 10 Book To Market Ratio 1963




Returns for 10 Book-To Market Ratio, 1963 –

2012




Jensen‘s Alpha

Jensen‘s Alpha shows in comparison to a (passive) benchmark the under- or over-performance (excess returns) achieved by active management

Jensen‘s Alpha is widely used to compare the performance of e.g. investment strategies or

mutual funds

Technically Jensen’s Alpha measures the risk -adjusted excess return of a portfoliocompared to its benchmark

= −

+ , ∙ −

Calculation of Jensen‘s Alpha with Fama French




Book-to-Market Ratio

Low Medium High

Marktkapi-

talisierung

Small S/L S/M S/H

Big B/L B/M B/H

Jensen‘s Alpha does not account for risk premiums for small companies („small caps“)

and value stock

Adjusting Jensen‘s Alpha with the so called SMB (Small Minus Big) and HML (HighMinus Low) Factors:

= 3

∙ + + ℎ − 3

∙ ( + + ℎ)

HML value− in comparision to growth stocks =

12

∙ + −12

∙ ℎ + ℎ

The risk-adjustment is done under consideration of Beta (systematic risk), SMB- and HML-factors:

= − + , ∙ − + , ∙ +,∙

Calculation of Jensen‘s Alpha with Fama-French

Factors

Jensen‘s Alpha: Historische Prämien der Fama




Jensen s Alpha: Historische Prämien der Fama-

French Faktoren

Book-to-Market Ratio

Low Medium High

Marktkapi-talisierung

Small S/L S/M S/H

Big B/L B/M B/H

Usage of Fama French Factors to Assess the




0

50

100

150

200

250

28.06.2004 28.06.2005 28.06.2006 28.06.2007 28.06.2008 28.06.2009 28.06.2010 28.06.2011 28.06.2012

DB PLATINUM IV-CROCI US-R1C CRSP firms

Usage of Fama-French Factors to Assess the

Performance of Investment Products

Illustrative example how Fama-French factors are applied to assess the performance of theDeutsche Bank PLATINUM IV — CROCI U.S.

Price chart comparison of the CRSP Equally Weighted Index to the CROCI

Obviuosly the CROCI „outperformed“ the CRSP Index at the end of the observation period

Is it really true if true if control for systematic risk (Beta) and Fama-French Factors?

Fama-French CROCI.xlsm

Comparision of standard“ CAPM and Fama




Comparision of „standard CAPM- and Fama-

French-Regression

"Standard" CAPM-Regression

Beta Alpha

t-Statistic 94.0984 0.3497

Coefficient 0.9508 0.00005

CROCI‘a Alpha is positive, but

statistically not different from

zero − < 1.96 The expected Alpha Return per

year is about 1.15% (0.00005 x

250 (trading days))

The Beta-Factor (systematic

risk) is 0.9508 and lower than

the systematic of theBenchmark CRSP

As a result, the CROCI is moredefensive compared to the

benchmark CRSP, based on the

Beta factor

Fama-French Regression

HML SMB Beta Alpha

t-Statistic -0.1883 -5.8869 86.3252 0.9407

Coefficient -0.0047 -0.0336 0.9595 0.00013

The annual alpha of the CROCI is about XXX% andtherefore XXX compared to the CAPM-Regression, but

statistically XXX different from zero

The Beta-Factor XXX

The coefficient for the SMB-Factor is XXX and statistically

XXX from zero

Der SMB-coefficient indicates an XXX weight of bigcompanies (because of the negative coefficient)

The expected annual XXXperformance related to the SMB-

Factor is about XXX% = (SMB-coefficient [ XXX ] x (SMB-

Factor [ XXX ] x number of month [ XXX ])

Der HML-coefficient statistically XXX from zero

Fama-French CROCI.xlsmStart date June 29th, 2004 and ending date June 27th, 2013




Agenda







Alternative Investments as an Asset Class

“An alternative investment (AI) is any asset that

is not a publicly-traded stock, bond or mutual fund”

Alternative Investments show...

... a low correlation with traditional asset classes ... a wide dispersion of returns in the Alternative Investment Strategies

The key to success are the managers’ skills

What happened during the financial market crisis?

What is a Hedge Fund / Private Equity / Commodity Manager? What is an asset class?




Characteristics of Alternative Investments

Private Equity refers to investments in companies not listed on any stock exchange(private companies)

Is this still true?

Private Equity managers will normally use privileged sources of information or resourcesto achieve a favorable acquisition, develop the acquired company and then sell theinvestment with (hopefully) an “appropriate” return

There are two major investment styles: “venture capital” and “buyout”

Private Equity




Characteristics of Alternative Investments

Hedge Funds refer to privately organized, low regulated investment vehicles, that usually

specialize on a certain investment style No regulation?

Managers are usually renowned traders, or experienced fund managers

Hedge Funds usually have absolute return strategies aiming at positive returns in all market

conditions What does it mean?

Hedge Funds have no (few) investment constraints, can use short-selling techniques,derivatives, and leverage What about mutual Funds?

Hedge Funds

Termination and Special Features of Alternative




Termination and Special Features of Alternative

Investments

Money market investments, bonds, stocks and mutual fund investments are termed“traditional” investments

Traditional investments usually feature the following properties: High dependence on movements of the financial markets

Is this still true for the current financial market crisis?

Traditional investments go up and down in accordance to the market development

High liquidity – usually vendible daily

High transparency (official daily price quotes, obligations for publication, researchactivities, credit ratings)

Strong regulation, comprehensive supervision (exceptions are e.g. pink sheet)

Traditional Investments




Definition: Asset Class

Practical categorization of investment objects (e.g. stocks, bonds etc.) Practicability of the categorization complies with various criteria, for example:

Expected return

Risk (type and amount)

Correlations

Liquidity

Further categorization in sub-classes (e.g. stocks USA, stocks Europe)

Definition „Asset Class“:

Congeneric assets with homogenous risk and return profiles to each other (high internal

correlation) and heterogeneous risk and return profiles to other assets (low externalcorrelation), but without an explicitly co-moving development.




Categorization in “Super Classes” (Greer 1997)

1. Capital Assets

Have a continuous value development /claim on the futurecash flows

3. Store of Value Assets

Assets for theconservation of

values / requiresownership andpossession

Super classes

2. Consumable and

transformable assets

To which aneconomic value isassigned / economicinputs

Greer, Robert, 1997, What is an Asset Class, Anyway?, Journal of Portfolio Management 23, 86-91.



A

Survey of the Alternative Investments Universe

Alternative Investments Universe

AI Strategies AI Assets

Equity HedgedPrivate Equity

Relative Value

Event Driven

Global Macro

Managed Futures

(CTAs)

Hybrid Investments

Buyouts

Restructuring

ExpansionFinancing

Physical Assets

Agricultural Area

Timberland

Real Estate

Commodities

Artwork, Wine...

Securitized Prd. Traditional AI

Convertible

Bonds

High Yield Bonds

Emerging Markets

REITInsurance Linked

Products

CBOs

Cat Bonds

CLOs

Venture CapitalMBS

This is one of many possible categorizations, many others are available!

1. Introduction to Alternative Investments

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