I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi MGMT-6330 Investment Analysis II 1 Asset Classes, Commodities and Derivatives.

Investment

Analysis II

Investment Analysis II - © 2012 Houman Younessi

MGMT-6330 Investment Analysis II

1

Asset Classes, Commodities and Asset Classes, Commodities and DerivativesDerivatives

Investment

Analysis II

Investment Analysis II - © 2012 Houman Younessi 2

Asset Classes

In order to have a diversified portfolio, we need to understand various asset classes as investment options.

Assets are often classified into two distinct classes:

Traditional Assets, and

Alternative Investments

There is no fundamental economic difference between these classes except that alternative investments generally:

Are less liquidAre more difficult to value

Have limited historical risk and return data

Compared to traditional assets

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Alternative Asset ClassesInvestment Funds

Investment funds are intermediaries that invest investor pooled funds for a fee.

The investor usually receives a share of the fund proportional to his/her investment.

Investment funds are either managed or unmanaged.

Unmanaged funds are also called Unit Investment Trusts and hold a fixed portfolio for the life of the trust and is often tax exempt. Unmanaged funds are usually ready to redeem investors’ shares immediately at market value.

Managed funds are in turn classified in terms of their readiness to redeem investors’ funds.

Open-end funds (Mutual Funds) do redeem at request

Closed-end funds do not . Instead they issue shares that are then traded on secondary markets

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4Investment Analysis II - © 2012 Houman Younessi

Traditional Asset ClassesTraditional asset classes include:

Domestic equityU.S. treasury bondsU.S. municipal bondsInternational developed market equityInternational emerging market equityU.S. blue chip corporate bondsCash

We have already studied these in

Investment Analysis I and earlier in this

course

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Alternative Asset ClassesAlternative asset classes include:

Investment FundsTangible AssetsCommoditiesAbsolute Return InvestmentsDerivatives and Exotics

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Valuation

The basic valuation metric is Net Asset Value (NAV), the per share value of the investment company’s assets minus its liabilities. The most significant liability

comes from fees owed to investment managers (if any).

For unmanaged and open-end investment funds, the share value is the NAV as they stand ready to redeem at market value.

For closed-end funds, the share price is determined in a secondary market and may be at a premium to the NAV or at a discount to it.

Fees are usually calculated as a % and are either one-time or periodic (e.g. annual). One-

time fees may be front-end loaded (a % of purchase) or back-end loaded (a % of value at

exit). Back-end charges may be declining (reduce as you stay in the fund)

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Exchange Traded Funds (ETF)

ETFs allow investors to buy or sell exposure to an index through a single financial instrument. They trade on a stock market just as shares of any

individual company.

ETFs have many advantages:

Can assist in diversification. With a specific type of ETF (say an equity-oriented ETF), the investor can gain exposure to different types of capitalization (large cap, mid cap, etc.), style (value or growth), sector, industry or country or region.

ETFs trade as stock and can be sold long or short or bought on margin.

Traditional mutual-funds often are traded only once a day at closing, ETFs trade throughout the day.

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Exchange Traded Funds (ETF)ETFs advantages (cont’d):

For many – if not most – ETFs, there exists futures and options contracts on the same index.

ETF portfolios are published on a daily basis whereas other funds are only published quarterly at best.

ETFs are cost efficient. You can buy exposure with one transaction that otherwise would require establishing an entire portfolio wit many individual transaction fees

ETFs are cost effective. There are no load fees, and the expense ratio can be held low as there is no shareholder accounting at the account level.

Dividends are reinvested immediately whereas for mutual funds timing of reinvestment varies.

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Exchange Traded Funds (ETF)ETFs dis-advantages:

In many countries, actively traded ETFs track only a narrow-based index, such as only large-cap stocks. No ETFs are often available for mid and small cap investments. This is NOT the case in the US.

Some ETFs do not have sufficient trading volume to have a small bid-ask spread.

ETFs are often of limited use to very large institutional investors as they can invest directly in an index (roll their own). The costs may be less and the tax situation usually better.

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Exchange Traded Funds (ETF)Risks of ETFs:

The following are the risk elements that must be considered when valuing an ETF. Note that not all risks impact all ETFs uniformly:

Market risk: Like all other market based investments, the value/price of an ETF (NAV) changes with the changes in the market.

