Alternative Investments : Prepared by: CA Tarun Mahajan Alternative Investments
Mutual Funds: Open ended Vs. Close ended : Mutual Funds: Open ended Vs. Close ended Open-end investment companies are funds that continue to sell and repurchase shares after their initial public offerings. They will buy or sell these shares at net asset value (NAV). There may be a sales or redemption fee charged for the transaction.
Closed-end investment companies are initiated through a stock offering to raise funds. The fund does not issue or redeem shares after the initial offering. Shares are traded in the public markets and are priced by supply and demand.
The net asset value (NAV) is the value of the fund’s assets minus its liabilities, stated on a per-share basis. The share price of an open-end fund will always equal the NAV since the firm is obligated to redeem shares at any time at current market value. The share price of a closed-end fund may trade at a premium or at a discount to the actual NAV since the share price is determined in the secondary market.
Types of fees include load charges, management fee, administrative fees, and 12b-1 fees (marketing fees). All of these fees are built into the NAV of the fund and can significantly affect fund performance.
Exchange Traded Fund : Exchange Traded Fund Prepared by: CA Tarun Mahajan An exchange traded fund (ETF) is a special type of fund that invests in a portfolio of stocks or bonds and is designed to mimic the performance of a specified index.
Shares are traded in the secondary market like the shares of a closed-end fund, with the investor having the ability to trade at any time during market hours, sell short, or margin the shares.
Although they trade like shares of a closed-end fund, the legal structure of most ETFs in the U.S. is that of a traditional (open-end) mutual fund.
However, the creation and redemption of units in an ETF is in kind. It issues units to those who deposit shares with the fund.
Exchange Traded Fund : Exchange Traded Fund Prepared by: CA Tarun Mahajan
Advantages of ETFs : Advantages of ETFs Prepared by: CA Tarun Mahajan Diversification is easily obtained with an ETF transaction - ETFs are a convenient diversification method.
While they represent a portfolio of securities, they can be easily traded like a "stock" on an exchange.
Many ETFs also have companion futures and options contracts on the same index, which is convenient for risk management purposes.
ETF portfolio holdings are transparent, in contrast to traditional mutual funds.
ETFs are cost effective, since there are no load fees, and expense ratios are low since they are passively managed.
ETFs have an advantage over closed-end index funds because their structure prevents major premiums/ discounts.
There is less exposure to capital gains distribution taxes, compared to mutual funds.
Disadvantages of ETFs : Disadvantages of ETFs Prepared by: CA Tarun Mahajan ETFs are not available for all market sectors, and currently track a narrow market index, such as large market cap.
Investors with long investment horizons have no need for intraday trading.
Some ETFs have low trading volumes, which equates to high bid-ask spreads.
ETFs are not always the best choice for large international institutional investors, whose alternatives include investing directly in indexed, actively managed portfolios.
Risks in ETFs : Risks in ETFs Prepared by: CA Tarun Mahajan Market risk: Same risks as with holders of other diversified portfolios.
Asset class / sector risk: Implied by the fund's specified investment strategy.
Trading risk: Pricing may vary significantly from NAV. Lack of liquidity can be a large factor.
Tracking error risk: It is hard to exactly duplicate the performance of the "underlying" index.
Derivatives risk: These additional risks include counterparty credit risk, and overall risk of higher leverage.
Currency risk and country risk: Numerous risks of loss exist here.
Classification of Real Estate Investment : Classification of Real Estate Investment Prepared by: CA Tarun Mahajan Outright ownership (sometimes called “fee simple”). This is the most straightforward form of ownership, which entitles the holder to full ownership rights for an indefinite time period.
Leveraged equity position. Investors have the same entitlements as those having outright ownership but with the addition of some type of loan with terms that must be met in order to maintain ownership.
Mortgages. The investor is the holder of a mortgage loan and receives the monthly principal and interest payments paid by a borrower. This is considered to be a form of real estate investment because the underlying real estate may revert to the mortgage investor if the borrower defaults on the mortgage. Investors may choose to diversify their real estate exposure by investing in a group or pool of mortgage loans.
Aggregation vehicles. These allow investors to increase diversification in direct real estate holdings by investing in groups of real estate projects. Common forms include real estate limited partnerships, commingled funds, and real estate investment trusts (REITs).
