Hedge funds are not subject to investment restrictions and thus have greater breadth of investment instruments at their disposal. These typically include leverage, short sales, derivatives, and concentrated or illiquid positions.See also:
Hedge funds are privately organized, loosely regulated and professionally managed pools of capital not widely available to the public.
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.See also:
Inflation has different effects on different types of assets. As a result, it is important both to diversify assets in terms of their response to inflation and to form expectations of inflation in order to overweight the assets that will respond best to future conditions.
Cash – inflation causes rising interest rates, and therefore cash tends to earn a higher return when inflation is higher.
Bonds – inflation erodes the fixed payments and terminal values of bonds. Therefore, bonds perform worse when inflation is higher.
Stocks – inflation can increase asset values but erode real cash flows. Rising interest rates can reduce the present value of future cash flows. Stocks tend to do best when inflation is low and predictable, and to fall in either high inflation or deflation.
Real estate – higher cash flows and asset values tend to result in a positive relationship between real estate and inflation.See also:
The N-firm concentration ratio is an intuitive measure of industry concentration. Industries with high (or low) levels of concentration have few (or many) competitors.
The N-firm concentration ratio is found simply by adding the market shares of the N largest firms in the industry. For example, in an industry with six competitors with respective market shares of 30%, 20%, 20%, 10%, 10% and 10% the three firm concentration ratio would be 30% + 20% + 20% = 70% and the 5-firm concentration ratio would be 90%.
The N-firm concentration ratio is an intuitive measure, but the Herfindahl index provides a greater degree of discrimination. As a result, when the two indicators offer differing signals the Herfindahl index is likely more reliable.See also:
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.See also:
Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.
In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. IfÂ the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.
Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.
Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.See also:
Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.
Event risk relates to unexpected company-specific or situation-specific events that affect valuation.
Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.
J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.See also:
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:
- 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
- Operational review
- Have experts validated the technology
- Consideration of employment contracts
- What intellectual property rights have been established
- Financial and legal review
- Potential dilution of interest
- Financial statement (or tax returns, or investor-conducted audit)
The Herfindahl index is a measure of how concentrated an industry is. An industry with few competitors will have a high level of concentration, while many competitors results in low concentration.
The Herfindahl index measures concentration as the sum of the squared market share of each firm in the industry. For example, consider an industry with six competitors, with respective market share of 30%, 20%, 20%, 10%, 10% and 10% the Herfindahl index will be (0.3*0.3) + (0.2*0.2) + (0.2*0.2) + (0.1*0.1) + (0.1*0.1) + (0.1*0.1) = 0.09 + 0.04 + 0.04 + 0.01+0.01 + 0.01 = 0.2.
As a general rule, a Herfindahl index below 0.1 signals low concentration, while a Herfindahl index above 0.18 signals high concentration. Between 0.1 and 0.18 the industry is moderately concentrated.
If all firms in an industry have equal market share, the reciprocal of the Herfindahl index (1/H) will equal the number of firms in the industry. For industry in which firms have unequal share, the reciprocal of the Herfindahl indicates the “equivalent” number of firms. In this example, the six firms in the industry have the same level of concentration as an industry with 1/0.2 = 5 competitors with equal market share.
Compared to the N-firm concentration ratio, the Herfindahl index offers greater discrimination as it includes all firms in the industry and weights the firms according to market share. However, it is not a particularly intuitive measure.See also: