The Handbook ofTraditional and

AlternativeInvestment

VehiclesVehicles

The Frank J. Fabozzi SeriesFixed Income Securities, Second Edition by Frank J. FabozziFocus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. AbateHandbook of Global Fixed Income Calculations by Dragomir KrginManaging a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. FabozziReal Options and Option-Embedded Securities by William T. MooreCapital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. FabozziThe Exchange-Traded Funds Manual by Gary L. GastineaulProfessional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. FabozziInvesting in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia PilarinuHandbook of Alternative Assets by Mark J. P. AnsonThe Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad ChoudhryThe Handbook of Financial Instruments edited by Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis by Laurie S. Goodman and Frank J. FabozziInterest Rate, Term Structure, and Valuation Modeling edited by Frank J. FabozzigInvestment Performance Measurement by Bruce J. FeibeltThe Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. FabozzitThe Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. MarkowitztFoundations of Economic Value Added, Second Edition by James L. GrantFinancial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. PetersonMeasuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi,

Steven V. Mann, and Moorad ChoudhryProfessional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. FabozziThe Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad ChoudhryThe Handbook of European Structured Financial Products edited by Frank J. Fabozzi and

Moorad ChoudhryThe Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi andt

Frank J. FabozziShort Selling: Strategies, Risks, and Rewards edited by Frank J. FabozziThe Real Estate Investment Handbook by G. Timothy Haight and Daniel SingerMarket Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. LevySecurities Finance: Securities Lending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. MannFat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and

Frank J. FabozziFinancial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M.

Focardi, and Petter N. KolmAdvanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by

Frank J. Fabozzi, Lionel Martellini, and Philippe PriauletAnalysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. FabozziCollateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S.

Goodman, and Frank J. FabozziHandbook of Alternative Assets, Second Edition by Mark J. P. AnsonIntroduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad ChoudhryFinancial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and

Teo JasicDevelopments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas,

Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. ManningRobust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm,t

Dessislava A. Pachamanova, and Sergio M. FocardiAdvanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev,

Stogan V. Stoyanov, and Frank J. FabozziHow to Select Investment Managers and Evaluate Performance by G. Timothy Haight,

Stephen O. Morrell, and Glenn E. RossBayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and

Frank J. FabozziStructured Products and Related Credit Derivatives by Brian P. Lancaster, Glenn M. Schultz, and Frank J. FabozziQuantitative Equity Investing: Techniques and Strategies by Frank J. Fabozzi, CFA, Sergio M. Focardi,

Petter N. KolmIntroduction to Fixed Income Analytics, Second Edition by Frank J. Fabozzi and Steven V. Mann

John Wiley & Sons, Inc.

The Handbook ofTraditional and

AlternativeInvestment

VehiclesVehicles

Investment Characteristics and Strategies

MARK J. P. ANSON FRANK J. FABOZZI

FRANK J. JONES

Copyright © 2011 by John Wiley & Sons, Inc. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

MJPATo my wife Mary,

my children Madeleine and Marcus, and our two cats, Scout and Fuffy—

two important members of our family

FJFTo my wife Donna

and my children Patricia, Karly, and Francesco

FJJTo my wife Sally for her good humor and patience

ContentsContents

vii

Preface xiii

About the Authors xv

CHAPTER 1

Introduction 1

Risks Associated with Investing 1Asset Classes 7Super Asset Classes 11Strategic vs. Tactical Allocations 13Effi cient vs. Ineffi cient Asset Classes 14Beta and Alpha Drivers 15Financial Instruments and Concepts Introduced in this Chapter 16

CHAPTER 2

Investing in Common Stock 17

Earnings 18Dividends 22Stock Repurchases 28The U.S. Equity Markets 29Trading Mechanics 31Trading Costs 37Financial Instruments and Concepts Introduced in this Chapter 38

CHAPTER 3

More on Common Stock 41

Pricing Effi ciency of the Stock Market 41Stock Market Indicators 42Risk Factors 46Tracking Error 49Common Stock Investment Strategies 54Financial Instruments and Concepts Introduced in this Chapter 67

viii CONTENTS

CHAPTER 4

Bond Basics 69

Features of Bonds 69Yield Measures and Their Limitations 77Interest Rate Risk 83Call and Prepayment Risk 86Credit Risk 87Financial Instruments and Concepts Introduced in this Chapter 95

