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.
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 five of the more popular types of alternative investments — hedge funds, venture capital, commodities, real estate, and currencies — in this section.
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? Hardly. A hedge fund is simply a professionally managed pool of money that is largely unregulated and can only be accessed by sophisticated 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:
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.
Hedge funds have even captured the imagination of the entertainment world. The popular Showtime series Billions has as its protagonist, Bobby Axelrod, a fictional character based loosely on S.A.C. Capital Advisors’ hedge fund manager Stephen Cohen, right down to the firms’ names. Axelrod’s firm is Axe Capital, while the name SAC Capital Advisors is derived from Mr. Cohen’s initials. Cohen amassed an enormous fortune but then later suffered a fall from grace as he was implicated in an insider trading scandal. While Cohen wasn’t personally charged, S.A.C. Capital Advisors pleaded guilty to insider trading charges and paid $1.8 billion in penalties. Cohen no longer runs a hedge fund, instead operating Point72 Ventures, a venture capital firm. (More on venture capital later in this chapter.)
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.
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.
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.
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, you guessed it, two and twenty).
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 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:
Most investors would be shocked to learn that the biggest financial market in the world is the currency, or forex (FX) market. The FX market does not set a currency’s absolute value but rather determines the value or one currency relative to another. You can take a position in virtually any major currency against another major currency in the FX market. For instance, you can take a position in the U.S. Dollar versus the British Pound or a position in the Yen versus the Australian Dollar.
While most of the activity in the FX market involves multinational corporations hedging natural positions, some FX market activity involves institutions or individuals speculating on currency movements. The U.S. dollar is the most traded FX currency in the world (88 percent of all FX transactions), followed by the Euro (32 percent of all transactions). Because each FX transaction involves two pairs, the grand total of all transactions equals 200 percent and not 100 percent as in every other financial market.
Investing in currencies, whether traditional currencies or cryptocurrencies, is fundamentally different than investing in stocks, bonds, or real estate. Over the long-term, investing in the stock market is a positive-sum game. That is, over the long run the value of stocks, both individually and collectively, generally rise. On the other hand, over both the short and long term, investing in currencies is a zero-sum game. That is, when the U.S. dollar strengthens versus the Yen, those holding U.S. dollar positions win and those holding Yen positions lose an equal and opposite amount. If you want to build wealth over the long-term, the stock market is the place to be.
Without question the biggest development in the financial markets in the past few years has been the rise of cryptocurrencies, particularly bitcoin. Bitcoin is a specific type of cryptocurrency: a decentralized digital currency that isn’t backed by a central bank. Users send each other payments via cryptocurrencies on an electronic peer-to-peer network. Bitcoin is created by a process known as mining. But unlike gold and silver miners, bitcoin miners use computers instead of picks and axes to mine bitcoin.
In some respects, referring to bitcoin as a currency is misleading. Sure, some people will take payment in bitcoin, but one of the fundamental characteristics of a good currency is stability of value. And bitcoin takes it on the chin with respect to price stability, as the chart of the price of bitcoin resembles a ride on a wild roller coaster. In January of 2017, a single bitcoin could be purchased for under $1,000. In December of that year, bitcoin nearly reached the $20,000 level. It subsequently fell below $3,300 by December of 2018. Are you dizzy yet?
For a period of time, you couldn’t browse a financial website or tune in to financial news without being inundated with analysis and opinions on bitcoin. Stories of cryptocurrency millionaires pocketing obscene sums of money, purchasing Lamborghinis with bitcoin and retiring to island mansions captured the imagination of many “investors.” Bitcoin frenzy was everywhere, as people didn’t want to get left behind and many clamored to participate in the 21st century gold rush.
The problem is that purchasing bitcoin isn’t an investment; it is speculation in an unproven commodity. You see, the crypto markets do not lend themselves to fundamental analysis as there is no intrinsic value to these supposed assets. But don’t take my word for it. Listen to Warren Buffett’s sidekick and Berkshire Hathaway Vice Chairman, Charlie Munger. Munger said, “I think it is perfectly asinine to even pause and think about them (cryptocurrencies). It’s bad, crazy people, bad idea, luring people into the concept of easy wealth without much insight or work.”
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.
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.
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.
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.
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:
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:
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.
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. Other popular issues are the iShares ETFs sponsored by BlackRock, which track many country and industry indexes.
Leveraged ETFs are a relatively recent type of ETF that attempt to achieve returns that are more pronounced than a market index. For instance, there are leveraged ETFs that attempt to earn daily returns that are two or three times more pronounced than the S&P 500 Index or the Dow Jones Industrial Average. In fact, there are even inverse ETFs that attempt to earn returns that are minus two or three times the index daily returns. In other words, a minus 2 times S&P 500 Index ETF would go up in value by approximately 2 percent if the S&P 500 dropped in value by 1 percent.
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.
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.
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.
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.
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.
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?
Investment banks manage money for client accounts and execute trades on behalf of clients. 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.
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.
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 firewall (sometimes colloquially referred to as a Chinese wall) 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.
Firms often place restrictions on personal trading by employees and carefully monitor 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.
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.
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:
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.