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Specialist asset classes (2) (Hedge funds (Other characteristics (the…
Specialist asset classes (2)
Securitisation
Issue of securities, usually bonds, serviced and repaid exclusively out of a defined element of future cashflow owned by issuer
Often used to convert a bundle of highly unmarketable assets into a negotiable, structured financial instrument
Main asset classes that have been securitised
residential and commercial mortgages
credit card receivables
Bank loans
Corporate bonds
Credit derivatives
Risks facing investor
default risk- cfs from underlying assets insufficient to cover interest and capital payments on asset-backed securities
Prepayment risk- risk that loan repaid earlier than originally anticipated because underlying assets redeemed
Structure
Normally issued in multi-tranche format, with different ranking tranches e.g. senior, mezzanine and equity
Credit ratings and/or credit default protection obtained for (at least) major tranches
Any excess remaining collateralisation returned to original asset owner or kept by bond holders.
Tranches repaid in order of rating with actual timing of amortisation/repayment dependent on underlying assets, early repayments and any default losses and recoveries
Why use over bond issue
Crystallising future profits which can be invested now
bankruptcy remote- so securitised bonds don't appear on balance sheet of issuer- so gearing isn't increased
May appeal to investors who want exposure to subset of issuer's assets.
Multi-tranche format enables default and prepayment risks to be structured in a way that most appeals to range of different investors
May obtain better credit rating than straight bonds secured on general assets of issuer
Special purpose vehicle (SPV)
Original owner of assets sells them to SPV
SPV raises funds to purchase assets by issuing securities to investors
Receivables transferred into SPV meet principal and interest liabilities on debt
SPV may grant security over receivables
SPV strucutred to be "bankruptcy remote", so that in the event of default by the SPV, investor has no recourse to assets of the original owener and vice versa.
Private equity
Investment in unquoted companies not listed on stock exchange
No immediate exit route via secondary market
Forms:
Venture capital
capital for business in conceptual stage or where products are not developed
Leveraged buyouts
Equity capital for acquisition or refinancing of larger company. Typically this involves buying out shareholders of an existing public company and de-listing it. Acquisition often funded by borrowing.
development capital
may be en-route to public issue once sufficiently large and profitable
restructuring capital for financially or operationally distressed companies
Private equity fund
Collective investment vehicle
Unlikely to have quoted price and so no easy way to sell investment, even in small amounts
May be restrictions on when and how investment may be sold,, to which investors agree on entry
Life cycle
3-6m fund raising period
Series of further fund raising period with closing dates over next 3-4yrs. Monies committed in fund raising periods and called on and invested in tranches
Fund starts to make distributions to investors after about 3yrs.
Fund makes all purchases by end of investment period, which may be about 3yrs before end of fund
Fund typically wound up after 8 to 12 yrs.
Why issue private equity
Cost of capital lower under private ownership
Company too risky for public ownership
Valuation is difficult in public arena, perhaps because of lack of information or past history
Advantages of investment
high returns
compensation for high default risk and low marketability
Due to inefficient pricing
due to incentivised management
returns highly leveraged
low correlation with existing investments
Disadvantages of investment
high default risk
lack of marketability
lack of information/ track record
difficult to value
may be constrained by regulation e.g. admissibility regulations
high gearing in LBOs
Hedge funds
An investment fund that aims to meet high or absolute returns by investing across a number of asset classes or financial instruments
Typically less restrictions on
borrowing
short-selling
the use of derivatives
Other characteristics
the placing of many aggressive positions on different assets
a high level of borrowing given the limited size of the capital of the funds compared to the size of the individual investments
a mix of investments for which the price movements would be expected mostly to cancel each other out, except for the positive effect the hedge fund is looking for
Willingness to trade in derivatives, commodities and non-income bearing securities
a higher risk tolerance than other funds
Classes
Global tactical asset allocation
concentrate on macroeconomic changes around the world.