CHAPTER 5

U.S. Treasury and Federal Agency Securities 97

Treasury Securities 97Federal Agency Securities 104Financial Instruments and Concepts Introduced in this Chapter 109

CHAPTER 6

Municipal Securities 111

Tax-Exempt and Taxable Municipal Securities 111Types of Municipal Securities 114Tax-Exempt Municipal Bond Yields 123Risks Associated with Investing in Municipal Bonds 125Build America Bonds 125Financial Instruments and Concepts Introduced in this Chapter 126

CHAPTER 7

Corporate Fixed Income Securities 127

Corporate Bonds 127Medium-Term Notes 132Commercial Paper 134Preferred Stock 135Convertible Security 138Financial Instruments and Concepts Introduced in this Chapter 145

CHAPTER 8

Agency Mortgage Passthrough Securities 147

Mortgages 147Mortgage Passthrough Securities 151Types of Agency Mortgage Passthrough Securities 152Prepayment Conventions and Cash Flows 153Factors Affecting Prepayment Behavior 159Prepayment Models 162

Contents ix

Yield 162A Closer Look at Prepayment Risk 164Trading and Settlement Procedures for Agency Passthroughs 165Stripped Mortgage-Backed Securities 167Financial Instruments and Concepts Introduced in this Chapter 170

CHAPTER 9

Agency Collateralized Mortgage Obligations 173

The Basic Principle of CMOs 173Agency CMOs 174CMO Structures 174Yields 199Financial Instruments and Concepts Introduced in this Chapter 200

CHAPTER 10

Structured Credit Products 201

Private Label Residential MBS 202Commercial Mortgage-Backed Securities 206Nonmortgage Asset-Backed Securities 209Auto Loan-Backed Securities 210Collateralized Debt Obligations 215Financial Instruments and Concepts Introduced in this Chapter 222

CHAPTER 11

Investment-Oriented Life Insurance 223

Cash Value Life Insurance 223Stock and Mutual Insurance Companies 224General Account vs. Separate Account Products 226Overview of Cash Value Whole Life Insurance 227Taxability of Life Insurance 229Products 230Financial Instruments and Concepts Introduced in this Chapter 242

CHAPTER 12

Investment Companies 243

Types of Investment Companies 243Fund Sales Charges and Annual Operating Expenses 248Advantages of Investing in Mutual Funds 253Types of Funds by Investment Objective 254The Concept of a Family of Funds 256Taxation of Mutual Funds 259

x CONTENTS

Structure of a Fund 260Financial Instruments and Concepts Introduced in this Chapter 260

CHAPTER 13

Exchange-Traded Funds 263

Review of Mutual Funds and Closed-End Funds 263Basics of Exchange-Traded Funds 264ETF Mechanics: The ETF Creation/Redemption Process 267ETF Sponsors 270Mutual Funds vs. ETFs: Relative Advantages 272Uses of ETFs 274The New Generation of Mutual Funds 274Financial Instruments and Concepts Introduced in this Chapter 276

CHAPTER 14

Investing in Real Estate 277

The Benefi ts of Real Estate Investing 277Real Estate Performance 278Real Estate Risk Profi le 280Real Estate as Part of a Diversifi ed Portfolio 282Core, Value-Added, and Opportunistic Real Estate 285Financial Instruments and Concepts Introduced in this Chapter 298

CHAPTER 15

Investing in Real Estate Investment Trusts 299

Advantages and Disadvantages of REITs 299Different Types of REITs 302REIT Rules 304Economics of REITs 306Financial Instruments and Concepts Introduced in this Chapter 312

CHAPTER 16

Introduction to Hedge Funds 313

Hedge Funds vs. Mutual Funds 313Growth of the Hedge Fund Industry 315Categories of Hedge Funds 316Hedge Fund Strategies 318Financial Instruments and Concepts Introduced in this Chapter 342

