Alternative Assets and Strategic Allocation

Rethinking the Institutional Approach

John B. Abbink

• Publisher: Bloomberg Press
• Year: 2010
• Print ISBN: 9781576603680
• eBook ISBN: 9780470927434
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

An insightful guide to making strategic investment allocation decisions that embraces both alternative and conventional assets

In this much-needed resource, alternative and portfolio management expert John Abbink demonstrates new ways of analyzing and deploying alternative assets and explains the practical application of these techniques.

Alternative Assets and Strategic Allocation clearly shows how alternative investments fit into portfolios and the role they play in an investment allocation that includes traditional investments as well. This book also describes innovative methods for valuation as applied to alternatives that previously have been difficult to analyze.

• Offers institutional investors, analysts, researchers, portfolio managers, and financial academics a down-to-earth method for measuring and analyzing alternative assets
• Reviews some of the latest alternatives that are increasing in popularity, such as high-frequency trading, direct lending, and long-term investment in real assets
• Outlines a strategic approach for including alternative investments into portfolios and shows the pivotal role they play in an investment allocation

Using the information found in this book, you'll have a clearer sense of how to approach investment issues related to alternative assets and discover what it takes to make these products work for you.

PART I

ANALYTIC TOOLS

CHAPTER 1

Risk and Return

The reader for whom this volume is intended is no doubt already thoroughly aware of the intimate relationship between risk and return, so there is no need to rehearse the usual clichés about the availability of free lunch, the obverse and reverse of coins, the relationship between timber growth and the sky, and so forth. The analyses found here rely on the premise that understanding the returns that investment vehicles produce means understanding the risks that they take. My contention that the palette of available return-generating risks is fundamentally the same for all investment vehicles, and that the risks are quite limited in number, informs my expectation that it will be possible to uncover some useful continuity of analysis between conventional and alternative investments.

This book seeks the common features that permit comparison and, ultimately, a rationally grounded approach to allocation among a range of investment opportunities that includes both conventional and alternative investments within its scope. In this endeavor, it is useful to draw a distinction between investment strategies, return enhancers, and volatility generators. Investment strategies are the fundamental sources from which investment returns derive—they are the risks that investment managers must take in order to generate any return at all. I have been able to identify only three of them, although they frequently operate in combinations that produce the wide variety of very differently structured return streams available to investors. This chapter will examine these investment strategies and the two quite distinct roles that time plays in the context of investment.

Return enhancers are applied to investment strategies in order to make their return streams more attractive, whether from a risk or a return perspective. Almost all of them involve risks of their own, as the most notable and common of them—leverage and tactical allocation or style rotation—certainly do. However, they do not themselves produce the returns that investors seek but rather accentuate the returns generated by one of the investment strategies (although this requires some footnoting in the case of tactical allocation). The strategies to which return enhancement techniques are applied provide the targeted returns, and in most cases one can regard return enhancers as overlays on those strategies.

Volatility generators are uses of investment assets for purposes other than generating return: they generally employ one of the investment strategies, but for the purpose of trading around its volatility rather than, or at least more than, for capturing those returns themselves. In fact, those who exploit volatility generators (typically investment banks) usually sell those underlying returns to other investors, retaining for their own purposes only the exposure to the tradable volatility that they provide. Return enhancers and volatility generators will be discussed in the following chapter.

The Three Sources of Investment Returns

There is a wild profusion of investment techniques, whether conventional or alternative—a thicket of investment styles that is an affront to tidy minds and an impediment to new initiates’ understanding. It does not help that the nomenclature for distinguishing among them is shifting and unruly. However, just three investment strategies underlie the many approaches to investing; all investments derive their returns from one or—as often if not more frequently—a combination of them. As would be expected, each strategy represents a distinct risk. The interplay among them can be complex, and they sometimes appear in unexpected guises. Investment managers may even be unconscious of the fact that several distinct strategies contribute to their returns, and it may be difficult for analysis to determine precisely which strategy is contributing what to returns in any given market circumstance. The pursuit of just these strategies, sometimes amplified through the use of return enhancers, accounts for all the many different ways of confronting the challenges of investment.

The numerous investment styles and disciplines are, at bottom, different approaches to these strategies:

• Directional strategies purchase or sell short to capture anticipated price changes. Their trades may last seconds or years, and their exposure may be naked or partially hedged. However, any hedge used in conjunction with a directional trade cannot be a complete one, as the returns to this strategy derive from the transaction having at least some net exposure to price movements in the underlying asset or some other changeable factor such as volatility that can provide the source of such a return. A perfect hedge against a purely directional trade would result in no net investment exposure at all, only a loss due to transaction costs.

