Chapter 17

Understanding Alternative Investments and Asset Management

In This Chapter

Getting an overview of alternative investments

Understanding why investment banks engage in asset management

Getting an introduction to asset management tools

Becoming familiar with the conflicts in investment banking

Discovering how investment banks manage conflicts

If you're like most people, when you hear the term investments, you immediately think of stocks and bonds. Stocks and bonds are the vanilla and chocolate of the investing world. There is nothing wrong with vanilla and chocolate — they're quite tasty. But just as ice cream lovers often want to satiate their palates with more exotic flavors, investors are increasingly looking to expand their holdings into assets beyond stocks and bonds. The broad class of assets outside traditional stocks and bonds is referred to as alternative investments, and it's rapidly gaining in popularity with both institutional and individual investors. Investment bankers are increasingly also putting together deals and offering funds in the alternative asset arena.

Knowing Your Alternatives

Alternative investments are any investments outside of stocks and bonds. Anything from real estate to precious metals, commodities, and even bottles of vintage wine are types of alternative investments that are increasingly attracting the attention of many institutional and well-heeled individual investors.

Alternative investments are often attractive from both a risk perspective and a return perspective. From a risk standpoint, alternative investments are viewed as good diversification vehicles because their returns are often not closely related to the returns from stocks and bonds. In other words, when stocks and bonds are performing poorly, precious metals like gold may perform better. Alternative investments are also attractive from solely a return standpoint, because the returns from asset classes such as venture capital and hedge funds can be greater than returns from the more traditional asset classes.

We cover four of the more popular types of alternative investments — hedge funds, venture capital, commodities, and real estate — in this section.

Hedge funds

If there were ever a contest for the most misleading naming convention, the term hedge fund would be a winner. The term hedge is defined as “a means of protection or defense.” The act of hedging in finance involves risk reduction or protection against adverse outcomes. Companies producing goods or providing services that rely on certain commodities will hedge against price increases on those commodities by contracting in the futures markets to purchase inputs well in advance of production. For example, airlines will often hedge against rising jet fuel prices by contracting in advance to purchase oil in the futures markets (markets that allow investors and traders to bet on the price of commodities months or years from now). If fuel prices go up, the airline is unaffected because the cost has been agreed to in advance. This allows airlines to better manage costs, plan, and reduce risk.

So, a hedge fund must be some sort of vehicle that allows investors to reduce risk, right? Not hardly. A hedge fund is simply a professionally managed pool of money that is largely unregulated and can only be accessed by sophisticated (accredited) investors (see the nearby sidebar).

Whoever came up with the name hedge fund was a pure marketing genius, because the goal of most hedge funds is not to reduce or limit risk, but to seek high returns by taking positions in a wide variety of asset classes. Hedge funds typically take positions in complex derivative securities and strategies involving derivatives securities and often leverage highly concentrated positions.

There are a wide variety of hedge funds that pursue many distinctly different investment strategies and styles. Although some people refer to hedge funds as an asset class, they're more accurately defined by their strategies. The most common types of hedge-fund strategies include the following:

• Long-only: These funds are most like stock mutual funds. They buy stocks they believe are going to go up in value.
• Equity long-short: In these funds, managers purchase the securities of stocks they expect to go up in value while short-selling stocks they expect to fall in value. Often, these types of funds choose to specialize in particular sectors or geographical regions of the stock markets.
• Event-driven funds: These funds invest in securities of corporations involved in special situations such as bankruptcy, spinoffs, mergers and acquisitions, and other restructuring events. As an example, these funds buy or sell the stocks and bonds of firms involved in mergers and acquisitions — betting that some securities are overvalued while others are undervalued.
• Relative value and arbitrage funds: These funds seek to identify securities and positions that have the same risk and return characteristics and purchase the underpriced securities and sell the overpriced securities. One of the most common types of relative value funds is convertible arbitrage, which typically purchase convertible bonds and sell the common stock of the issuer.
• Global macro funds: These funds have the broadest investment style of all hedge-fund categories. They have no limitations on the asset classes, security types, or geographical locations of investments. They invest in whatever investments strike the fancy of the asset manager. They often take highly leveraged and large positions.
• Fund of funds: A fund of funds invests in many different hedge funds. This strategy can help reduce the risk of a single manager achieving poor performance or running off with investors’ funds, because the investor's holdings are spread across many different hedge-fund managers. Although this sounds like a very prudent and risk-averse strategy, the downside is that it introduces another layer of fees — those of the manager of the fund of funds.