Event-driven
trade in distressed securities or securities of companies involved in M&A (risk arbitrage)
Market-neutral
enter simultaneously into long and short positions, while trying to exploit individual price movements
Multi-strategy
a combination of the above
Biases that influence hedge fund performance data
survivorship bias
data doesn't realistically reflect survivors and failures
selection bias
funds with good history more likely to apply for inclusion in databases
marking to market bias
Since underlying securities may be relatively illiquid, funds typically use latest reported price or own estimate of current market price for valuation. Use of stale prices can lead to underestimation of true variances and correlation
Why out-performance can be questioned
Return distributions are far from normal- many of them tend to be negatively skewed
Therefore, performance measures such as portfolio's alpha and its Sharpe ratio will biased upwards
management fees
fixed fee 1-2% p.a. plus incentive fee of 15-25% of annual fund return over some benchmark
advantages of investing
high returns
low correlation with other investments
disadvantages of investing
high fees
lock-in and/or notice periods
limited regulation means lack of protection
lack of information/ transparency
maximum/ minimum investment sizes
4 heading for key features
management
operations (e.g. legal structure, tax jurisdiction, fees, lock-in periods)
past performance
strategies (e.g. short selling, gearing) and investments
FX market
largest market in world
Players: large banks, central banks, currency speculators, multinational corporations, governments and other financial markets and institutions
Spot transaction
delivered in two working days, with settlement actually taking place in the two separate countries
Forward transaction
Agreeing price today for which buyer will take delivery of the currency on a specific future date
Infrastructure
economic e.g. highways, water and sewerage facilities, energy distribution, telecommunication networks
Social e.g. schools, universities, public housing, prisons
Characteristics
Single purpose in nature, such as a gas pipeline, toll road or hospital
investor's participation often for a finite period
high upfront capital costs with payback occurring over the asset's lengthy life
exhibit characteristics of natural monopolies
subject to varying degrees of government regulation, depending largely on the degree of natural monopoly
Commodities
products that can be used in commerce, i.e. any goods that are traded
Internationally traded agricultural goods such as coffee, fuels such as oil and raw materials such as copper
derivatives
traded around the world, primarily in Chicago and London
future price= spot price+ cost of carry - convenience yield
used by producers and consumers who wish to reduce the uncertainty on the amount they will pay or receive for the product
Specification
contact size
delivery dates
quality of the product
method of the packaging
package size
delivery site
method of resolving disputes about quality
Advantages
significant real returns produced by doing real economic work within the economy
returns accrue without active management
in periods of poor returns, commodities have been highest returning asset class
unlike other asset classes, concerned with short-term supply and demand and short-term risk
disadvantages
no strong historical evidence for a real return from commodities
markets are volatile, being driven by a number of factors unrelated to the underlying economic factors that affect institutional liabilities
Insurance-linked securities (ILS)
Return depends on the occurrence of a specific insurance event, which can be either related to non-life (e.g. catastrophe bonds) or life risks.
Offer the ability to transfer risks from its balance sheet to investors in return for payment of a risk premium
Process of creating a catastrophe bond
Ceding insurance company establishes an SPV in a tax-efficient jurisdiction
SPV establishes a reinsurance agreement with the sponsoring insurance company
SPV issues note to investors; this has default provisions that mirror the terms of the reinsurance agreement
Proceeds from the note sale are invested in money market instruments within a segregated collateral account
If no trigger events occur, the SPV returns principal to investors with the final coupon payment. If event does occur, the assets of the SPV are first used to meet the insurer's losses, before any return of principal (if any)
Structured products
Pre-packaged investment strategy in the form of a single investment. A typical product will consist of two components
A note- zero coupon debt security that provides capital protection
A derivative component that provides exposure to one or several underlying assets such as equities, commodities, FX or interest rates.
advantages
practical- investors may be unable to invest themselves in the underlying derivatives
legal- designed to satisfy legal or reg. requirements
Tax treatment may be more favourable
Accounting- may be structured to avoid income statement volatility from the underlying derivatives
disadvantages
pricing- difficult to assess whether a quoted price is competitive
Costs- distribution costs are generally not explicit and are normally implicit in the quoted price
New ways to invest in old asset classes
Index funds
Exchange-traded funds (ETFs)
Closed-ended investment trust
ETF represents shares of ownership of a unit investment trust (UIT) which holds portfolios of stocks, bonds, currencies or commodities. The investor purchases the shares on a stock exchange.
Actions of arbitrageurs mean that prices are kept very close to NAV of underlying securities
Examples
Index ETFs
SPDRs (track S&P 500 and major sectors of this index)
iShares (cover broad based US, international, industry sectors, fixed income and commodities)
PowerShares including the QQQQ NASDAQ 100 ETF.
Bond ETFs
VIPERs
Commodity, currency, actively managed and leveraged ETFs
Contracts for differences (CFD)
contract stipulating that the seller will pay to the buyer the difference between the current value of the asset and its value at a specific time
examples
Major global indices (Dow Jones, NASDAQ, S&P 500, FTSE, DAX and CAC), many global stocks, commodities, treasuries and currencies