CHAPTER 17

Considerations in Investing in Hedge Funds 343

Hedge Fund Performance 343

Contents xi

Is Hedge Fund Performance Persistent? 345A Hedge Fund Investment Strategy 347Selecting a Hedge Fund Manager 354Financial Instruments and Concepts Introduced in this Chapter 360

CHAPTER 18

Investing in Capital Venture Funds 361

The Role of a Venture Capitalist 362The Business Plan 367Venture Capital Investment Vehicles 374The Life Cycle of a Venture Capital Fund 378Specialization within the Venture Capital Industry 380Stage of Financing 382Historical Performance 386Financial Instruments and Concepts Introduced in this Chapter 388

CHAPTER 19

Investing in Leveraged Buyouts 389

A Theoretical Example of a Leveraged Buyout 389How LBOs Create Value 392LBO Fund Structures 402Profi le of an LBO Candidate 406Venture Capital vs. Leveraged Buyouts 408Risks of LBOs 410Financial Instruments and Concepts Introduced in this Chapter 411

CHAPTER 20

Investing in Mezzanine Debt 413

Overview of Mezzanine Debt 413Examples of Mezzanine Financing 418Mezzanine Funds 421Venture Capital and the Distinction Between Mezannine

Financing and Different Forms of Private Equity 423Advantages of Mezzanine Debt to the Investor 424Advantages to the Company/Borrower 425Negotiations with Senior Creditors 426Market Performance 428Financial Instruments and Concepts Introduced in this Chapter 429

CHAPTER 21

Investing in Distressed Debt 431

Vulture Investors and Hedge Fund Managers 432

xii CONTENTS

Distressed Debt Is an Ineffi cient and Segmented Market 432Distressed Debt and Bankruptcy 434Distressed Debt Investment Strategies 438Risks of Distressed Debt Investing 450Market Performance 452Financial Instruments and Concepts Introduced in this Chapter 453

CHAPTER 22

Investing in Commodities 455

Gaining Exposure to Commodities 457Commodity Prices Compared to Financial Asset Prices 462Economic Rationale 463Commodity Futures Indexes 471Financial Instruments and Concepts Introduced in this Chapter 485

APPENDIX A

Arithmetic Mean vs. Geometric Mean 487

APPENDIX B

Measures of Risk 491

Range and Location 491Moments of the Distribution 494

INDEX 499

PrefacePreface

xiii

The fi nancial industry has grown tremendously in terms of size and sophis-tication over the last 30 years. The great bull stock market that began in

the early 1980s combined with the birth of enormous computing power ledto a growth in the fi nancial markets that no one could have predicted. So,it was a bit of a daunting task to produce a one-volume handbook to thefi nancial instruments that exist in the global marketplace.

At the outset of this book, we decided to take a pragmatic approach—mixing a little theory with a lot of real world examples. As authors, wethought it better to provide you with a user-friendly reference guide than to provide you with a theoretical treatise. Not that we are beyond being academic—indeed we have all been professors at one point in our careers.However, we thought a better approach would be to dazzle the reader lesswith our academic credentials and instead, to provide a more descriptive textbook.

In this book we provide a “soup to nuts” approach to describing the various fi nancial instruments there are in the marketplace. We start withthe basics: commons stock and basic bonds. We then move on to municipal bonds, agency passthrough securities, collateralized mortgage obligations,and the more specialized structured products in the credit industry. We alsocover the fastest growing part of the asset management industry: exchange-traded funds. Over the past decade, exchange-traded funds have grown ata cumulative average growth rate of over 40% per year—stronger growththan the alternative asset market.

This brings us to the next part of the book. We provide an in depthreview of the major segments of the alternative asset market. We start withreal estate and then move on to publicly traded real estate investment trusts.We then venture into the world of hedge funds, providing both a descriptiveoverview of the many types and styles of hedge funds as well as providinga “how to” guide to investing in these vehicles. We also cover the world of private equity—dedicating a chapter to each of the four parts of the pri-vate equity world: leveraged buyouts, venture capital, mezzanine debt, anddistressed debt. Last, we include commodities. Over the last 20 years, com-modities have developed as an investable asset class.

xiv PREFACE

In summary, our goal in this book is not to display our command of the arcane nomenclature associated with the fi nancial markets, but instead, to provide the reader with a thoughtful guide to fi nancial instruments. If you pull this book down from your bookshelf from time to time to consult howthe market works for a particular fi nancial instrument, we consider this asuccessful effort.