Asset class/sector risk: Any asset class or sector may underperform the market.

Trading risk: As there may always be market impediments, the ETF may trade at a discount to its NAV.

Tracking error risk: ETFs are constructions. They are designed to track their corresponding index closely. They cannot guarantee this.

Country and currency risk: ETFs may be subject to unfavorable fluctuation in currency or stability of the country in which the ETF has invested.

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Exchange Traded Funds (ETF)Applications of ETFs

Implementing asset allocation: ETFs can be used to effect asset allocation among baskets of stocks, bonds and other assets

Diversifying sector or industry exposure: ETFs can be used to diversify away the sector or industry specific event risks

Gaining exposure to specific market on a broad basis

Equitizing cash: By investing in ETFs investors may be able to put idle cash to good short-term use

Adjusting the portfolio: Investors can use ETFs to quickly adjust exposure to an industry or sector to re-align an overall strategy

Applying sophisticated tactics: Investors can long, short, leverage and time ETFs

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Alternative Asset ClassesTangible Assets

Tangible assets, as opposed to financial assets, are those assets that may be touched and seen in themselves in addition to their ownership documents.

Tangible assets come in a wide variety including:

Land Buildings Natural resources (timber, minerals, fish) Vehicles (e.g. ships), containers, etc. Artworks

We will concentrate on Real Estate (land, buildings and land based resources), as it is by far the largest section of this category

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Alternative Asset ClassesReal Estate

Real estate investments may be actual (tangible) or derivative (intangible).

Actual real estate may be:

Non-value added (land)Value-added (land and buildings)Value-adding real estate (timberland, mines, etc.)

Derivative real estate investment are securities derived from the sale of real estate or related to the sale of real estate (such as buying mortgages or mortgage-backed security bundles)

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Alternative Asset ClassesReal Estate

Forms of Real Estate Investment

Free and clear holding: Unencumbered full ownership rights for an indefinite period

Leveraged equity: Full ownership rights for an indefinite period encumbered by debt (a promissory note unrelated to the real asset under consideration) or a mortgage (a pledge that in case of inability to discharge the debt, the ownership would transfer to the mortgagor)

Mortgages: Loans secured by the underlying real estate made to third parties

Aggregation vehicles: Aggregates investors and gives them access to real estate investment to which they may not otherwise have access. Real Estate Limited Partnerships (RELP) and Real Estate Investment Trusts (REIT) are examples of these aggregation vehicles

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Alternative Asset ClassesReal EstateValuation

Real estate valuation is very difficultOne often has to estimate the actual value of the asset, AND the value of the potential “value added” income streams, AND the on-going cost of ownership

Note that:

Properties are immovable and usually indivisible and as such usually very illiquid

Properties are only approximately comparable in value

There is no national or international real estate auction market, to determine values by consensus

Transaction costs and management fees are usually very high

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Basically there are four approaches:

1. The replacement cost approach:

How much would it cost today to replace this real asset? Of course one needs to estimate the value of land (an independent exercise), PLUS estimating today’s cost of the current improvements.

This approach is limited in value as a) we still need to estimate the value of the land, and b) the market value of a building may

differ enormously from its construction cost (an office building may be very valuable

because it has some prestigious, long term tenants)

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2. The sale comparison approach:

How does this property compare to a similar property whose value is known, or the median or average of a collection of “similar” properties.

A variation called hedonic valuation is when the major characteristics of a property are evaluated on an ordinal (1-10) or absolute ($) scale and and used to modify the estimate.

This approach has become standard in

valuation of residential properties and its use in commercial appraisals is

increasing

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3. The income approach:

This method uses a perpetuity discount model to value real estate.

The perpetuity is the annual Net Operating Income (NOI). NOI is gross potential income minus expenses including vacancy, collection losses, insurance, property taxes, repairs, utilities, and maintenance costs.

Appraisal rate = NOI ÷ Market Cap Rate

where Market Cap Rate = Benchmark NOI ÷ Benchmark Transaction Price

Benchmark may be a single property or the average or median of a number of properties

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4. The discounted after-tax cash flow approach:

This method is based on the fact that an investment is worthwhile when its expected net present value is positive. Alternatively, the investment yield (internal rate of return) should exceed the investor’s required rate of return.

