IC311: Alternative Investments in the 21st century 2013-2014

1IC311: Alternative Investments in the 21st century 2013-2014

Lecturers: Dr. Andreas HoepnerEmail: a.hoepner@icmacentre.ac.ukAdditional Information provided on handout(s) Slides are subject to modification on demand1Students evaluate on Lecturer individually on:Ability to communicate clearlyOrganization of materialAbility to generate enthusiasm2Module InformationModule Information Handbook Read in detail!IC 311 Assignment HandoutTo be explained in detail!Remember: In addition to your Blackboard submission, you have to hand in 2 hardcopies of your assignments to the Postgraduate Office!In doubt, trust up to date Blackboard resource, not hardcopy from beginning of term

23General Lecturing Style (1):Please Engage!Please ask questions in Lectures & Tutorials! There are no stupid questions!Without student questions, a lecture is only as valuable as a Teaching videoa tutorial is nearly uselessYou are encouraged toBring notebook to lectures & tutorialsApply techniques to real world data & discussGo as far beyond class coverage as you like you will be supported (e.g. Industry Assignments)34General Lecturing Style (2):Communicate Problems anytime!If you experience problems at other times than during Lectures or Tutorials, you are encourage to Come to my Office HourEmail me to a.hoepner@icmacentre.ac.uk

45General Lecturing Style (3):Underlying PhilosophyAssumed Achievement Drivers:4 Skill Sets ModelTopic SkillsMethod SkillsSocial SkillsCommunication Skills4 (Personal) Characteristics:AmbitionCommitmentSustainable Personal Process Management (e.g. long term, sufficiently deep thought)Personal Happiness (= (Quality of Efforts * Quantity of Efforts Expectations) * Emotionality Function)56General Lecturing Style (4):Thinking within Topic- & Method SkillsTwo Spheres of Thinking:Space of ThinkingBreadth of Thinking(Height of the) Validity of ThinkingDepth of ThinkingTime of ThinkingEndurance of one session of ThinkingSpeed of ThinkingEndurance of many sessions of Thinking

67List of ContentsIntroduction into Alternative InvestmentsHedge Funds: An IntroductionHedge Funds: Performance Evaluation Responsible Investment: An IntroductionResponsible Investment: Performance EvaluationCarbon Finance: An Introductioni-finance (intangibles integrating finance)MicrofinanceIntermarket AnalysisFurther Alternative Investments

Lecture 2; 3; 6; and 8 are substantially based on Lhabitant (2006); Anson (2006); Rueddigkeit (2009); and Murphy (2004) respectively / Lectures 1, 4, and 5 -7 Hoepner781. Introduction into Alternative Investments89Structure of Introductory Lecture 1st part:Lecturer discusses the two assignments, which cover 100% of the modules marksLectures gives very brief introduction in all Alternative investment covered in the module and states data availability chances for student projects2nd part:Students skim through the Lecture Slides to indentify topics of their interest and ideally register an assignment topic by Monday, latest by Friday of 2nd week. Before registering a topic, however, a student needs to provide evidence of sufficient data access.Aim of Introductory Lecture: Students should be prepared best possible for their very important topic selection! Students can choose aspects of one Lecture topic, they can combine lecture topics or come up with entirely new ideas.10Hedge FundsData Access: (Very) difficultJobs: Many for heavy QuantsMarket NeutralEquity Market Neutral (comprise 4% of hedge fund assets in CS/Tremont Index as of May 2006)Fixed Income Arbitrage (8%)Convertible Bond Arbitrage (2%)Event-Driven (24%)Distressed Securities Funds Merger Arbitrage FundsDirectionalLong/Short Equity Hedge (28%)Dedicated Short Bias (1%)Emerging Markets Funds (6%)Global Macro Funds (11%)Managed Futures / Commodity Trading Advisors (5%)Multi-Strategies (11%)Fund of Hedge Funds (not included in CS/Tremont Index as of May 2006)

1011Responsible InvestmentData Access: Very Easy Often freeJobs: HiringUnited Nations Principles for Responsible Investment have been signed by institutions representing assets worth more than $15 trillion in the first 28 months of their existence, (UNPRI, 2006, 2008a)This represents nearly 20% of the worldwide assets under professional management (Maslakovic, 2008a) PRI growth still very strong (see graph below)Several governments support RI with legislations such as tax cuts