Mark J. P. Anson Frank J. Fabozzi Frank J. Jones

About the AuthorsAbout the Authors

xv

Mark Anson is the Chief Investment Offi cer and Managing Partner for OakHill Investments, a wealth advisory fi rm serving high net worth clients. Priorto joining OHIM, Mark was President and Executive Director of InvestmentServices at Nuveen Investments, an asset management fi rm with $150 billionassets under management. Prior to Nuveen, Mark served as Chief ExecutiveOffi cer of Hermes Pensions Management Ltd., an institutional asset man-agement company based in London, where he was also the Chief ExecutiveOffi cer of the British Telecom Pension Scheme, the largest pension fund inthe United Kingdom and the sole owner of Hermes. Prior to joining Hermes,he served as the Chief Investment Offi cer of the California Public Employees’Retirement System, the largest pension fund in the United States. Mark is theformer Chairman of the Board of the International Corporate GovernanceNetwork. He also has served on the advisory boards for the New York StockExchange, NYSE/Euronext, MSCI-Barra, The Dow Jones-UBS CommodityIndex, and the International Association of Financial Engineers. Currently,he is a member of the Board of Governors of the CFA Institute and the SECAdvisory Committee to SEC Chairwoman Mary Schapiro. He has publishedover 100 research articles in professional journals, has won two Best PaperAwards, is the author of four fi nancial textbooks including the Handbook of Alternative Assets, which is the primary textbook used for the CharteredAlternative Investment Analyst program, and sits on the editorial boards of several fi nancial journals. Mark earned a B.A. in Economics and Chemistryfrom St. Olaf College, a J.D. from Northwestern University School of Law,and a Masters and a Ph.D. in Finance from Columbia University GraduateSchool of Business, all with honors. In addition, Mark has earned the Char-tered Financial Analyst, Chartered Alternative Investment Analyst, Certifi edPublic Accountant, Certifi ed Management Accountant, and Certifi ed Inter-nal Auditor professional designations.

Frank J. Fabozzi, Ph.D., CFA, CPA is Professor in the Practice of Finance in the Yale School of Man agement. Prior to joining the Yale faculty, he was aVisiting Professor of Finance in the Sloan School at MIT. Frank is a Fellowof the International Center for Finance at Yale University and on the Ad-visory Council for the Department of Operations Research and Financial

xvi ABOUT THE AUTHORS

Engineering at Princeton University. He is the editor of the Journal of Port-folio Management and an associate editor of the t Journal of Fixed Incomeand the Journal of Structured Finance. He is a trustee for the BlackRock family of closed-end funds. In 2002, Frank was inducted into the FixedIncome Analysts Society’s Hall of Fame and is the 2007 recipient of theC. Stewart Sheppard Award given by the CFA Institute. He has authorednumerous books in investment management and structured fi nance. Frankearned a doctorate in economics from the City University of New York in1972 and earned the designation of Chartered Financial Analyst and Certi-fi ed Public Accountant.

Frank J. Jones is a Professor of Finance and Accounting at San Jose State University. He is also the Chairman of the Investment Committee of PrivateOcean Wealth Management, a wealth management advisory fi rm servinghigh net worth clients. Frank served on the Board of Directors of the Inter-national Securities Exchange for 10 years until 2010 where he was alter-nately Chairman and Vice-Chairman and was on the Executive Committee,IPO Committee, and Finance and Audit Committee. Prior to returning toacademia, he was the Executive Vice President and Chief Investment Of-fi cer of the Guardian Life Insurance Company; President of the Park Av-enue Portfolio, a mutual fund company; Director of Global Fixed IncomeResearch and Economics at Merrill Lynch and Company; and Senior VicePresident at the New York Stock Exchange. Frank has been on the Gradu-ate Faculty of Economics at the University of Notre Dame; an AdjunctProfessor of Finance at the New York University Stern School of Business;and a Lecturer at the Yale University School of Management. He is on theEditorial Board of the Journal of Investment Management. He received aDoctorate from the Stanford University Graduate School of Business and aMasters of Science in Nuclear Engineering from Cornell University. He isthe author of several books, chapters in books, and articles in investmentsand fi nance.