WORKSHOP

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Alternative Asset ClassesCommodities

While investing in most stocks and in corporate bonds allow the investor to invest in an economy’s manufacturing and service sectors, and government bonds

allow investment in the government, commodities allow investment in the primary production of an economy.

Commodities generally come in three categories:

Agricultural and farming products (soft commodities:

Fibers, grains, livestock, beverages (coffee, cocoa, etc) , spices, dairy

Energy:Oil, gas, electricity

Minerals:Gold, silver, copper, coal, aluminum

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Most investors do not wish to store grain or oil or tend to animals. Very few investors (as opposed to consumers) buy the actual commodity.

Investment in commodities is usually indirect by way of:Future contractsCommodity or inflation indexed bondsStock of primary production companies

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Futures Contracts

As we have learned, a futures contract is a standardized, exchange-traded agreement between two parties in which the buyer agrees to buy an asset from

the seller at a future date at a price agreed upon at contract time.

Futures contracts are the easiest and cheapest way to invest in commodities.

There are two types of commodities futures indices:

Broad-based (tracker)Investible Index

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Futures Contracts

Broad-based Tracking Indices: Several commodity indices have been developed. Some traditional indices are broadly based and have a global perspective and aim to track the changes in

input prices.

Investible Indices: are in turn based on a limited basket of the most liquid commodity futures

contracts so they can be easily replicated by taking proportional positions in the participating commodities. For example, the Goldman Sachs Commodity Index

(GSCI) is a world-production weighted index of 24 commodities with liquid futures contracts

Although available elsewhere, commodities usually have their own exchanges. For instance the Chicago Mercantile Exchange (CME)

is the largest of its kind in the US.

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Commodity-Linked Bonds

During inflationary periods, many governments have been forced to offer loans (bonds) with coupons or

principal indexed to either the price of a specific commodity or an inflation index.

Examples are: The Gilt in Britain (based on the price of gold and introduced in the 1980s) and the

Treasury Inflation Protected Securities (TIPS). The principal is indexed to the consumer price index CPI

and as such (somewhat indirectly) to commodity prices.

Many other countries such as France, Australia, Sweden, Canada, and Italy have offered bonds

based on the price of gold, oil, or agricultural products.

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Stock of Primary Production Companies

BHP Billiton (BHP) is an Australian conglomerate involved in oil production, oil exploration, gold mining, agriculture, coal, bauxite, and commodities

management. Of course buying a share of BHP Billiton would be investing in a diversified basket of commodities!!

There are many companies similar to BHP and those that are more focused on a single or narrow range of commodities such as Exxon-Mobil. Single product

mining companies are a good example of a stock very directly influenced by the price of the underlying product.

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Investment Features

Commodities tend to have positive correlation with inflationThey tend to have a low or negative correlation with stocks

Supply and demand clearly has a determining role in the price of commodities as often do weather and fuel (transportation) costs.

The general growth in population and demand from emerging nations would in long-term help to increase all commodity prices

Improvements in technology, transport and means of production would tend in long-term to lower commodity prices.

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Investment Examples

Futures:

Cocoa (CJ, CC); Coffee (C, KC, KT, KO); Corn (ZC); Cotton (TT, CT)

Company Stock:

Monsanto (MON); Deere and Co. (DE); Bunge (BG)

Funds:

DB Agriculture Fund (DBA); MLCX Grains Index (GRU); Dow Jones USB Cocoa Total Return (NIB); Dow Jones USB Sugar Total Return (SGG)

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Alternative Asset ClassesAbsolute Return Investments

Many investments seek above market returns (alpha) through pursuing opportunities that do not correlate with specific market securities, indices or securities markets. In fact, the only way to generate alpha is to go beyond the characteristics and provisions of the market.

There are two ways of creating such absolute return:

Working outside the “market”Playing “against” the market

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Private Equity Investing

Working outside the markets means creating absolute return and hopefully absolute value, by working outside or almost outside the context of the public securities market.

Private Equity Investment is the means by which an investor can play outside or almost outside the securities markets sandbox. There are several approaches:

Venture capital investing Privatization through buy-outs, takeovers, (management buy-outs), and leveraged buy-outs Vulture (distressed asset) Investing

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Hedge FundsPlaying against the market means using hedging and other techniques to try to create opportunities to reduce or eliminate risk or increase return not normally available in the regular market.