1112Carbon Finance Data Access: Very Easy Often freeJobs: Long term yes, short term cyclical

13i-financeData Access: Not too hard especially with IT skillsJobs: Coming up Twitter mood can predictBox Office Sales on opening weekend (Asur and Huberman, 2010)Dow Jones Industrial Average (Bollen, Mao, Zeng, 2010)Share price shock in BP crisis (Hoepner et al., 2012, Project)Social Media allows for Nowcasting (Lampos and Christianini, 2011)e.g. rainfall or illness ratesEmotional Nowcasting also possible (see graph)Example of a Social Media Lab (Andreas Hoepner and Damian Borth, McKinsey Technology Award Winner of German Centre for Artificial Intelligence):http://sociovestix.appspot.com/

Emotional Nowcasting by DiMatteo, Hoepner, Musolesi & Schaul (2012, Project)13MicrofinanceData Access: Easy free on MIX MarketJobs: Enough for the dedicated

Intermarket AnalysisData Access: Easy at ICMAJobs: Coming up

16Further Alternative Investments Data Access: Some easy some difficult / Jobs: Some in Commodities, FX and Islamaic Finance; Real Estate: cyclicalPrivate EquityIslamic FinanceReal EstateCommoditiesForeign Exchange (FX) Trading StrategiesWeather DerivativesPhilantrophy / Impact InvestingCollectiblesWineSports BettingVirtual Investment

172. Hedge Funds: An Introduction 1718HistoryAlfred Winslow Jones Sociologist Fortune EditorFund Manager1949 Partnership called A.W. Jones & Co.First for-profit hedge fundmarket-neutral position high incentive fee for fund managerleverage1819Market sizeEstimation for end of 2007 (Maslakovic, 2008):Over 11,000 hedge funds worldwideSize of about $2.25trillionHowever, after Anglo-American Credit Crisis both figures should today be substantially reduced1920(Original) Theory of Hedge FundsShort position finances long positionShort positions exposure matches long positions Zero exposure to market movements This technique is called market neutral investment2021Basis of Hedge Fund PerformanceManager skill in identifying opportunities Not derived from passive long position Focused on potentially inefficient market sectors Depend critically upon special manager skills and knowledge 2122DefinitionHedge funds are private pooled investment limited partnerships which fall outside many of the rules and regulations governing mutual funds. Hedge funds therefore can invest in a variety of securities on a leveraged basis. Today, the term hedge fund refers not so much to the hedging techniques, which hedge funds may employ, as it does to their status as private investment partnerships. (Maslakovic, 2008: 2)

2223Hedge Fund Characteristics (1)Actively ManagedRepresent Securitized Trading FloorsThe emergence of new technologies gave talented individuals and investment banking gurus (genuine or fake) the opportunity to start doing for their own account what they had been doing for several years [on tradeing floors for] large institutions. (Lhabitant, 2006: 26)Largely unregulated2324Hedge Fund Characteristics (2)Limited liquidityThey often do not hold a sufficient cash position to allow investors daily subscription or redemptionHigh incentive fees (15-25%) for managers, whose performance exceeds a high hurdle rateHedge fund managers are partners, not employees 2425Hedge Fund Characteristics (3)Limited transparencyStrategies are not scalableStrategies depend crucially on available investment opportunitiesManager skillsBoth input factors cannot just be scaled by hedge funds with increasing portfolio inflows as index tracker funds can doMain investor type are High Net Worth Individuals (HNWI)2526Hedge Fund Strategies (CS/Tremont Classification)Market NeutralEquity Market Neutral (comprise 4% of hedge fund assets in CS/Tremont Index as of May 2006)Fixed Income Arbitrage (8%)Convertible Bond Arbitrage (2%)Event-Driven (24%)Distressed Securities Funds Merger Arbitrage FundsDirectionalLong/Short Equity Hedge (28%)Dedicated Short Bias (1%)Emerging Markets Funds (6%)Global Macro Funds (11%)Managed Futures / Commodity Trading Advisors (5%)Multi-Strategies (11%)Fund of Hedge Funds (not included in CS/Tremont Index as of May 2006)