1

CHAPTER 11Introduction

There is a wide range of fi nancial instruments. The most general clas-sifi cation of fi nancial instruments is based on the nature of the claim

that the investor has on the issuer of the instrument. When the contractualarrangement is one in which the issuer agrees to pay interest and repaythe amount borrowed, the fi nancial instrument is said to be a debt instru-ment. In contrast to a debt instrument, an equity instrument rt epresents anownership interest in the entity that has issued the fi nancial instrument.The holder of an equity instrument is entitled to receive a pro rata share of earnings, if any, after the holders of debt instruments have been paid.Common stock is an example of an equity claim. A partnership share in abusiness is another example.

Some fi nancial instruments fall into both categories in terms of theirattributes. Preferred stock, for example, is an equity instrument that entitlesthe investor to receive a fi xed amount of earnings. This payment is contin-gent, however, and due only after payments to holders of debt instrument are made. Another hybrid instrument is a convertible bond, which allows the investor to convert a debt instrument into an equity instrument undercertain circumstances. Both debt instruments and preferred stock are calledfi xed income instruments.

In this chapter, we’ll provide some basics about fi nancial instruments,the general types of risks associated with investing, and characteristics of asset classes.

RISKS ASSOCIATED WITH INVESTING

There are various risks associated with investing and these will be describedthroughout the book. Here we will provide a brief review of the major risksassociated with investing.

2 THE HANDBOOK OF TRADITIONAL AND ALTERNATIVE INVESTMENT VEHICLES

Total Risk

The dictionary defi nes risk as “hazard, peril, exposure to loss or injury.”With respect to investing, investors have used a variety of defi nitions todescribe risk. Today, the most commonly accepted defi nition of risk is onethat involves a well-known statistical measure known as the variance and is referred to as the total risk. The variance measures the dispersion of the outcomes around the expected value of all outcomes. Another name for theexpected value is the average value.

In applying this statistical measure to the returns for a fi nancial instru-ment, which we refer to as an asset for our discussion here, the observedreturns on that asset over some time period are fi rst obtained. AppendixA explains how returns for an asset are calculated. From those observedreturns, the average return (which is the average or mean value) can becomputed and using that average value, the variance can be computed. Thesquare root of the variance is the standard deviation.

Despite the dominance of the variance (or standard deviation) as a mea-sure of total risk, there are problems with using this measure to quantify thetotal risk for many of the assets we describe in this book. The fi rst problem is that since the variance measures the dispersion of an asset’s return aroundits expected value, it considers the possibility of returns above the expectedreturn and below the average return. Investors, however, do not view pos-sible returns above the expected return as an unfavorable outcome. In fact,such outcomes are viewed as favorable. Because of this, it is argued thatmeasures of risk should not consider the possible returns above the expectedreturn. Various measures of downside risk, such as risk of loss and value atrisk, are currently being used by practitioners.

The second problem is that the variance is only one measure of how thereturns vary around the expected return. When a probability distribution isnot symmetrical around its expected return, then another statistical measureknown as skewness should be used in addition to the variance. Skewed dis-tributions are referred to in terms of tails and mass. The tails of a probabil-ity distribution for returns is important because it is in the tails where theextreme values exist. An investor should be aware of the potential adverseextreme values for an investment and an investment portfolio. The statisti-cal measures important for understanding risk, skewness and kurtosis, areexplained in Appendix B.

Diversifi cation

One way of reducing the total risk associated with holding an individualasset is by diversifying. Often, one hears fi nancial advisors and professional

Introduction 3

money managers talking about diversifying their portfolio. By this it ismeant the construction of a portfolio in such a way as to reduce the port-folio’s total risk without sacrifi cing expected return. This is certainly a goalthat investors should seek. However, the question is, how does one do this in practice?

