Lecture 14 Week 13

Alternative investment classes and

Performance Evaluation
 1 Introduction
• Alternative investments tend to:
– Require large initial capital
– Possess barriers to entry
– Illiquid
– Be restricted to professional investors
• Examples:
– Venture capital funds
– Hedge funds

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 1 Introduction
• Principles of investments should still apply:
– Diversification
– Risk-return trade-off
• Do alternative investments offer superior
risk-return trade-offs?
• Do alternative investments enhance the risk-
return of a portfolio?

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 2 Private equity
• What is private equity?
• Business concepts need capital
• Private equity generally funds business
concepts
• Small group of investors
• Not available to the public
• Common in early stages of a business

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 2 Private equity
• Includes family businesses
• Worth USD $8 trillion in USA
– Compared with $9 trillion for stock market
• Typical industries:
– Services
– Retail & wholesale
– Light manufacturing

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2 Private equity

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 2 Private equity
• Private equity returns might be higher
because:
– Illiquidity
– Poor diversification
– Low survival rates
• Difficult to estimate private equity returns
because:
– No public trading by definition
– Lack of disclosure
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 2 Private equity
• Performance of private equity
• All private equity in USA, 1963-99
– Includes small businesses 5 million units worth
$6 trillion
– Compound return: 13.2%pa
– S&P500 return: 15.6%

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2 Private equity

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 2 Private equity
• Returns from private equity appear no better
than public equity returns.
• Why?
– Entrepreneurs over-estimate success ability
– Entrepreneurs are more risk tolerant
– Entrepreneurs enjoy non-pecuniary benefits
– Entrepreneurs have preference for skewness

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 2 Private equity
• Private equity life cycle:
– Business concept
– Angel investor
• Business angel
– Business structure
– Venture capital
– IPO
• As the business grows, so capital requirements increase
• Not all good business ideas succeed
• Dilution of ownership
– Creates conflict for the entrepreneur
• Average IPO in Aust raised $13.7 million
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 2 Private equity
• Private equity funds bundle up investments
and offer them to broader range of investors
• Control of $9 billion in Australia
• Capital is typically locked-up for several years
• Opportunity to increase exposure through
additional capital contributions
• Exit strategy is typically through an IPO

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 3 Venture capital
• Venture capital is a sub-set of private equity
• VC funds specialise in private equity
investments
• VC funds provide enhanced access to
investors to private equity
• VC works with the business to get it to exit
• Exit strategy is typically through an IPO

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 Venture capital
• Australian market
– Around $9 billion
– Small by world standards (US: $180 billion)
– Low relative share of 0.12% of GDP
• OECD average is 0.26%
– Dominated by superannuation funds
– Some specialisation in biotech
3 Venture capital

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 3 Venture capital
• Funding Stages:
– Stage 1: Start-up
• $1-3 million
– Stage 2: Development
• $2-5 million
– Stage 3: Expansion
• $5-10 million
– Possible mezzanine financing
• VC takes large fees
• VC takes large ownership stakes
• Costly compared to traditional investments
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 3 Venture capital
• Returns to VC funds
• Early research supported high returns
– Gompers & Lerner (1997): 30% pa
– Chen et al (2002): 45% pa
– Cochrane (2005): 698% to financing rounds
(not pa)
• But VC returns are non-normal and
traditional averages are not appropriate

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 3 Venture capital
Distribution of VC winners
Source: Cochrane (2001)

Several losers

Lots of small winners

A few big winners

-100% 0% 500%

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 3 Venture capital
• Appearance of winners, but many
funding rounds are hidden
• Focus on those that make it to market
– IPOs and Acquisitions
• Returns:
– Mean winners: 108% compound
– Several in excess of 500%

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 3 Venture capital
• Many VC rounds end with no further
action
• Not all rounds/ investors make it to
market
• No exit strategy (no liquidity)
• Returns:
– Mean: 15% compound
– More than 50% of rounds earn negative IRR
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 3 Venture capital
Distribution of all VC rounds
VC projects all rounds: n=16,800 (USA); Source: Cochrane (2001)

Lots of losers

A few small winners

Almost no big winners

-100% 0% 400%

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 3 Venture capital
• VC have high risk
– Gompers & Lerner: Beta = 1.4
– Cochrane: Beta = 1.7
• Risk adjust (against NASDAQ): mean
return is -7.1%
• Evidence does not support superior risk-
adjusted returns