2627Equity Market NeutralMarket Neutrality involvesDollar Neutrality (equal $ amount of long and short investment)eta NeutralitySector NeutralityFactor Neutrality (e.g. Size, Book value to market vaue ratio)Sub-strategy examples:Pairs trading of two sister stocksStatistical Arbitrage based on groups of related stocks with similar characteristicsComputerized equity market arbitrage (e.g. on multiple exchanges)

2728Fixed Income ArbitrageVery attractive area for hedge funds due toLack of agreement on a standard absolute pricing modelMultiple relative pricing relationships between various fixed income securitiesInfluence of irrational but predictable supply and demand factors on specific asset pricesComplex nature of some fixed income securitiesSub-strategy examplesTreasury StrippingArtificial creation of undersupplied zero coupon bonds from level coupon bondsCarry TradesLong/Short investment at different interest rates (e.g. due to different maturities or currency regions)2829Convertible Bond ArbitrageExploitation of Arbitarge opportunities between convertible bonds and their underlying equityVery attractive area for hedge funds due toLack of agreement on a standard absolute pricing modelMultiple relative pricing relationships between various fixed income, equity and option components of convertible bondsVery complex nature due to summary of equity, bond and option characteristicsSub-strategies are usually hedged for Delta to make them insensivite of price variations in the underpying assetDelta measures the sensitivity of a convertible bonds to a one point change in the underlying equity asset

2930Distressed Securities FundsThey focus on the equity or debt of companies that are expected to be in operational or financial difficulty (e.g. bankrupcy, restructuring)Very detailed knowledge and special skills are expected to lead hedge funds to superior returnsDistressed securities are attractive for hedge funds sinceLess competitors, as many institutional investors are for internal or legal reasons not allowed to invest in distressed securitiesSelling pressure leads to attractive discountsGovernments often provide substantial support to rescue parts of distressed securities

3031Merger Arbitrage FundsCan also relate to Leveraged Buyouts or Hostile TakeoversUse of spread between offered price for a share of the target company and ist last market quote Strategies are based on expectation about success of acquirers bid and market reaction to failure 3132Long/Short Equity HedgeCombination of long investments with short sales to reduce but not completely eliminate market exposureSub-strategy examplesFundamental Analysis (usually based on Discounted Cash Flows)Assumes at least semi-strong market inefficiencies (e.g. for micro-cap companies, which are often covered by zero analysts)Sector Specific Funds (e.g. Life Sciences, New Technologies)Shareholder Activism StrategiesAttempt to release value of potentially underpriced assets by actively influencing management or lobbying government for favourable legislation3233Dedicated Short BiasUse only short positionsMirror traditional long only investmentsTypical Targets are CompaniesWith weak financials, but high share priceThat regularly change auditorsWhose Price/Earnings ratios are much higher than justified by the growth rateWhich are already shorted by more than 10% of their market capitalizationWith a public image problemWith too much self marketing

3334Emerging markets fundsPure Long Equity or Debt strategies and strategies similar to the ones of Long/Short Equity Hedge, Equity Market Neutral or Fixed Income Arbitrage Hedge FundsDeveloped Markets (24) as defined by MSCI in January 2013 are:Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United StatesEmerging Markets (21) as defined by MSCI in January 2013 are:Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and TurkeyFrontier Markets (25) as defined by MSCI in January 2013 are:Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qutar, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, the United Arab Emirates, Ukraine and VietnamNot (yet) classified but index produced (7) in January 2013:Bosnia-Herzegovina, Botswana, Ghana, Jamaica, Trinidad & Tobago, Saudi-Arabia, and Zimbabwe3435Global Macro FundsHeterogenouos category of funds trading on macroeconomic factorsCommon characteristicsGlobal nature of strategyPrimary focus areStructural macroeconomic imbalancesDetection of macroeconomic trends3 major approachesFeedback based approachPsychology based approach, which tries to profit from irrational investor reactions (feedbacks) to special circumstancesModel-based approachSearch for empirical disequilibria according to academic economic theoriesInformation based approach (basically Data Mining)