Managers of hedge funds are the new titans of business — the Rockefellers and Mellons of the 21st century. These new-age billionaires include John Paulson, Stephen Cohen, and James Simons, men who have amassed fortunes by achieving investment returns that often exceed market averages by wide margins.

Successful hedge funds get the headlines, but there are some major risks to investors. First of all, not all hedge funds do well, in fact, most do not. And if a hedge fund is on a hot streak, the managers know it and demand to be paid accordingly. Running a hedge fund is a lucrative business — fees paid to managers are typically 2 percent of assets under management annually, as well as a cumulative payout of 20 percent of the profits of the fund. This fee structure is often referred to as “two and twenty” and means that considering these fees, hedge-fund managers must really bring home the bacon to earn their keep. And some certainly do. For instance, James Simons’ Medallion Fund at Renaissance Technologies has returned an average annual compound return in excess of 35 percent since it was established in 1988. (Before you go running out and try to invest some money in Medallion, realize that the fund has been closed to new investors for many years.)

Venture capital

Venture capital is money provided to startup companies and young firms that don't yet have a track record that would allow them to tap the more traditional sources of funds, such as bank loans or initial public offerings (IPOs). Anyone who has watched the reality TV show Shark Tank is getting a glimpse into the world of venture capital financing.

Essentially, venture capital is the place where the entrepreneur with a great idea and a solid business plan gets seed capital or working capital from sophisticated investors who are looking for the next big thing like Microsoft or Cisco Systems — two companies that were financed by venture capital investment.

Venture capital firms are generally structured as partnerships. The limited partners are the investors and provide the capital. The general partner manages the investments — essentially figuring out which companies to invest in.

Unlike traditional stocks and bonds, investment in venture capital is very illiquid — the commitment of funds is generally for a fairly long time period (generally five to ten years) and cannot be readily bought and sold. In contrast to investing in traditional stocks and bonds, venture capitalists typically take a very large ownership position in a company and play an active role by providing management expertise and closely monitoring the company's progress.

The fee structure in venture capital is similar to that in the hedge fund industry. The two and twenty compensation scheme described in the preceding section is standard fare in the venture capital world. So, for the investment in a venture capital fund to prove to be profitable, the underlying investments must collectively perform at a high level to provide both the return to the investor and cover the management fees.

Venture capital investing is a risky endeavor — the average investment proves to be unprofitable. Most young firms simply don't make it and only a select few make it big. So, successful venture capital investing is a numbers game. To justify the risks taken, the returns expected by investors are much larger than those on traditional investments that involve less risk of failure. Many venture capital investors target returns of over 30 percent per year. To hit such a lofty target and to mitigate their risk, venture capital funds often invest in a large number of young firms. If a venture capital investor provides financing to ten firms and only one of them is successful — but that one is wildly successful — the investment can be a major success.

Success for the individual firm that receives venture capital financing — and for the venture capitalist that provided the financing — is realized when the firm goes public via an IPO or is sold to another company for a huge price. That's the ultimate dream of both the entrepreneur and the venture capitalist.

Commodities

The commodities asset class includes a wide variety of goods, ranging from agricultural commodities (such as corn, soybeans, and cattle) to precious metals (like gold, silver, and platinum). While assets such as stocks, bonds, and real estate are purchased for the expected stream of revenues that will come from owning the assets, commodities don't provide such cash flows and are purchased and sold on the basis of their consumption and speculative values.

