Archive for the 'Investment Returns' Category

Factors Affecting the Business Cycle

The business cycle refers to the swings in gross domestic product from recovery to recession. There are several factors influencing the business cycle.

Consumers tend to be the most important, reflecting 60-70% of GDP in developed countries. Trends in consumer spending can be monitored through retail sales and personal income data.

Business spending on inventories and investment is a smaller but more volatile component of GDP. It can be tracked using surveys such as PMI or ISM.

Monetary policy is used by governments to dampen the overall business cycle. The ability to use monetary policy as a business cycle lever is dampened by inflation, the pace of growth, unemployment levels and capacity utilization.

Posted on 18th February 2009
Under: Economic Analysis, FInancial Planning, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Business Cycles in the Economy

The typical business cycle can last as long as 10 years or more. It is typically represented by several stages.

In the recovery stage, there is still a large gap between output and capacity. Bond yields are bottoming and stocks often surge. Taking risk (cyclical and risky stocks, high yield bonds) tends to offer above-average rewards.

In the early upswing, the economy experiences robust growth without causing inflation because output is still below capacity. As the capacity utilization improves, so does profitability. Short rates begin to rise, though long-term rates remain stable.

In the later stages of the upswing, the output gap closes and overheating becomes a danger. Inflation can pick up, resulting in rising interest rates and stock market volatility.

In a slowdown, the slowing economy becomes sensitive to potential shocks. Interest rates are peaking, and interest-sensitive stocks tend to perform well.

In a recession, declining GDP leads to falling short-term interest rates and bond yields. The stock market bottoms out and often starts to rise well ahead of the business cycle recovery.

Posted on 18th December 2008
Under: Asset Allocation, Fundamental Analysis, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Strategy and Due Diligence for Private Equity Investments

When considering an investment in private equity, investors need to consider a number of factors.

  • Can a small investor obtain the diversification needed
  • Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
  • Will the investor be able to fund promised commitments to the private equity fund when called for
  • What mix of sector, stage and geography is required to provide the best diversification

In addition, selecting managers requires special due diligence considerations:

  1. Can the investor and manager evaluate prospects for market success
    • Understanding of the markets, competition and sales prospects
    • Experience and capabilities of management team
    • Management’s commitment – ownership, compensation structure, etc
    • Opinion of customers
    • Identity of current investors – do they have particular expertise that lends confidence to outsiders
  2. Operational review
    • Have experts validated the technology
    • Consideration of employment contracts
    • What intellectual property rights have been established
  3. Financial and legal review
    • Potential dilution of interest
    • Financial statement (or tax returns, or investor-conducted audit)

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

Inventory Cycles in Business

Inventory cycles tend to last two to four years. As business improves, greater confidence in future sales cause management to build inventory in anticipation of those sales. At some point, the sales fall below expectations and the inventories form a glut.

In order to clear inventories, prices are cut and fewer inventories are ordered. Eventually the inventory gets worked down. When sales do finally pick up again, this can sometimes lead to shortages.

Posted on 18th November 2008
Under: Asset Allocation, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Portfolio Rebalancing Strategies

Buy and Hold

Investors who use a buy and hold strategy set their initial allocation weights and then do nothing. Such allocations are directly related to the market performance of risky assets, and using them implies that risk tolerance is directly related to wealth and market returns.

Consider a 60/40 split between stocks and the risk-free asset. As the stock market rises (falls), stocks represent a larger (smaller) weight in the portfolio and The risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship.

When markets are trending, buy and hold methods can perform well because the better performing assets get increasingly larger weights and poor-performing assets have less impact.

Constant-mix

Constant mix rebalancing is a dynamic process that requires rebalancing to the intial target allocation by trading whenever market conditions alter the ideal balance. The strategy ensures that the portfolio’s risk characteristics remain stable over time, consistent with a risk tolerance that varies proportionately to wealth.

Constant-mix strategies can be characterized as contrarian, as they sell the best-performing assets to buy the worst-performing. However, when markets are mean-reverting this will perform better than a buy and hold strategy. The shape of returns is concave – return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.

Constant Proportion

In a constant proportion strategy, the target allocation is a function of cushion, where cushion is the difference between the portfolio value and the floor value, and the allocation to risky assets is the product of the cushion and the proportion (m).  A buy and hold strategy represents a special case in which m = 1. This strategy is consistent with having no risk tolerance if there is no cushion.

If m > 1, the strategy is known as constant proportion portfolio insurance, or CPPI. CPPI strategies buy more stocks when markets are rising and sell stocks as markets fall. The dynamic allocations also affect the floor value, as changing the weight of the risky asset necessitates an opposite-direction change in the floor value.

In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex shape as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.

When markets are characterized by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.

Posted on 4th November 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management | No Comments »

Investing in Distressed Securities

Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.

There are a number of security types that relate to distressed companies:

  • The publicly traded debt and equity
  • Newly issued (orphan) equity of companies recently emerged from reorganization
  • Bank debt and trade claims that the original creditor may wish to monetize
  • “Lender of last resort” notes

Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.

The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.

Posted on 28th October 2008
Under: Active Management, Alternative Assets, Investing in Distressed Securities, Investment Returns, Portfolio Management, Risk Management | No Comments »

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 »

Tools for Setting Capital Market Expectations

When estimating the risk and return characteristics of various asset classes, there are a number of tools available to analysts.

  1. Statistical methods can be descriptive (classify past results) or inferential (used for predicting results.)
    • Sample estimators estimate the future mean and variance based on the sample’s past mean and variance.
    • Shrinkage estimators rely on judgment to weight historical estimates with other parameters in order to reduce the impact of extreme values
    • Time series estimators forecast a variable based on the lagged values of either the variable itself or other variables
    • Multi-factor models explain returns for an asset in terms of the values of a set of return drivers or risk factors
  2. Discounted cash flow models express current value in terms of the future cash flows an asset will generate
  3. The risk premium approach expresses expected return as the risk free rate plus a risk premium that reflects the uncertainty surrounding future results
  4. Financial market equilibrium models describe relationships between expected return and risk in which supply and demand are in balance

Posted on 18th October 2008
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High Yield Bond Returns: Downgrades versus Original Issues

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

  • Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
  • Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
  • Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
  • Lottery-like returns for specific original issue bonds
  • Yield appeal due to higher yields typically found with original issue bonds

Posted on 6th October 2008
Under: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »

Portfolio Rebalancing: Setting Optimal Asset Class Target Corridors

One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:

  1. Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
  2. Risk tolerance – higher risk tolerance also justifies wider corridors
  3. Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
  4. Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
  5. Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.

Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.

Posted on 4th October 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management, Risk Management | No Comments »