Archive for the 'Institutional Investing' Category

The Role of Private Equity Investments in a Portfolio

Private equity investments typically have a low correlation to the returns on stocks and bonds, which provides a diversification benefit. Investors should understand, however, that the use of appraisals can result in a stale valuation and could partially explain the low correlation. If annual returns are used for both private equity and traditional assets, the correlations appear higher.

Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.

Posted on 27th October 2008
Under: Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Benchmarks for Private Equity Investments

Benchmarking the returns of private equity investments is complicated by the fact that events that would indicate a change in market value (such as a new financing, acquisition, IPO, or failure of the business) occur infrequently.

Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds. They typically calculate the internal rate of return based on cash flows since fund inception. Often firms are compared by vintage year for comparability across the stage of financing and any macroeconomic influences.

Since the venture capital must provide appraisals of some assets, stale valuations can result in a smoother return appearance than is actually realized.

Posted on 27th September 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Model Uncertainty and Input Uncertainty

Model uncertainty is the risk that a selected model is inappropriate or incorrect for the purpose used.

Input uncertainty relates to whether the inputs fed to a model are accurate.

Input and model uncertainties make it difficult to evaluate potential inefficiencies or market anomalies.

Posted on 18th September 2008
Under: Active Management, Fundamental Analysis, Industry Analysis, Institutional Investing, Portfolio Management | No Comments »

Forecasting Fund Manager Alphas

Because the investment returns of all managers, on average, will be average paying higher fees for active management is justified only if the superior managers can be identified in advance.

In the March/April 2008 Financial Analysts Journal Waring and Ramkumar write that the expected alpha from active fund managers can be forecasted, as long as investors pay heed to the rules of zero-sum-game investing.

The forecasts are based on two equations derived from the fundamental law of active management. Variables for the equation are estimates of the manager’s skill, estimates of the sponsor’s assessment of its own skill in identifying skilled managers, the cross-sectional standard deviation of manager skill, portfolio breadth, implementation efficiency, expected active risk, and fees.

Posted on 5th September 2008
Under: Active Management, Institutional Investing, Investment Returns, Performance Measurement, Portfolio Management, Risk Management | No Comments »

The Structure of Private Equity Funds

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.

Posted on 27th August 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Portfolio Management, Securities Regulation | No Comments »

Psychological Traps in Investment Analysis

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.

Posted on 18th August 2008
Under: Asset Allocation, Behavioral Finance, FInancial Planning, Institutional Investing, Portfolio Management | No Comments »

Implied Volatility and Future Portfolio Returns

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.

Posted on 9th August 2008
Under: Active Management, Institutional Investing, Investing in Stocks, Investment Returns, Options, Portfolio Management | No Comments »

Evaluating Market Quality

High quality securities markets are those that supply liquidity, transparency and assured completion.

Liquidity can be defined a number of ways:

  • Tightness (low bid/ask spread)
  • Depth (limited price impact from large trades)
  • Resiliency (rapid adjustments for discrepancies between market price and intrinsic value)

Transparency means access to quotes is quick, easy and inexpensive. It also requires that trade details (size and price) are rapidly disseminated to the public.

Assurity of completion simply means that the counterparties of a trade can be trusted to honor the trade.

Posted on 3rd August 2008
Under: Active Management, Institutional Investing, Investing in Stocks, Risk Management, Trading Execution | No Comments »

Use of Convertible Preferred Stock in Venture Capital Invesments

Venture capital investors typically receive convertible preferred stock when funding companies. If the company is forced to liquidate, the preferred shares will have precedence in receiving funds. The company founders will hold a residual stake of common shares. If subsequent funding rounds are provided, each round is typically senior to the previous.

Typically the preferred investors must see a return of capital and also some investment return (often a total of 2x the capital contributed) before any cash can be returned to common shareholders. This provides the founders with an incentive to earn the return required by their investors so they can reap their own rewards.

The preferred shares are also convertible to common shares, which is typically done when a corporate action (merger or IPO) creates liquidity for the common shares and an opportunity to cash out.

Posted on 27th July 2008
Under: Active Management, Alternative Assets, Institutional Investing, Investing in Private Equity, Portfolio Management | No Comments »

Misinterpretations of Correlations

Suppose an analysis finds that semiconductor sales have a strong relationship with semiconductor equipment sales. There are three possible explanations for the relationship:

  1. Higher semiconductor sales result in a need for more semiconductor equipment (A predicts B)
  2. Having more equipment to make semiconductors results in higher sales (B predicts A)
  3. Some other factor (such as economic conditions) results in higher need for both semiconductors and semiconductor equipment (C predicts A and B)

Without investigating and modeling the underlying linkages, using correlations relationships in a prediction model can lead to significant errors.

Equally important, suppose that no correlation is found between semiconductors and semiconductor equipment. They may still have a strong (but nonlinear) relationship that should be considered. Such relationships may be found by using multiple regression techniques.

Posted on 18th July 2008
Under: Asset Allocation, FInancial Planning, Institutional Investing, Investment Returns, Portfolio Management | No Comments »