Lecture 14 Week 13: Alternative Investment Classes and Performance Evaluation
Lecture 14 Week 13: Alternative Investment Classes and Performance Evaluation
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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
-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
-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
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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
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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
(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
TI p
R p Rf
p
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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
R pt R ft p p R mt R ft p Max 0, R mt R ft pt
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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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