lecture 14 week 13

8/8/2019 Lecture 14 Week 13

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Lecture 14 Week 13

Alternative investment classes and

Performance Evaluation


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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 businessconcepts

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 returnsbecause:

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 requirementsincrease

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: $18

0

billion) Low relative share of0.12% of GDP

OECD average is 0.26%

Dominated by superannuation funds

Some specialisation in biotech


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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

-100% 0% 500%

A few big winners

Several losers

Distribution of VC winners

Source: Cochrane (2001)

Lots of small winners


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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 of500%


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3 Venture capital

Many VC rounds end with no furtheraction

Not all rounds/ investors make it tomarket

No exit strategy (no liquidity)

Returns:

Mean: 15% compound

More than 50% of rounds earn negative IRR


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3 Venture capital

-100% 0% 400%

Almost no big winners

Lots of losers

Distribution of all VC rounds

VC projects all rounds: n=16,800 (USA); Source: Cochrane (2001)

A few small winners


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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

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 traditionalfunds


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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 significantexcess 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 themarket 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 certaincircumstances

Portfolio efficiency is improved

Suggestion of 1

0

-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% ofcommercial advertisements


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2 The relevance of past

information Empirical research find past performance

correlated with future fund flows.

That is funds with good past performancegenerate 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 Reviewand PersonalInvestmentregularly carry statistics and rankings

of funds based on past performance


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Index benchmarks

comparison to a pre-selected benchmarkportfolio, which is typically an index (eg. S&P/ASX200

or 300

) benchmark related to fund objective

Success measured by tracking error

where Rpt = portfolio return over time period t

RBt = benchmark return over time period t

!

!T

1t

Btpt RR

T

1ATP


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Index benchmarks Example: index portfolio designed to track the

S&P/ASX 200 index


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Index benchmarks the absolute average tracking performance

(AATP) measure is sometimes used.

This measure is sensitive to errors in both

directions. overcomes averaging problem

where |x| = the absolute value of x

T

1t

tpt

T

1T


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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

WT

1t

2

tptT

1

)T(


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Index benchmarks: Example: consider the following returns on

mimicking portfolio of world market index.


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Traditional performance measures

Jensen's alpha

Jensens (1968) alpha relies upon the security

market line.

If a fund is performing to expectations (relative to

the CAPM) then E would be zero. Superior performance is indicated positive Ewhile

under-performance negative E

relies on CAPM being correct model

fmpfpp FE


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The Sharpe Index

based on the capital market line

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

p

fp

p

RRSI

!


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The Treynor index

similar to the Sharpe index except that it is based

on the ex-post security market line

superior performance indicated where Treynorindex exceeds the market risk premium (MRP)

problems include correct value of MRP and need toestimate beta. Also appropriateness of CAPM

p

fp

pTIF


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The information ratio

claimed to be an efficiency measure

ie. how much risk was taken to earn the excessreturn

values close to 1 indicate good performance

!

!

T

1t

2

Btpt

Btpt

p

RR

T

1

)RR(IR


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Example: Using the following data, compare the

performance of the following 3 funds.


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Example (cont.):


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Example (cont.): Summary of key points

First, both Funds A and B are judged to be superior

performers. Their values of Jensens alpha are positive

both the Sharpe and Treynor indices exceed those of themarket 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 Jensens alpha, Sharpe and Treynor indices forFund C are less than those of the market index.


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Example (cont.): Summary of key points

Third, there is inconsistency in rankings across the

measures. Fund A is ranked highest under both Jensens 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 theTreynor index uses beta risk. Note: if fund is welldiversified, these measures will become similar.


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Market timing measures

seek to specifically measure fund manager

attributes such as market timing

A positive value of

Ep is indicative of superior stockselection performance

a positive value for p indicates superior market

timing ability.

pt2

ftmtpftmtppftpt I]FE


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Market timing measures Merton (1981) defines market timing as

performance relative to risk-free rate.

Managers can switch between equity and bonds, soportfolio return is comprised of a return on the equitymarket plus a put option on the equity market

option valuable when equity return falls below risk-freerate

positive values ofJp indicate market timing ability.

? Aptftmtpftmtppftpt ,0Max IJFE


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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 lessthan 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 fundsexhibiting 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

lecture 14 week 13

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