Characteristics of real estate : Characteristics of real estate Prepared by: CA Tarun Mahajan Properties are not movable, and are unique assets.
Properties are unique - can never be exactly comparable to another property.
Properties can be illiquid.
There lacks a national, or international auction market for properties.
It is hard to assess market value.
High transaction costs.
Real estate market itself can be inefficient - information not as readily available.
Real estate Valuation Approaches : Real estate Valuation Approaches Prepared by: CA Tarun Mahajan With the cost method, value is determined by the replacement cost of improvements plus an estimate for the value of the land.
The sales comparison method uses the price of a similar property or properties from recent transactions.
The income method uses a discounted cash flow model to estimate the present value of the future income produced by the property.
The discounted after-tax cash flow model links the value of a property to an investor’s specific marginal tax rate.
Net Operating Income of a Real Estate : Net Operating Income of a Real Estate Prepared by: CA Tarun Mahajan Example: An investor is considering the purchase of a small office building and as part of his analysis, must calculate the NOI. The information on the building is as follows:
Gross potential rental income: $250,000
Estimated vacancy and collection loss rate: 5%
Insurance: $10,000
Property Taxes: $8,000
Utilities: $7,000
Maintenance: $15,000
NOI = $250,000 – ($250,000 × 0.05) - $10,000 – $8,000 – $7,000 – $15,000 = $197,500
Valuation of a Property : Valuation of a Property Prepared by: CA Tarun Mahajan The sales comparison approach is based on sales prices of comparable properties. Valuation can then be done relative to a specific similar property or relative to a benchmark such as the median home price in the area. Then additions/subtractions (e.g., size, location, vacancy) are made to estimate the value of the subject property.
Another approach under the general heading of sales comparison methods is "hedonic price estimation." This involves creating a statistical model of the sales prices of properties, showing how the prices are related to certain key characteristics that influence the value of a property. The model produces an estimate of how much each of these factors contributes to the value of a property on average. For example, "distance from nearest public transportation in miles" might have an estimated effect of –$5,000. This means that, other things equal, sales prices for properties five miles from public transportation have been $25,000 less than sales prices for properties adjacent to public transportation.
The income approach is based on taking the present value of the stream of annual NOI, assuming it is an infinite stream, using the required rate of return
Income Approach: An example : Income Approach: An example Prepared by: CA Tarun Mahajan Purchase price of property: $2,500,000
Financing: 20% by equity, 80% by a mortgage loan
Property will be sold in 5 years
Estimated after-tax cash flows: Year 1 = $50,000; Year 2 = $60,000; Year 3 = $80,000; Year 4 = $98,000
In Year 5, property would be sold, after-tax cash flow exclusive of property sale is estimated at $110,000
After-tax cash flow expected from property sale = $600,000
Investor's cost of equity for similar-risk projects = 17%
Assuming cost of equity of 17%, the present value of after-tax cash flows:($50,000 / 1.17) + ($60,000 / 1.172)+ ($80,000 / 1.173) + ($98,000 / 1.174) + ($710,000 / 1.175) = $512,652Investment requires equity of 0.20 × $2,500,000 = $500,000. Thus, NPV = $512,652 - $500,000 = $12,652. Accept project (positive NPV).
Stages in venture Capital Investing : Stages in venture Capital Investing Prepared by: CA Tarun Mahajan Seed Stage: Investors are providing capital in the earliest stage of the business and may help fund research and development of product ideas.
Early Stage: Early stage financing includes:
Start-up financing which typically refers to capital used to complete product development and fund initial markets.
First stage financing which refers to the funding of the transition to commercial production and sales of the product.
Formative Stage: Broad category which encompasses the seed stage and early stage.
Later Stage: Marketable goods are in production and sales efforts are underway, but the company is still privately held. Within the later stage period, second-stage investing describes investments in a company that is producing and selling a product but is not yet generating income. Third-stage financing would fund a major expansion of the company. Mezzanine or bridge financing would enable a company to take the steps necessary to go public.
Venture Capital: Characteristics & Valuation : Venture Capital: Characteristics & Valuation Prepared by: CA Tarun Mahajan Characteristics:
Illiquidity.