Many firms buy and sell commodities in order to hedge their natural positions in commodities — airlines buy oil in the futures markets and farmers sell wheat in the futures markets. However, many investors buy and sell commodities as investments — in effect, speculating on future prices. One of the attractions to commodities as an asset class is that commodity prices and stock and bond prices generally don't move together. This quality helps to reduce risk of a portfolio that includes commodities along with stocks and bonds.

Investors can take positions in commodities either by purchasing the physical commodity — taking delivery of 5,000 bushels of corn or 1,000 barrels of crude oil — or by agreeing to buy or sell claims to these assets in the futures markets. Investors can buy or sell futures contracts based on many commodities, and these markets are global in nature. As you may suspect, transacting in the futures markets is the preferred method because these contracts are liquid (they can be readily bought and sold), and the investor doesn't have to find a place to store all that corn or crude oil.

Investors generally invest in commodities either passively or actively. Passive investment is often done by taking a position in a commodities index. A commodities index is much like a stock index, and the value of the index rises and falls as the value of the individual commodities rises and falls. One of the most popular ways to gain broad exposure to commodities is to purchase a futures contract on the Goldman Sachs Commodities Index.

If investors want to attempt to beat the market and earn rates of return that exceed that of a simple index of commodities, they may look to the services of a commodity trading advisor (CTA; a professional money manager who specializes in commodities and, for a fee, will provide individualized advice for investors) or may invest in managed futures (funds of futures contracts where the typical fees are similar to those in the hedge fund and venture capital industries — that is, two and twenty).

The greater fool theory says that the prices of some assets aren't determined because an investor thinks it's worth the price but because the investor thinks he can sell it to someone in the future at an even higher price — that is, sell it to a greater fool. The greater fool theory explains speculative bubbles through time from tulip mania in the Netherlands in the 1600s to the Internet bubble in 2000 and the residential real estate bubble of the last few years. Many people believe that the price of some commodities like gold are largely determined by the greater fool theory. Warren Buffett has made the point that if you put all the world's gold together, it would form a cube about 68 feet per side. For the value of that cube of gold, Buffett notes you could buy all the farmland in the United States and about 16 Exxon Mobils, and you'd have $1 trillion left over for walking-around money. What would you rather have?

Real estate

It's ironic that real estate is referred to as an alternative asset, given that home equity is often the single largest investment position that many investors in the United States hold. Generally, though, when investors refer to investing in real estate, they're considering any holdings beyond their personal residence.

Real estate has traditionally been very difficult to invest in for several reasons, chief among them illiquidity, large minimum investment, the unique nature of properties, and monitoring and upkeep required. Investment bankers are a very creative lot, and over the years, they've developed methods for investors to more easily access the real estate markets. The two major methods are through real estate mortgage investment conduits (REMICs) and real estate investment trusts (REITs).

REMICs purchase mortgages on both commercial and residential properties, place them in trust, and then issue interests in these mortgages to investors. Essentially, they allow investors to invest in a diversified portfolio of real estate mortgages. The securities issued by the REMIC are called mortgage-backed securities because the collateral or backing of the securities is the real estate that the mortgages were issued on. REMICs can be designed in many different ways, and some mortgage-backed securities are much riskier than others as investors found in the recent financial crisis.

REITs are publicly traded closed-end investment funds that invest in real estate directly or through mortgages on real estate. REITs trade just like shares of stock on major stock exchanges. Investment bankers have created three types of REITS:

• Equity REITs: Equity REITs purchase commercial, industrial, or residential real estate properties. Income is derived primarily from the rental on the properties, as well as from the sale of properties that have increased in value. Many equity REITs specialize in a particular market segment; some specialize in a particular geographic area.
• Mortgage REITs: Mortgage REITs invest in property mortgages. They may make original mortgage loans or purchase existing loans or mortgage-backed securities. The income is primarily from the interest that they earn on the mortgage loans.
• Hybrid REITs: Hybrid REITs invest both directly in property and in mortgages on properties.

