Financial Education

Private equity funds are typically structured as limited partnerships or limited liability corporations (LLCs). There are a number of reasons for this preference.

• No double taxation (profits taxed at limited partner or shareholder level)
• No liability beyond the initial investment

Typically private equity funds will be structured to have a 7-10 year life, with options to extend this for an additional 1-5 years. The objective is to realize the full value of investments by the liquidation date. Rather than manage pools of uninvested capital, private equity managers typically require commitments that are drawn down as the funds are needed to make investments or cover expenses.

Fees for private equity managers typically include a management fee of 1.5% - 2.0% of assets under management, plus an incentive fee of 15%-20% of the profits retained after capital is returned to the limited partners. The incentive fee may include a hurdle rate of return that must be met before the fee is earned, and also may include a claw-back provision in case later investments do poorly.

Companies that operate in global industries are subject to influences from both their country of domicile and their industry. As a result, both country analysis and global industry analysis are typically needed.

Country analysis can include not just the country of domicile, but also the major end markets in which a company operates. In each significant country market, analysts and economists typically monitor a wide range of economic, social and political variables. These can include:

• Expected real and nominal growth
• Monetary and fiscal policy
• Investment climate
• Business cycle stage
• Long-term sustainable growth
• Competitiveness
• Factors affecting employment and wages
• Social and political environment

Business cycles across countries are not fully synchronized, so some countries may recover or enter recession sooner than others. However, as markets become more globally integrated international business cycles tend to converge.

To estimate long-term sustainable growth, there are two primary competing theories.

• Neoclassical growth theory assumes that the marginal productivity of capital declines as more capital is added.
• Endogenous growth theory assumes that technological advances and improved labor force education can result in efficiency gains. These can prevent the decline in marginal productivity of capital.

As industries become more global, the country factors are also becoming less significant. Industry factors to consider include:

• Demand analysis - how is the global market for the company’s products and services growing?
• Value creation - Where on the supply chain is value created? Are there advantages to size, scale or scope? Is there a productivity learning curve in the industry?
• Industry life cycle - is the industry a pioneer, accelerating growth, mature, stable or decelerating industry?
• What is the industry’s competitive structure?
• What is the competitive advantage pursued by each industry participant?

Duration measures the change in value for a bond given a 100 basis point change in interest rates. However, since international rates are not perfecltly correlated with domestic rates, the duration of a foreign bond does not have the same impact on value and portfolio duration for a change in domestic interest rates.

Instead, the relationship between domestic and foreign rates can be estimated empirically to determine a country beta.

The percentage change in a foreign bond due to a change in domestic interest rates would be estimated as the product of country beta and duration. The portfolio’s weighted average duration would also be affected by the weight of the foreign bond multiplied by the product of country beta and duration.

Investment analysts can fall into several psychological traps (and should strive to avoid doing so.)

Anchoring refers to giving disproportionate weight to the first information received about a topic.

Status quo bias is the tendency to perpetuate recent observations in forecasts.

Confirming evidence is the tendency to give more weight to information that supports existing or preferred points of view than to information that contradicts the preferred view.

Overconfidence is having too much faith in the accuracy of one’s forecasts.

Recallability is when forecasts are overly influenced by events that left a strong impression on the forecaster’s memory.

Continuous markets are those in which trades can occur at any time that the market is open. This can happen in one of three ways:

• An auction market, in which the trades are placed between investors without intermediaries. A trade occurs whenever the highest bid price and the lowest ask price match.
• A dealer market, in which intermediaries provide liquidity by setting minimum bid and maximum ask prices. In a dealer market, a dealer takes one side of each trade, and an investor takes the other.
• A hybrid market, in which dealers step in whenever the auction market is not sufficiently liquid.

Sentiment indicators monitor the activity of market participants such as floor traders, insiders, mutual fund managers, etc. The premise behind such indicators is that certain types of investors will have similar reactions to future market events as they have had to past events. These reactions may prove useful for identifying market turning points.

Insiders and New York Stock Exchange members have historically been “right.” They tend to be net buyers at market tops and net sellers at market bottoms.

Advisory services, on the other hand, tend to buy at the top and sell at the bottom. Tracking the sentiment of newsletter writers, for example, may prove to be a useful contrary indicator.

The level of the Chicago Board Options Exchange Volatility Index (VIX) has been shown to predict returns on equity indexes, implying either that VIX variables are priced risk factors or that markets are inefficient. In the October 2007 Journal of Banking and Finance, Banerjee, Doran and Peterson show that this relationship is strongest for high-beta portfolios.

Studies have shown that high volatility index scores are positively related to future stock market returns. In an efficient market, an observable variable such as the VIX should not have predictive power. The authors confirm that the predictive power exists, and offer support for both the market inefficiency and the priced risk arguments.

It is generally accepted that more accurate earnings forecasts by analysts should result in superior investment performance. In the Winter 2007 Journal of Investing Fortin, Gilkeson and Michelson examine three hypotheses to determine what factors may be advance indicators of superior forecast accuracy.

Hypothesis 1 is that more frequent forecast updates represent greater analyst effort and indicate greater accuracy. No support is found for this hypothesis.

Hypothesis 2 is that (a) greater changes in successive estimates result in more accurate forecasts and (b) given a tendency toward optimism, a decrease in estimates is a stronger indicator than a similar-size increase. Tests of this hypothesis find no support and even that larger changes suggest greater error and may be a signal of higher uncertainty, regardless of direction.

Hypothesis 3 is that (a) the magnitude of the change in earnings relative to last year’s earnings indicates greater accuracy and (b) a decrease is a stronger indicator than a similar magnitude increase. They find that larger changes lead to less accuracy, but that forecast declines lead to greater accuracy.

The authors conclude that investors should avoid following recommendations of analysts who frequently revise estimates and who change forecasts by significant amounts. However, they suggest that analysts forecasting earnings declines are worth noting.

Many have characterized Chinese stock markets as inefficient, casino-like and speculative. In the November 2007 Pacific Basin Finane Journal Eun and Huang show that China’s markets may be more rational than many credit.

China’s markets, more than others, are characterized by small investors with undiversified portfolios. Only 37% of shares are publicly tradable, and only 10% of listed companies can offer the B- or H- class shares available to foreign investors. In studying various preferences, the authors find the following:

1. Stocks are priced according to company-specific rather than systematic risk. There are strong size and value effects, similar to the results found in U.S. markets.
2. Investors will pay a premium for more liquid stocks.
3. Investors will pay a premium for dividend paying stocks, possibly because dividends may reduce the ability of managers to expropriate funds.
4. Investors require lower returns for A-share companies that also issue B- or H-shares, possibly because such companies must meet more stringent disclosure requirements.

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability - especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.