Although the original “hedge funds” were funds that used hedging to secure an advantage, today this term is applied to a wide variety of funds whether or not they engage in hedging. Colloquially, a hedge fund these days is any fund that:

Uses sophisticated means and vehicles of investing to isolate specific bets to generate alpha Is focused on performance relative to a pre- assigned benchmark Has greater flexibility (fewer constraints) in how it can invest Has a small and “elite” client base with high barrier to entry

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Private Equity Investing

Private equity investing has several characteristics that although some are common to other alternative investing in general, make private equity investing what it is:

Illiquidity Long term commitment required Difficulty in valuation Limited historical risk and return data Investor (equity company) and management mismatch Hands-on

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Hedge FundsClassifications

Long/Short (Real Hedge) Funds Market-Neutral Funds Macro (Global Macro) Funds

Managed Futures Funds Emerging Markets Funds Emerging Sectors Funds

M&A Arbitrage Funds Fund of Funds Funds

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Long/Short funds are traditional hedge funds, taking short and long bets in generally common stocks. They vary their

long and short exposures according to forecasts, use leverage and operate on numerous markets throughout the

world. They often maintain net positive or net negative positions.

These funds are seeming the simplest in terms of philosophy but often amongst the most sophisticated in terms of

execution and technology (they need to be).

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Market neutral funds attempt to hedge against a general market movement. They take bets on valuation differences of individual securities

or funds within some market segment. This could involve simultaneous long and short positions in closely-related securities with a zero net exposure to the market itself. A market-neutral portfolio is usually

constructed so it is:Dollar neutral (equal $ value of long and short positions)

Beta neutral (total sensitivity of long positions equal that of short positions)

Long positions may be (usually are) in stocks considered undervalued, and the shorts are in stock considered overpriced.

Leverage is generally and often liberally used to enhance the returns

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Global Macro Funds take bets on the direction of a market, a currency, an interest rate, a commodity, or any

macroeconomics variable. These funds tend to be highly leveraged and make extensive use of derivatives.

There are many sub-groupings but three are particularly prominent:

Managed Futures FundsEmerging Markets FundsEmerging Sectors Funds

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Managed Futures Fund are pools in which fund managers take bets on directional moves in the positions they hold (long or short) usually in a

single asset class, such as currency, fixed income, or commodities and tend to use many actively traded futures contracts.

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Emerging–markets funds primarily take bets on all types of securities in emerging markets. The securities in these

economies are usually less efficient and less liquid than those in the developed markets thus allowing for greater arbitrage potential. But as there typically is not an organized lending

market for securities, it is difficult to sell short or leverage most positions. Emerging markets represent growth but they also tend to be more volatile and subject to political and currency

risks.

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Emerging-sectors funds primarily take bets on all types of securities in emerging sectors and technologies. These securities are usually subject to a good deal of growth although there is a

corresponding level of volatility. As emerging sectors are by definition new, there is little historical data to guide investment.

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Merger and acquisition arbitrage funds bet on the price difference between the stock price of a company just before merger or acquisition

goes through and the acquisition strike price. Before the effective date of a merger, the stock of the acquired company will typically sell at a

discount to its acquisition value as officially announced. A hedge fund manager simultaneously buys stock in a company being acquired and

sells short stock in the acquirer.

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Funds of funds have been created to allow easier access to hedge funds by small investors. An FoF has access to a large potential investor base (albeit each may invest a much small amount; that is the point) but has

enough funds to invest in a variety of hedge funds thus providing retailing, access, diversification, and expertise to those who otherwise may not be

able to enjoy these in the context of multiple hedge funds.

There are drawbacks with FoFs. They have fees of their own on top of the base hedge fund fees, their performance will be diversified (diluted) if not

all funds perform. Also, as funds in FoFs are selected based on past performance, they may be already passe by the time they make it into a

FoF.