Digging Into Asset Management

Many investment banking firms have robust asset management divisions that help clients manage their money. Investment banks typically offer financial advice, actively manage accounts, provide wealth management services, and offer financial counseling. The typical clients are institutional investors and high-net-worth and ultra-high-net-worth individuals. Investment banks typically offer proprietary products such as mutual funds to assist in this role.

Investment banks, particularly the large investment banks, want to be considered a one-stop shop for clients’ financial needs. Asset management services are an important product and often a very profitable product line for these firms and one that increasingly attracts a great deal of attention.

Attracting investors to asset management

Investment banks often employ armies of analysts who follow the economy, firms, and industries. These analysts craft research reports and make recommendations regarding virtually everything from the direction of the stock or bond market, to the value of individual companies, or the attractiveness of investments in certain regions of the world or industries.

Analysts typically are assigned specialty areas — specific asset classes or industries — and produce research reports with buy, sell, or hold recommendations. These research reports are distributed to both buy- and sell-side clients. Investment banks compete on the basis of their research quality and eagerly await the rankings such as Institutional Investor's All-American Research Team and Zack's All-Star Analysts Ratings. Many analysts become stars themselves and command multi-million-dollar compensation packages. Internet analysts Jack Grubman, Henry Blodget, and Mary Meeker became famous (and later infamous) in the dot-com bubble in the mid to late ’90s.

Be careful when listening to the recommendations of Wall Street analysts. Research analysts are presumably giving advice to investors on whether to buy or sell securities. But remember that they're working for the investment banking firms, which make huge amounts of money for selling securities. Both Grubman and Blodget are barred from being involved in the securities business for allegedly violating their duty to investors and placing their firms’ interests over their own.

These analyst reports serve functions beyond simply helping clients make investment decisions. They assist traders of the firm's own proprietary accounts in making decisions, help the firm's sales force in suggesting new investment ideas to clients, as well as provide coverage to the companies whose securities the investment bank has assisted in recent IPOs.

Creating asset management tools

In Chapter 1, we explain that some investment banking firms actually make more money on asset management than on traditional investment banking functions. To become a full-service, one-stop shop for everything financial, investment banking firms have developed a plethora of asset management tools. We cover three of the most common — stock mutual funds, bond mutual funds, and exchange-traded funds — in this section.

Stock mutual funds

Most full-service investment banking firms offer their own mutual funds as an asset management tool to clients. A stock mutual fund is a professionally managed pool of money that simply takes clients’ money and invests in a wide variety of companies. The big advantages of mutual funds are diversification (investors’ funds are spread across many companies) and professional management. Investment banks earn management fees for managing mutual funds.

Mutual funds are also very liquid securities. Open-end mutual funds must stand willing to buy back their shares from their investors at the end of every business day at the net asset value computed that day. Closed-end mutual funds, on the other hand, trade in the secondary market (the active buying and selling of stocks on an exchange, such as the New York Stock Exchange) and may trade at a premium or discount to net asset value. The share value of a closed-end fund is determined by the interaction of buyers and sellers in the marketplace — by supply and demand — much like the value of a share of stock itself is determined.

The only limit to the variety of mutual funds is the creativity of investment bankers. Here are some of the most common types of stock mutual funds:

• Sector or industry funds: Invest in firms within a particular segment of the market such as healthcare or technology.
• International funds: Invest in stocks from around the world.
• Emerging-market funds: Invest in stocks from developing countries.
• Country funds: Confine investments to stock within a particular country.
• Growth funds: Invest in stocks forecast to have above-average growth prospects.
• Value funds: Invest in stocks that appear to be undervalued based upon fundamental investment metrics, such as price-to-earnings or price-to-book ratio (see Chapter 8 for more on these ratios).
• Index funds: Instead of being actively managed — that is, with professional managers making decisions on which stocks to buy and sell — the holdings simply mirror the composition of an index such as the S&P 500 or the Dow Jones Industrial Average.
• Cap-based funds: Limit their holdings to stocks within certain market capitalization (the value of the entire equity of the firm) ranges. Large-cap, mid-cap, and small-cap funds have become very popular for investors to focus on the market segment they desire.