Some fi nancial advisors and the popular press might say that a port-folio can be diversifi ed by including assets across all asset classes. (We’llexplain in more detail what we mean by an asset class below.) Although thatmight be reasonable, two questions must be addressed in order to constructa diversifi ed portfolio. First, how much of the investor’s wealth should beinvested in each asset class? Second, given the allocation, which specifi cassets should the investor select?

Some investors who focus only on one asset class such as common stockargue that such portfolios should also be diversifi ed. By this they mean thatan investor should not place all funds in the stock of one company, but rather should include stocks of many companies. Here, too, several ques-tions must be answered in order to construct a diversifi ed portfolio. First,which companies should be represented in the portfolio? Second, how muchof the portfolio should be allocated to the stocks of each company?

Prior to the development of portfolio theory by Harry Markowitz in1952,1 while fi nancial advisors often talked about diversifi cation in thesegeneral terms, they never provided the analytical tools by which to answerthe questions posed here. Markowitz demonstrated that a diversifi cationstrategy should take into account the degree of correlation (or covariance)between asset returns in a portfolio. The correlation of asset returns is ameasure of the degree to which the returns on two assets vary or changetogether. Correlation values range from −1 to +1.

Indeed, a key contribution of what is now popularly referred to as“Markowitz diversifi cation” or “mean-variance diversifi cation” is the for-mulation of an asset’s risk in terms of a portfolio of assets, rather than the total risk of an individual asset. Markowitz diversifi cation seeks to combineassets in a portfolio with returns that are less than perfectly positively cor-related in an effort to lower the portfolio’s total risk (variance) without sacrifi cing return. It is the concern for maintaining expected return whilelowering the portfolio’s total risk through an analysis of the correlationbetween asset returns that separates Markowitz diversifi cation from otherapproaches suggested for diversifi cation and makes it more effective.

The principle of Markowitz diversifi cation states that as the correlationbetween the returns for assets that are combined in a portfolio decreases,so does the variance of the portfolio’s total return. The good news is that 1Harry M. Markowitz, “Portfolio Selection,” Journal of Finance 7, no. 1 (1952): 77–91.

4 THE HANDBOOK OF TRADITIONAL AND ALTERNATIVE INVESTMENT VEHICLES

investors can maintain expected portfolio return and lower portfolio totalrisk by combining assets with lower (and preferably negative) correlations.However, the bad news is that very few assets have small to negative cor-relations with other assets. The problem, then, becomes one of searchingamong a large number of assets in an effort to discover the portfolio withthe minimum risk at a given level of expected return or, equivalently, the highest expected return at a given level of risk. Such portfolios are calledeffi cient portfolios.

The recent fi nancial market crisis has taught an important lesson aboutconstructing effi cient portfolios and what to expect from them. Specifi cally, when constructing a portfolio based on the historical correlations observed,there is no assurance that those correlations may not adversely change overtime, particularly in stressful periods in fi nancial markets. By “adverselychange” it is meant that correlations that may be considerably less thanone when designing a diversifi ed portfolio might move closer to one. Thisis because during such times there are typically massive sell offs of allassets because of the concerns of a systemic threat to the fi nancial marketsthroughout the world.

Systematic vs. Unsystematic Risk

The total risk of an asset or a portfolio can be divided into two types of risk:systematic risk and unsystematic risk. William Sharpe defi ned systematicrisk as the portion of an asset’s variability that can be attributed to a com-mon factor.2 It is more popularly referred to as market risk. Because in the models developed to explain how total risk can be partitioned, the Greekletter beta was used to represent the quantity of systematic risk associatedwith an asset or portfolio, the term “beta” or “beta risk” has been used tomean market risk.

Systematic risk is the minimum level of risk that can be attained for a portfolio by means of diversifi cation across a large number of randomlychosen assets. As such, systematic risk is that which results from generalmarket and economic conditions that cannot be diversifi ed away. For this reason the term undiversifi able risk is also used to describe systematic risk.

Sharpe defi ned the portion of an asset’s return variability (i.e., total risk) that can be diversifi ed away as unsystematic risk. It is also called diversifi -able risk, unique risk, residual risk, idiosyncratic risk, or company-specifi crisk. This is the risk that is unique to a company, such as an employee strike,the outcome of unfavorable litigation, or a natural catastrophe.