• Cash flow strategies seek returns from the ownership of cash-generating assets. In principle, these strategies are unconcerned with price changes in those assets, and in some circumstances may even achieve their owners’ investment objectives without the asset ever being realized. The cash flows anticipated may be regular and specifiable in advance, or they may be intermittent and quite variable in size. These trades can, at least in principle, be perfectly hedged against price movement in the instruments employed while remaining productive of returns, although in most cases hedging is likely to sacrifice a sizable share of those returns.

• Arbitrage strategies exploit discrepancies between related prices, generally through pairing long and short exposure to the related instruments. They succeed whether the short position’s price rises toward the long position’s, the long falls toward the price of the short, or their prices meet anywhere in between. An arbitrage is market-neutral—fully hedged against price movements—provided that the relationship of counter-correlation between the legs of the trade is strong and persistent. Arbitrages are, in the final analysis, exposed to the price convergence of the legs of the trade rather than to the price movement of either leg separately.

It is impossible to prove a negative existential proposition of the form “No other investment strategy exists,” so there is no way to guarantee the completeness of this list, but I know of no investment technique that cannot be reduced to these strategies, although occasionally doing so may require a little imagination. Based on this negative evidence, we can be fairly certain that the list is complete. However, as has become a truism, the belated discovery of black swans (Cygnus atratus, taxonomically described in 1790) indicates that negative empirical generalizations are vulnerable to counter-example. There are certainly other sources of return, such as engaging in games of chance, treasure-hunting with a metal detector, and (if all else fails) work. However, it is appropriate to respond to claims for any of them by employing terminological sleight-of-hand—that is, by simply refusing to regard them as investing activities. If they are not investments, then clearly they cannot deliver investment returns. Investment, according to this view, involves purchase or short sale of one or more assets to exploit its (their) economic characteristics. This might raise the question whether day-trading qualifies as a form of investment, but the fact that price volatility is an economic characteristic, too, ensures that it does.

Three strategies form a small toolkit, but as we will see in Part II of this volume, there is considerable nuance in each of them, and each can be applied quite flexibly whether alone or in combination. Further, they are not asset-specific, and in some cases each can be applied separately to the same asset in order to generate quite different sorts of return streams. Consider distressed debt—a periodically fashionable category of investment that is sometimes (but not exclusively) classified among alternative investments. Arbitrageurs may buy it and take a short position in some other portion of the issuer’s capital structure against it, cash flow investors may hold it to maturity to capture its yield, and directional investors may hold it for some part of its life in the expectation that its credit rating and thus its price will improve: one asset, three investment strategies, and three quite different patterns of return generation. A wide range of assets may be profitably exploited using each of the three strategies.

Directional Strategies

The purest forms of directional strategies are cash purchase of long positions in physical commodities, collectibles, and equities that do not pay dividends. As it is usually unleveraged, venture capital may also qualify as similarly “pure.” The returns on these investments consist of sale price less purchase price, commissions and storage, or custody costs.³ The risk to them is an incorrect forecast of the price development of these assets, compounded, as is the case for all investments of any type, by a virtual and unquantifiable factor: opportunity cost. As opportunity cost attaches to every investment except the single best-performing one in any given time period, I will not discuss it further here, but as it is such a universal feature of investment activity, I will return to it later in this volume.

A critical reader may grant physical commodities and collectibles but may object that the value of an equity (and venture capital) is derived from some form of discounting model. This implies that the analysis includes a cash flow element, if only virtual cash flows in the case of equities without earnings or dividends. In response to such an objection, there is clearly no point in denying the point that equity analysis generally does include some form of cash flow modeling. However, note that the actual returns on venture investments or equities that do not pay dividends, as opposed to their expected returns, do not depend on cash flows (virtual or otherwise) generated by the investment. In these cases, the return computation above is unaffected by in- or out-flows of investors’ cash apart from those involved in the purchase and sale of the investments, so the return on investment is due solely to price change less costs.

That is, there is a real and potentially very powerful distinction between the value or expected return of such an investment and its price. Valuation involves discounting, but price is simply what the market delivers (or what can otherwise be negotiated) at any given moment. If price were always identical to value, there would be no opportunities for directional investment—or arbitrage, for that matter. The only possible investment strategy would be the pursuit of cash flow, and assets such as bullion, raw land, or rare postage stamps that do not distribute cash flows to investors could not be regarded as investments at all—thus Black (1976).