Bond mutual funds

Bond mutual funds are structured in an identical fashion to stock mutual funds and are popular asset management vehicles created by investment banks. Bond mutual funds allow investors to diversify across many holdings — something difficult to achieve outside of bonds funds because bonds generally trade in larger denominations than stocks.

Here are the most common types of bond mutual funds:

• Investment-grade funds: Invest only in the debt of highly rated creditworthy companies.
• High-yield funds: Invest in the debt of below-investment-grade companies.
• Municipal funds: Invest in the debt issues of state, county, city, or other nongovernmental agencies.
• International funds: Invest in debt issues of companies and sovereign issuers outside the United States. A variety of international bond funds invest in the debt of emerging markets.
• Treasury-Inflation Protected Securities (TIPS): Bonds issued by the U.S. Treasury that pay a rate of interest that is adjusted on a semiannual basis with the rate of the Consumer Price Index (a measure of inflation).

Exchange-traded funds

An exchange-traded fund (ETF) is much like a mutual fund; it's invested in a diversified number of individual securities. However, unlike a mutual fund, an ETF actively trades on a stock exchange, much like stocks. Although mutual funds provide investors with liquidity on a daily basis, exchange-traded funds provide the investor with immediate liquidity.

Most ETFs are index funds, but since 2008 the Securities and Exchange Commission (SEC) has allowed the creation and marketing of actively managed ETFs. Investment bankers have created ETFs on stocks, bonds, and commodities.

The popularity of ETFs has increased dramatically in recent years. Some of the more popular ETFs are the sector SPDRs sponsored by State Street Global Advisors, which follow the sectors of the S&P Index. Another popular issue are the iShares ETFs sponsored by BlackRock, which track many country and industry indexes.

Managing Potential Conflicts with Clients

Given all the different functions of investment banking and all the various clients these firms serve, it is not surprising that the industry is rife with conflicts that need to be both managed and disclosed.

The investment banking industry has come under fire recently for behavior viewed as detrimental to market integrity. Investment banks have been accused of taking advantage of their unique position in the industry to manipulate markets and line their pockets. The result has been legislation designed to lessen this chance. (You can find more on legislation in Chapter 15.)

It's important that financial markets be viewed as a fair game. If individual investors feel that they're at a distinct disadvantage, they may withdraw from participation in the capital markets, and the flow of capital through the system will be reduced and capital formation will be less effective. These kinds of market frictions serve to stunt economic growth and reduce people's standards of living.

How asset management can cause conflicts

The lifeblood of investment banking is information. Managing who has that information, how that information is disseminated, and who can act upon that information is central to mitigating the conflicts of interest created from having an investment banking operation that serves so many masters. The following represents a sampling of the conflicts that exist in investment banking firms.

Let's put lipstick on this pig

One of the biggest potential areas of conflict involves investment banking firms that both provide investment banking services to a corporate client and have analysts producing research reports with buy or sell recommendations on that same stock. The potential conflict is obvious. Investment banks could offer favorable research coverage and in return expect the company's investment banking business. Companies, on the other hand, could penalize investment banks who have unfavorable research opinions by going to other firms for their investment banking business.

Mom likes me best

Investment banks often serve somewhat of a parental role for corporations. They don't want to appear to favor one client over another, just as parents try to treat all children equally. Investment banks often broker deals between companies and between clients.

In one of the most infamous cases from the financial crisis, some pundits alleged that hedge-fund titan John Paulson's bet that the housing market would crash was arranged by investment banks that specifically created packages of mortgage-backed securities at the behest of Paulson. These securities were sold to clients of the investment banks so Paulson could wager against them. By the way, this seemingly clever strategy backfired on the investment banks because they ended up not being able to sell all the mortgage-backed securities. The result? When the real estate market tanked, the investment banks were left holding big losses.