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 4 Hedge funds
• Hedge strictly means to establish a
position to offset downturns
• General view is hedge funds avoid losses
• Global industry:
– 8,000 funds with $1,000 billion
• Popularity rose through 1990s

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 4 Hedge funds
• Characteristics:
– Minimum large investment
– Not regarded as public funds
– Light regulation
– Smaller than superannuation and mutual
funds
– Investment strategies are unorthodox
– Investment assets can be unorthodox
– High fees

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 4 Hedge funds
• Investment Characteristics:
– Levered positions
– Focus on absolute rather than relative returns
• Absolute return funds
– Low correlations with traditional portfolios
– Use of derivative instruments
• Claimed benefits:
– 1. Higher returns
– 2. Low risk
– 3. Diversifying power
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 4 Hedge funds
• Strategies and Types:
– Long-short equity
– Arbitrage
– Event driven
– Global macro
– Emerging markets
– Distressed

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 4 Hedge funds
• Fee structures
• Management fee
– Around 1.5%
• Performance fee
– High water mark
• Overall, fees are higher than traditional
funds

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 4 Hedge funds
• Fund-of-funds
• Fund invests in other hedge funds
• Creates diversification
• Provides small investor access
• But additional fees
– Fund-of-fund fees plus individual fund fees

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 4 Hedge funds
• Performance measurement problems
• Lack of required disclosure
• Reporting lags in the system
• Establishing net of fees return measures
• Appropriate return measure given non-normal
distributions caused by derivatives
• Early research
– Positive alphas
– Superior Sharpe ratios
• exceed mutual funds by 20%
– Low betas (ave: 0.23)
– Ackermann et al (1999)
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 4 Hedge funds
• New evidence:
– Alpha = -4.5% (annual excess of market
return)
– Beta = 0.84 (vs benchmark of 1.0)
• Source: Asness et al (2001)
• Only 1 in 4 hedge funds earn significant
excess returns
– Capocci & Hubner (2004)

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4 Hedge funds

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 4 Hedge funds
• Research casts doubt on ability of hedge
funds to earn superior returns
• Average hedge fund is less risky than the
market but not low risk
– Variable across fund strategy
• Appears that hedge funds do not earn
superior risk-adjusted returns

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 4 Hedge funds
• But, hedge funds do have lower
correlations
• Enhance a traditional portfolio in certain
circumstances
• Portfolio efficiency is improved
• Suggestion of 10-20% mix of hedge funds

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 Performance evaluation of managed funds

• key questions
– is past performance relevant?
– how can fund management be measured?
– what has been the evidence on fund managers performance?
• Typically regarded as important input in investment
decisions
– Sweeney Research found that 54% of investors regard long-
term performance as the most important factor
– Australian Securities and Investments Commission (ASIC)
revealed that past performance is included in 70% of
commercial advertisements
 2 The relevance of past information

• Empirical research find past performance

correlated with future fund flows.
• That is funds with good past performance
generate greater investor interest.
– Sirri and Tufano (1998)
• investors are attracted to good performers in the USA
– Sawicki (2000) and Frino, Heaney and Service
(2005)
• similar results for the Australian market.
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 3 Performance measures
• The managed funds industry places an
emphasis on performance measures
• Examples include;
– star ratings (from * to *****) of ASSIRT and
Morningstar
– publication of league tables
– Australian Financial Review and Personal
Investment regularly carry statistics and rankings
of funds based on past performance

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 3 Performance measures
• Index benchmarks
– comparison to a pre-selected benchmark portfolio,
which is typically an index (eg. S&P/ASX 200 or 300)
– benchmark related to fund objective
– Success measured by tracking error

 R 
T
1
ATP  pt  R Bt
T t 1

where Rpt = portfolio return over time period t

RBt = benchmark return over time period t
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 3 Performance measures
• Index benchmarks
– Example: index portfolio designed to track the
S&P/ASX 200 index

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 3 Performance measures
• Index benchmarks
– the absolute average tracking performance (AATP)
measure is sometimes used.
– This measure is sensitive to errors in both directions.
– overcomes averaging problem

 R 
T
1
AATP  pt  R Bt
T t 1

– where |x| = the absolute value of x

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 3 Performance measures
• Index benchmarks
– Yet another alternative that overcomes the
problem of the average measure is to measure
the standard deviation of tracking errors.
– This measure has the effect of penalizing large
tracking errors

(TP ) 
1 T
  R pt  R Bt  2

T t 1

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 3 Performance measures
• Index benchmarks:
– Example: consider the following returns on
mimicking portfolio of world market index.