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Hedge FundsSources and Indices

There are literally thousands of hedge funds around. To be able to operate as a true hedge fund, they are not allowed (by the SEC) to advertise for the purpose of investor solicitation. However, there are several firms, banks, index providers and even educational institutions that provide indices in which these funds can

“volunteer”.These include:

Specialist firms: Hedge Fund Research, Van Hedge, Hennessee, Greenwich

Banks: Credit Suisse/Tremont, ABN AMRO EurekaHedgeIndex providers: MSCI, S&P, FTSE

Educational Institutions: CISDM (Umass), EDHEC (school in France)

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DerivativesThe previous pages show us that we no longer live and invest in the simple world of stocks and bonds. Many new instruments have emerged, several – if not most – of which no longer represents a direct investment in an asset but ones that offer

a return based on the return of another underlying asset. These are called derivatives.

Derivative: A financial instrument that offers a return based on the return of some other underlying asset.

Derivatives are called thus as their value is derived from the return of the underlying asset

A derivative is a contract that initiates on a certain date and

terminates on a later date. Often (but not always) the payoff is

determined on the expiration date

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DerivativesTypes of Derivatives

There are two distinct but ultimately related markets for derivatives. Derivatives may be:

Exchange traded contracts: which have standard terms and features and are traded on an organized

trading facility/exchange such as a futures exchange or an options

exchange.

Over-the-counter contracts: which are transactions created by two

parties but not traded on an exchange and usually representing

a “private” deal vis a vis an underlying. This could be a wide

array of deals including purchasing of insurance.

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DerivativesForms of Derivatives

There are two distinct forms of derivatives. Derivatives may be:

Forward commitments: which are agreements between two parties in which one party agrees to buy from the other party an underlying asset

at a future date at a price established at the start.

Contingent claims: which are derivatives in which the payoff

occurs if a specific event occurs. We generally call these types of

claims as options.

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DerivativesForms of Derivatives

Forward Commitments

Forward commitments come in three categories:

Forward contracts or Forwards: This is a forward commitment in which the two

parties “privately” design and therefore customize the deal. The underlying could be anything from a pizza to Pizza Hut Inc.

Futures contracts: which are a variation of a forward commitment that is a

public, exchange-traded, standardized transaction the protection re the default

on which is guaranteed by the exchange. Futures are available on a

wide range of commodities, currencies, stocks, funds, etc.

Swaps: which are a variation of a forward contract (actually it is simply a series of forward contracts) in which the parties agree to swap a series of future cash

flows. Generally at least one cash flow’s value is determined by a later outcome

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DerivativesForms of DerivativesContingent Claims

Warrants

Options are by far the largest category of contingent claims. Other forms of contingent claims (all having option-like features) are:

Warrants: are issued by the firm whose stock (sometimes bonds) serves as the underlying. At the time of issue, a warrant entitles the holder to purchase one share of the stock for the appropriate exercise price. Further stock splits may alter the proportion, always reflecting the original offer. The major differences

between warrants and call options are that:

Warrants have longer expiry than call options, sometimes they are perpetual;

Warrants are dilutive, when a warrant is exercise, the company must issue new stock;

Most warrants are over-the-counter

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Callable/Putable bonds: We have seen these before (lecture 3). A callable/putable bond gives the issuer/buyer the right to redeem the bond for a pre-agreed price before the maturity or (in rare occasions) under certain pre-specified conditions).


Callable/Putable Bonds

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Convertible bonds: Again, we have seen these before. A convertible bond is a bond that carries the right at the holder’s option (the contingent claim) to convert it to another security, often common stock.

DerivativesForms of DerivativesContingent ClaimsConvertible Bonds

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Asset-backed Securities represent a claim on a pool of securities which may be mortgages, automotive loans, bonds, and similar instruments. As borrowers always have the option to pre-pay these loans when interest rates are favorable (re-finance), they hold an option. The investor who buys into the pool of such loans, is in fact selling an option.


Asset-backed Securities

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OptionsAll contingent claims have an option (in the sense of a choice to take action) at their core. As such one can consider them all as types of option instruments (some do).

A proper option however is usually a standardized, more often than not exchange traded instrument that has a contract associated with it called a term sheet that at a minimum specifies the following:

The underlying assetThe right(s) or exercise terms, (call/put)Settlement terms (e.g. deliver the underlying or an equivalent value)Expiration dateStrike price (the price of the underlying)Option price (the premium payable/paid to hold the option)

We shall study options and their pricing in the next lecture

I nvestment A nalysis II Investment Analysis II - © 2012 Houman Younessi MGMT-6330 Investment Analysis II 1 Asset Classes, Commodities and Derivatives.

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