The bottom line here is that it appears to be a major conflict of interest to create securities designed to make one client fabulously wealthy, while at the same time, lining up buyers for that same security. Can someone truly serve two masters?

Say it ain't so?

Investment banks manage money for client accounts, execute trades on behalf of clients, and trade using the firm's own capital — a practice known as proprietary trading. Information on order flow — the buy and sell orders in the pipeline both from firm clients and from funds managed by the investment bank on behalf of others — is extremely valuable information for anyone in the markets to have. For instance, if you know that there are a large number of shares of a certain stock to be liquidated for a major client, you have a pretty good idea that the stock is likely to go down in value in the near term. Likewise, if you know that a firm is a takeover target through your investment banking analysts, you know that, chances are, the stock price will advance when that information becomes public knowledge.

There is a temptation for investment bankers to take such privileged information about what clients are doing and trade on their own behalf prior to conducting trades on behalf of their clients. This is a practice known as front running, and it's both illegal and unethical.

How to eliminate and manage conflicts

We know that conflicts exist in investment banking, but how can they be eliminated or managed? The following are methods that investment banks use to both eliminate and manage conflicts.

Build a wall

For investment research to have any real value, it must be independent and objective. It must be based on the facts in evidence and not influenced by any relationships between the investment banking firm and the firm being researched. The best way to prevent information flow from the mergers and acquisitions and corporate finance personnel to the sales and traders at an investment bank is to erect a Chinese wall — the colloquial term for information and physical barriers implemented within a firm to separate and isolate people who make investment decisions from people who are privy to material nonpublic information that could influence those decisions.

A Chinese wall can refer to both informational and physical barriers. Investment banking firms often locate personnel with different functions on different floors or in other geographical locations. Also, information systems are designed to prevent unintended sharing of information between functional personnel.

Place restrictions

Firms often place restrictions on personal trading by employees and carefully monitor both proprietary trading and personal trading by employees. Firms often place companies on a restricted list when an investment banking firm has or may have material nonpublic information on companies.

Ensure compliance

Compliance has often been ridiculed as a necessary evil of investment firms, but that's changing. As the name suggests, the compliance function at investment banking firms is charged with the task of making sure the firm is not violating any laws in conducting business. At many firms, compliance is also responsible for ensuring that personnel are operating within the bounds of the firm's code of ethics.

All investment banking firms have compliance functions, but the emphasis some firms place on compliance and education regarding acceptable practices differs greatly. For compliance to truly matter at firms, the message must come from top management.

Disclose potential conflicts of interest

Disclosure is the best disinfectant. Federal securities laws require that investment banking firms disclose certain facts and relationships that could be (or could be interpreted as) potential conflicts of interest. These disclosures help clients and potential clients get the lay of the land and allow for more informed decisions.

Things that must be disclosed include, but aren't limited to, the following:

• Conflicts: Whether the investment banking firm is acting as a manager or co-manager of an impending underwriting for the company
• Ownership: Whether the investment banking firm owns more than one percent of the common stock of the company
• Payments: Whether the investment banking firm has received compensation for investment banking services from the company in the past 12 months
• Market making: Whether the investment banking firm makes a market in the securities or derivatives of the company

Establish a code of ethics

Codes of ethics are no panacea. Enron had a 64-page code of ethics that was distributed to all employees. Take the time to read it if you need a good laugh. Having said that, a robust code of ethics that is emphasized by top management sends a strong signal that the investment banking firm takes ethical behavior seriously.

Two nonprofit organizations of investment professionals — the CFA Institute (www.cfainstitute.org) and the Chartered Alternative Investment Analyst Association (CAIA; www.caia.org) — require their members to abide by a robust code of ethics. This gives clients and other investment professionals a strong signal about the ethical orientation of these professionals and the organization that employs them.