Long-term investment horizon.
Difficulty in valuation.
Entrepreneurial/management mismatches.
Timing in the business cycle.
Requirement for extensive operations analysis.
Valuing and measuring the performance of a venture capital investment is tricky at best, due to the large probability of failure plus the overall uncertainty as to amount and timing of cash flows. The three most important factors that must be assessed are the expected payoff at exit, timing of exit, and the probability of failure. Prior to exit (or failure), evaluation of the venture’s performance must be made, although precise measurement is challenging. Difficulties include deriving accurate valuations, establishing benchmarks, and lacking reliable performance measures.
Venture Capital: Valuation : Venture Capital: Valuation Prepared by: CA Tarun Mahajan Example: RiveraCap, Inc. is a venture capital financier. If a $3 million investment is successful, it is estimated to produce $45 million at the end of 6 years. Failure probabilities are: Year 1: 30%; Year 2: 25%; Year 3: 15%; Year 4: 10%; Year 5: 10%; Year 6: 5%. Cost of equity for project with similar risk: 27%Compute expected NPV of the specific venture capital project, and determine an accept / reject recommendation:
• Probability that project survives the 6th year: (1 - 0.30)(1 - 0.25)(1 - 0.15)(1 - 0.1)(1 - 0.1)(1 - 0.05) = 34.34% • Failure probability is thus 65.66%.• NPV of project, if it survives through the 6th year: -$3,000,000 + ($45,000,000) / 1.276 = 7,724,824• NPV of project if it fails is -$3,000,000.• Project's expected NPV is a probability-weighted average of the two above amounts: (0.3434)($7,724,824) + (0.6566)(-$3,000,000) = $682,905 • Project has a significant positive NPV: RiveraCap, Inc. should accept it.
Hedge Funds : Hedge Funds Prepared by: CA Tarun Mahajan Hedge funds today utilize a wide variety of strategies, which may or may not utilize hedging techniques to reduce or eliminate risk.
Objective: The common objective of hedge funds is that they strive for absolute returns.
Legal structure: Most hedge funds are in the form of a limited partnership, a limited liability corporation, or an offshore corporation.
Fee structure: The manager of the fund receives compensation that is comprised of two components: 1) the base fee, and 2) the incentive fee.
Classification of Hedge Funds : Classification of Hedge Funds Prepared by: CA Tarun Mahajan Long/short funds are the largest category of hedge funds in terms of asset size. These funds take long and short common stock positions, use leverage, and are invested in markets worldwide. By definition they are not market-neutral.
Market-neutral funds are a type of long/short fund that strives to hedge against general market moves. Managers may try to achieve this through any of several strategies, some involving derivatives. The fund may still have long and short positions, but the positions will offset each other so that the effect is a net zero exposure to the market.
Global macro funds make bets on the direction of a market, currency, interest rate, or some other factor. Global macro funds are typically highly leveraged and rely heavily upon derivatives.
Event-driven funds strive to capitalize on some unique opportunity in the market. This may involve investing in a distressed company or in a potential merger and acquisition situation.
Hedge Funds: Performance : Hedge Funds: Performance Prepared by: CA Tarun Mahajan Since hedge funds are not legally required to publicly disclose performance, only those hedge funds that elect to disclose performance information are included in the indexes.
Hedge funds, as a class, have historically outperformed both U.S. equity and bond market benchmarks.
Hedge funds have demonstrated a lower risk profile than traditional equity investments as measured by standard deviation.
In recent years, the Sharpe ratio has been consistently higher for hedge funds than for most equity investments and has been comparable to that of fixed-income investments.
There is a low correlation between the performance of hedge funds and conventional investments.
Hedge Funds: Biases in performance Measurement : Hedge Funds: Biases in performance Measurement Prepared by: CA Tarun Mahajan "Cherry picking" by managers: Managers may be unwilling to disclose poor performance.
Incomplete historical data: Only manager with good track record would be ready to be included in the performance index.
Survival of the fittest: Index included only those funds which are surviving.
Smoothed pricing: Hedge fund invest their money in thinly traded securities hence the actual market price is not available and only estimated prices are used.
