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Chapter 14

Alternative Assets

Portfolio Construction, Management, & Protection, 5e, Robert A. StrongCopyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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“It is unusual that something as boring as infrastructure—pipelines, toll roads, electricity transmission lines, and

airports—becomes the hot new thing but here it is."

Mark Weisdorf, CFA Managing Director

JPMorgan Asst Management

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Introduction Rapid recent growth in importance

• Pensions and endowments allocation growth:– 5 percent in 2000– 10 percent in 2008

Five Category Groups• Infrastructure• Private Equity• Hedge Funds• Commodities• Specialized Real Estate

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Infrastructure Investments Prominent alternative asset

• $3.0 trillion in 2006 Typically started under government authority and later

sold to private investors• Eliminates managerial burden• Raises cash for other societal needs• “brownfield projects”

Sometimes businesses provide originates services that are typically offered by government• “greenfield projects”• e.g., high-speed toll road to Washington D.C.’s airport• Considered to be more risky

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Popular Types of Infrastructure Approximately $3 trillion in 2006, including:

• Toll roads & bridges

• Airports and airport trolley systems

• Railway and ferry systems

• Sporting arenas

• Shipping ports

• Electricity transmission

• Water distribution networks

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International Aspect of Infrastructure Investment

Infrastructure investments:• Are also called public/private partnerships• Are necessary and facilitate economic

development• Are found across the globe

– Canada: $C66

– India: $150 billion

– Europe: €600 billion

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Infrastructure Investment Characteristics

Long-life Cash flows generally stable and inflation linked Significant barriers to entry by competitors Provides essential community service Few substitutes for service Typically are highly levered Highly illiquid

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Infrastructure Investment Options Direct investment

• Requires enormous capital reserves Listed funds

• Most popular investment method by individuals Unlisted funds

• Offered through investment banks• Most popular investment methods by pension

funds and institutional investors

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Advantages of Infrastructure Investment

Annual cash flow stream• Periodic increases to keep up with inflation

Private management may provide efficiencies unavailable to government

Low correlation with other assets• Too new for many long-term studies

• Australian equities and infrastructure: 0.32– Zero correlation between non-Australian equities and

Australian infrastructure

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Hedge Funds No single definition Common characteristics

• Low-correlation focused investment funds• Relatively few investors• Substantial minimal initial investment• Investors are limited partners

– Hedge fund is general partner– The unlimited liability of general partner is used to justify

management fees and large proportion of profits– Consistency of return is typical investment objective

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Hedge Fund Demographics Total number of funds is unknown Only hedge funds with $30 million in assets or

over 15 investors must register with SEC Hedge funds publicize success, biasing

perceptions in favor of hedge fund investment Alfred Jones started first hedge fund in 1949

• - used short positions to offset risk of equity positions In 2008:

• $2 trillion dollars invested• 44% held by individuals

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Hedge Fund Classifications Nondirectional/Directional Strategy

• Anticipated changes in the underlying market does not impact choices in nondirectional strategies

Arbitrage/Relative Value strategy• Assumes the “mispriced” securities will move towards

their normal relationship• Merger arbitrage may result in selling shares of

acquiring firm and buying those of acquired firm• Convertible arbitrage may result in selling shares and

buy convertibles bonds to earn interest income– “may” because one has to consider current price and perceived

value of both positions

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130/130 Strategy A long/short strategy

• Buying undervalued stocks and selling overvalued stocks Within a given portfolio, sell short the 30%

considered to be overvalued and invest the proceeds in the 30% considered to be undervalued.

For every $1 originally invested, there now is another $0.60 worth of positions taken• The proportions could be any number greater than 100

– 110/110 or 120/120, but not 120/110

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Hedge Fund-of-Funds Portfolio of hedge funds Lower initial investment than individual

funds Higher management fees

• Pay fees to fund managers and Fund-of-fund managers

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Commodities Now a widely-used investment class Primary advantage: Low correlation with equity

investments• Over 1994-2008 period, the correlation with the

Wilshire 5000 Index has been between 0.02 and 0.10, depending on index

Primary disadvantage: Returns typically do not outpace inflation• May outpace inflation during short periods• In 2008: Oil and wheat hit record high prices

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Commodities (cont’d) Some institutional investors use futures

markets Seek price gain, not the commodity itself Others invest in farmland, almond groves,

and vineyards where assets will be produced

“Price bubbles”• Farmland, ethanol, and all commodities

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Private Equity Acquisition of a significant portion of a

company, develop the company’s value, and sell it to the investment community• There always is a clear exit strategy consisting

of receiving cash Unlike the entrepreneur, and private equity

investor has a target selling date• Both are willing to put forth the time and effort

needed to influence corporate decisions

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Private Equity Investments in 2006

Private Equity Portfolio Allocation

Expect a Significant Increase in Allocation over 2007-2009 period

Corporate Funds 4.4% 36%

Endowment Funds 8.4% 61%

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Forms of Private Equity Venture Capital

• New companies or new ideas– High revenue growth, limited net income

Corporate Finance/Buyout• Established firm investment

– Help them take advantage of competitive advantage

Mezzanine Financing• Provision of second-mortgage financing

– May convert to equity

Distressed Firm Financing• Cash infusion when firm is unable to make debt payments

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J Curve Pattern of returns from private equity investment to cash

event Typically lose money in first four or five years Eventually, return turns positive, resulting in annual

returns in the 25 percent range Over 1992-2007 period, the U.S. venture capital market

earned a 19.65 percent annualized rate of return• The S&P 500 earned 11.19% over the same period

Given the risks, it is wise to own a “portfolio” of private equity investments!

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Opportunistic Real Estate High-risk, developed property investment

• Generally have a specific purpose• Examples include golf courses, churches, bowling alley, hotels, student

housing projects, single-family homes Opportunistic real estate opportunities may arise from:

• Severe regional economic conditions (bankruptcy of city’s primary employer)

• Natural disasters (Hurricane Katrina)• Systematic problems (Subprime mortgage problems)

Opportunistic real estate investors focus more on price appreciation• Income streams are smaller, more volatile, and inconsistent• Traditional real estate investors are more concerned with current income

Less than 1 percent of public institutional investment assets