The purity of the strategy is reduced as soon as cash flow considerations enter the picture, regardless of whether the cash flow is positive or negative. Consequently, the use of leverage in any form adds an element of cash flow strategy to the investment mix. For example, short sales of any asset are directional strategies with a cash flow admixture, due to negative cash flow incurred in borrowing the assets to permit delivery. If put options or short futures positions are used to establish the short position, an examination of the relevant pricing formulae makes quite clear that there is an interest-rate element involved in those cases as well. Financing a short position that takes either form creates a drag on performance—a negative cash flow—and occasionally an acute one. For example, in the summer of 2008, when it was difficult to locate bank stocks to borrow for the purposes of delivery on short sales, borrowing rates in some cases exceeded 10 percent per annum, which is a hefty performance hurdle. By the fourth quarter of that year, the general availability of credit to hedge funds, for short sales or other purposes, was drying up significantly: see Pulliam and Strasburg (2009).

Ownership of dividend-producing equities quite explicitly includes a positive cash flow element, regardless of whether the dividends are regularly scheduled payments or special dividends that issuers occasionally volunteer or that are extracted from them through investor activism. Cash flows extracted from leveraged buyouts prior to their initial public offerings are another example. Fixed-income instruments purchased in anticipation of yield-curve or credit-rating changes offer an even more cash flow-oriented mixture of strategies. Raw land that has been purchased with cash and that remains undeveloped is a purely directional speculation (apart from the negative cash flows demanded by tax authorities), but returns on undeveloped real estate are unlikely to be compelling without the enhancements of leverage or improvement, which introduce negative cash flow elements. Note, however, that compelling returns on an investment in raw land can be achieved if someone other than its owner—say, a turnpike authority—plans to make those enhancements. The improvement, rather than its underwriter, generates any appreciable directional return on raw land. This wrinkle is the source of some extraordinary directional returns on what would otherwise be a rather unpromising investment category.

The risk to directional strategies is simply that the forecast price movement is not achieved, although this may occur for any of a thousand reasons, some of which may be quite complex and entirely unexpected. Analyzing the factors that might contribute to forecast failure is among directional traders’ primary risk-control activities. While this may seem trivial, it further illustrates the distinction between price and value. There is no reason to research the source of directional trades’ returns: it is known in advance to be price activity. The causes of that price activity give rise to the multimillion-dollar question, keep numerous analysts employed, and are by no means a simple matter.

Hedging a directional strategy does not fundamentally change the strategy, provided that the hedge is imperfect or partial. A perfectly, completely hedged directional strategy is, in effect, no strategy at all: since the returns on directional strategies derive from price exposure, completely vitiating the exposure hedges away the strategy. Imperfect hedges involve elements of arbitrage. The extent to which a short position in a Standard & Poor’s 500 Index future hedges a position in an individual equity is a function of the volatilities of the equity and the index future as well as the relationship of correlation between their price movements. These relationships are subject to constant change, introducing a correlation risk that was not inherent in the original, unhedged directional trade. But partial (rather than imperfect) hedging need not entail arbitrage risk—buying individual-equity put options against a specific security position reduces potential exposure below the option’s exercise price without adding any appreciable element of correlation risk. Note the qualifier: no appreciable risk, but there is a small amount of arbitrage risk nonetheless, as will be discussed below.

When they run into trouble, all investment strategies become directional, and their direction is never the desired one. Thus, if a loan becomes questionable, the value of the lender’s asset plummets even if the lender continues to receive cash flow from it—an experience that has recently become all-too-familiar to holders of mortgages. If an arbitrage relationship weakens, then one or both legs of the trade are likely to move against the trader, and the resulting loss can be expected to be considerably greater than the gain that their convergence was forecast to generate when the trade was initiated. As we will see in the next chapter, when return enhancements go wrong, most of them also become unfortunate directional speculations.

Cash Flow Strategies

Cash purchase of bonds held to maturity is probably the most familiar form of cash flow investment....

Table of contents

• Title Page
• Copyright Page
• Dedication
• Table of Figures
• List of Tables
• Acknowledgments
• Introduction
• PART I - ANALYTIC TOOLS
• PART II - SOME EXAMPLES
• PART III - POSITION MANAGEMENT
• PART IV - PORTFOLIO CONSTRUCTION
• Bibliography
• Index