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 3 Performance measures
• Traditional performance measures
• Jensen's alpha
– Jensen’s (1968) alpha relies upon the security market line.

p   Rp  Rf   p  Rm  Rf 
– If a fund is performing to expectations (relative to the
CAPM) then a would be zero.
– Superior performance is indicated positive a while under-
performance negative a.
– relies on CAPM being correct model
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 3 Performance measures
• Traditional performance measures
• The Sharpe Index
– based on the capital market line

SI p 
 R p  Rf 
p

– The benchmark value is the Sharpe index for the

market
– does not rely on an asset pricing model
– captures jointly aspects of return and risk
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 3 Performance measures
• Traditional performance measures
• The Treynor index
– similar to the Sharpe index except that it is based on the ex-
post security market line

TI p 
 R p  Rf 
p

– superior performance indicated where Treynor index

exceeds the market risk premium (MRP)
– problems include correct value of MRP and need to estimate
beta. Also appropriateness of CAPM
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 3 Performance measures
• Traditional performance measures
• The information ratio
– claimed to be an efficiency measure
– ie. how much risk was taken to earn the excess return
( R pt  R Bt )
IR p 
 R  R Bt 
T
1 2
pt
T t 1

– values close to 1 indicate good performance

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 3 Performance measures
• Traditional performance measures
– Example: Using the following data, compare the
performance of the following 3 funds.

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 3 Performance measures
• Traditional performance measures
• Example (cont.):

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 3 Performance measures
• Traditional performance measures
• Example (cont.): Summary of key points
– First, both Funds A and B are judged to be superior
performers.
• Their values of Jensen’s alpha are positive
• both the Sharpe and Treynor indices exceed those of the
market index.
• However, Fund A is considered to be the most efficient given
the values of the information ratio
– Second, Fund C is judged to have poor performance
• negative Jensen’s alpha, Sharpe and Treynor indices for Fund
C are less than those of the market index.
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 3 Performance measures
• Traditional performance measures
• Example (cont.): Summary of key points
– Third, there is inconsistency in rankings across the
measures.
• Fund A is ranked highest under both Jensen’s alpha, the
Treynor index and the information ratio
• Fund B is ranked highest under the Sharpe index.
• The inconsistency in rankings is due to differences in the
unit risk measure.
• The Sharpe index uses standard deviation whereas the
Treynor index uses beta risk. Note: if fund is well diversified,
these measures will become similar.
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 3 Performance measures
• Market timing measures
– seek to specifically measure fund manager
attributes such as market timing
R pt  R ft    p  p  R mt  R ft    p  R mt  R ft    pt
2

– A positive value of ap is indicative of superior stock

selection performance
– a positive value for Ψp indicates superior market
timing ability. 50
 3 Performance measures
• Market timing measures
– Merton (1981) defines market timing as performance
relative to risk-free rate.
• Managers can switch between equity and bonds, so
portfolio return is comprised of a return on the equity
market plus a put option on the equity market
• option valuable when equity return falls below risk-free rate

R pt  R ft   p  p  R mt  R ft    p Max  0, R mt  R ft    pt

• positive values of fp indicate market timing ability.

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 4 Performance studies
• Performance
– Early studies found that managed funds, on
average, under-performed the benchmarks.
– Sharpe (1966) average Sharpe index was less
than the Dow Jones Market Index
– Jensen (1968) average Jensen's alpha was -1.1%
– recent evidence mixed
– depends on sample period used, benchmark
index and fees

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 4 Performance studies
• Performance persistence
– In essence, the research has examined whether
winners repeat over time
– mild evidence of top-performing funds exhibiting
performance persistence
– stronger evidence is towards poorly performing
funds, which tend to perform poorly in future
periods
– potentially related to interaction of the business
cycle and investment style
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