3536Managed Futures / Commodity Trading AdvisorsTwo types of analysis applied to Managed FuturesTechnical AnalysisProcess of predicting future price behaviour on the basis of past price behaviourUnderlying assumption that markets are driven more by psychological than fundamental factors and emotional set up of investors with its resulting price movements would repeat itself under comparable circumstance Fundamental AnalysisProcess of determining a fair value of an asset based on economic, political, environmental and other relevant fundamental factorsProvides expected direction of prices, while no entry point or risk management guidanceNote here that for fundamental factors be included in prices, human beings have to use fundamental analysis. But the more human beings use fundamental analysis, the less investment opportnities it unravels. This leads to Grossmann & Stiglitz (1978) Paradox of Market Efficiency.36Futures started with Commodities, but in 1970s several exchanges introduced them for various other assets

37Multi-StrategiesMulti-Strategy funds are characterised by their ability to allocate capital dynamically among strategies that fall within several traditional hedge fund disciplines. This approach requires more skill than a single hedge fund strategy ceteris paribusIt rewards fund managers and investors with a better risk diversification and scalability of returns than a single hedge fund strategy ceteris paribus

3738Fund of Hedge FundsA fund investing its capital in several (usually 30-60) individual hedge fundsAdvantages of Fund of Hedge FundsImproved risk diversificationAffordable for smaller investorsAccess to several top-tier hedge funds, which are closed funds, as they do not want to dillute their profitsMore flexible investment redemption policiesPotential for increased transparencyDisadvantages of Fund of Hedge FundsAdditional fund feesAdditional liquidity need due to better redemption policies

38393. Hedge Funds: Performance Evaluation3940Plain newspaper returns are dangerous!Plain daily return (e.g. Price yesterday/Price today) are upwards biasedTo see this, assume that your portfolio won 10% today and lost 10% tomorrow or vice versa. Are you at par?No, because 10% of a base value 110 or 90 are different from 10% of a base value 100.100 x 1.1 x 0.9 = 100 x 0.9 x 1.1 = 99 Basically, a plain return of -10% today cant be entirely equalized by a plain return of +10% tomorrow and vice versaThe plain return overstates gains & understates losses! A dangerous mix for supposedly anyway overoptimistic investors!40E^0.1=1.10517 / E^-0.1=0.90487 -> 0.90487 x 1.10517 = 141The appropriate return: The logged return (1)The appropriate formula to calculate returns (r) of stock i at time t for the previous period (t-[t-1]) is to take the natural logarithm (ln) of the division of the stock price (P) at time t by the stock price at time t-1

4142The appropriate return: The logged return (2)With respect to a equal weighted portfolio p of stocks i1 to iN, the appropriate formula to calculate returns (r) at time t for the previous period (t-[t-1]) is to take the natural logarithm (ln) of the average division of each stocks price (P) at time t by the same stocks price at time t-1Market value or otherwise weighted portfolio returns are caculated accordingly with the respective weighted scheme constructed at time t-1!!! If market value weight not at t-1 but a t, upwards bias!!!

4243Arithmetic mean returnArithmetic mean return of a portfolio (p)

rt is the logged return of the portfolio at time tN is the number of observations in the employed sampleAs the following formulas, this formula applies equally to an asset i as to a portfolio p

4344Arithmetic mean excess returnArithmetic mean excess return of a portfolio (xp) over the logged risk free asset return (rft) is:

With the same process, the arithmetic mean excess returns of an individual asset i (xi) or the market benchmark m (xm) are calculated

4445Excess Return varianceThe excess return variance of a portfolio (xp^2) is calculated as follows

rxpt equals the excess return of a portfolio over the risk free asset return at time t [rxpt = rpt rft]

4546Excess return standard deviationThe excess return standard deviation (xp) of a portfolio is the sqaure root of the excess return variance of it

With the same processes, the excess return variance and the excess return standard deviation an individual asset i (xi^2 and xi) or the market benchmark m (xm^2 and xm) are calculated, respectively

4647Skewness (1)

(+) Positively Skewed Distribution(-) Negatively Skewed Distribution--++4748Skewness (2)

---+++Mean=Median=ModeMean>Median>ModeMean