Asymmetrical returns: Some strategies may have limited upside but unlimited downside. Traditional measurement such as standard deviation may not capture the same.
Fee structures and incentives: incentive structure motivates fund manager to take big risk.
Closely Held Companies : Closely Held Companies Prepared by: CA Tarun Mahajan The equity shares of closely held companies are not publicly traded and are not subject to the same SEC regulations as public companies regarding reporting and disclosure. As the name implies, closely held companies are held by a relatively small group of owners. The companies may be in the form of any number of legal entities. The choice of structure affects the investors’ rights and responsibilities and, ultimately, the value of their investments.
When litigation situations arise, there can be questions as to the "value" of the corporation. There are not frequent transactions in the open market upon which to estimate value. Valuation, therefore, is based upon either a forecast of future cash flows, actual past cash flows, or a combination of both.
Closely held companies: Valuation Methods : Closely held companies: Valuation Methods Prepared by: CA Tarun Mahajan The cost approach: What is the cost today to replace the company’s assets in their present state?
The comparables approach: What is the value relative to an appropriate benchmark value? The benchmark would be based upon market prices of similar companies, adjusted for such factors as transaction date and any unique characteristics of the company. The benchmark may be difficult to establish if no comparable companies have been sold recently.
The income approach: What is the net present value of the company based upon discounted future cash flows?
When valuing closely held companies, the estimate of market value should be discounted to some degree to reflect the lack of marketability of the shares. Another factor to be considered is which party has control of the company. A discount for minority interest may be necessary for valuing a position that lacks the ability to influence corporate decision-making. Likewise, a premium would be appropriate for the valuation of a controlling ownership position.
Distressed Securities Investing : Distressed Securities Investing Prepared by: CA Tarun Mahajan When companies are on the brink of bankruptcy or have already filed for bankruptcy protection, their securities are considered "distressed." Also included in the group of distressed securities are those companies attempting to avoid bankruptcy by pursuing an out-of-court debt restructuring. A typical distressed security investment strategy would be to purchase the debt of a struggling company, pre-reorganization, in the hopes of ultimately owning an equity position in a new, revitalized operation. Pursuing a distressed security strategy is somewhat similar to venture capital investing. Both asset classes are illiquid, have a long expected investment horizon, and require heavy involvement by investors in order to be successful. Both situations mandate extensive analytical work in order to avoid pricing or valuation mistakes.
Commodities : Commodities Prepared by: CA Tarun Mahajan Investing in commodity derivatives is preferred, since most investors do not wish to deal with storing and transporting actual commodities themselves. When the economy experiences growth, the demand for commodities increases, and price increases are likely. Overall, swings in commodity prices are likely to be larger than changes in finished goods prices. There are several different ways to invest in commodities:
Futures contracts – contract is a standardized, exchange-traded agreement between two parties in which buyer agrees to buy commodity from seller at a future date, at a price agreed upon today. This investment strategy is the most common. There are managed futures funds that permit investors to take commodity positions.
Bonds indexed on a selected commodity price.
Stocks of firms that produce the commodity itself.
Motivations for commodity Investing : Motivations for commodity Investing Prepared by: CA Tarun Mahajan As an inflation hedge.
For speculation on the direction of commodity prices over the near term.
For diversification.
To profit from economic growth which is associated with higher commodity prices.
To provide income and exposure to commodity price changes.
collateralized commodities futures position : collateralized commodities futures position Prepared by: CA Tarun Mahajan Establishing a collateralized commodities futures position requires simultaneously purchasing a specific futures contract and the amount of government securities equal to the value (not the purchase price) of the futures contract. The total return will equal the change in price of the futures contract plus the interest earned on the government securities.
Example:A passive manager purchases a position worth $50 million in underlying value of a futures contract. The manager also buys $50 million worth of 10-year notes that pay an interest rate of 5%. Compute the gain in the value of the position if, at the end of one month, the futures contract position is worth $51 million and the price of the 10-year notes is unchanged.
Answer:Gain on the futures position = $1,000,000Interest earned = $50,000,000 × 0.05 × (30 / 360) = $208,333.33Total gain = $1,000,000 + $208,333.33 = $1,208,333.33