2William F. Sharpe, “Capital Asset Prices,” Journal of Finance 19, no. 3 (1963): 425–442.

Introduction 5

How diversifi cation reduces unsystematic risk for portfolios is illus-trated in Exhibit 1.1. The vertical axis shows the standard deviation of a portfolio’s total return. The standard deviation represents the total risk forthe portfolio (systematic plus unsystematic). The horizontal axis shows thenumber of holdings of different assets (e.g., the number of common stockheld of different companies). As can be seen, as the number of asset holdingsincreases (assuming that the assets are less than perfectly correlated as dis-cussed below), the level of unsystematic risk is almost completely eliminated(that is, diversifi ed away). The risk that remains is systematic risk. Studies of different asset classes support this. For example, for common stock, severalstudies suggest that a portfolio size of about 20 randomly selected compa-nies will completely eliminate unsystematic risk leaving only systematic risk.

The relationship between the movement in the price of an asset andthe market can be estimated statistically. There are two products of the estimated relationship that investors use. The fi rst is the beta of an asset.

EXHIBIT 1.1 Systematic and Unsystematic Portfolio Risk

0

Total riskSystematic ormarket-related

risk

Unsystematic ordiversifiable risk

Number of Holdings

Stan

dard

Dev

iati

on o

f Po

rtfo

lio R

etur

n

6 THE HANDBOOK OF TRADITIONAL AND ALTERNATIVE INVESTMENT VEHICLES

Beta measures the sensitivity of an asset’s return to changes in the market’sreturn. Hence, beta is referred to as an index of systematic risk due to gen-eral market conditions that cannot be diversifi ed away. For example, if anasset has a beta of 1.5, it means that, on average, if the market changes by1%, the asset’s return changes by about 1.5%. The beta for the market isone. A beta that is greater than one means that systematic risk is greaterthan that of the market; a beta less than one means that the systematic riskis less than that of the market. Brokerage fi rms, vendors such as Bloomberg, Yahoo! Finance, and online Internet services provide information on betafor common stock.

The second product is the ratio of the amount of systematic risk rela-tive to the total risk. This ratio, called the coeffi cient of determination orR-squared, varies from zero to one. A value of 0.8 for a portfolio means that 80% of the variation in the portfolio’s return is explained by movements in the market. For individual assets, this ratio is typically low because there isa good deal of unsystematic risk. However, as shown in Exhibit 1.1, throughdiversifi cation the ratio increases as unsystematic risk is reduced.

Infl ation or Purchasing Power Risk

Infl ation risk, or purchasing power risk, is the potential erosion in the value of an asset’s cash fl ows due to infl ation, as measured in terms of purchas-ing power. For example, if an investor purchases an asset that produces anannual return of 5% and the rate of infl ation is 3%, the purchasing powerof the investor has not increased by 5%. Instead, the investor’s purchasingpower has increased by 2%.

Different asset classes have different exposure to infl ation risk. As explainedin later chapters, there are some fi nancial instruments specifi cally designedto adjust for the rate of infl ation.

Credit Risk

The typical defi nition of credit risk is that it is the risk that a borrower will fail to satisfy its fi nancial obligations under a debt agreement. The securi-ties issued by the U.S. Department of the Treasury are viewed as free of credit risk. (Whether this remains true in the future will depend on the U.S.government economic policies.) An investor who purchases an asset notguaranteed by the U.S. government is viewed as being exposed to credit risk.Actually, there are several forms of credit risk: default risk, downgrade risk,and spread risk. We describe these various risks in Chapter 4 and we willsee that the defi nition of credit risk given above is for that of default risk.

Introduction 7

Liquidity Risk

When an investor wants to sell an asset, he or she is concerned whether theprice that can be obtained is close to the true value of the asset. For example,if recent trades in the market for a particular asset have been between $40and $40.50 and market conditions have not changed, an investor wouldexpect to sell the asset in that range.

Liquidity risk is the risk that the investor will have to sell an asset below its true value where the true value is indicated by a recent transaction. Theprimary measure of liquidity is the size of the spread between the bid price(the price at which a dealer is willing to buy an asset) and the ask price (theprice at which a dealer is willing to sell an asset). The wider the bid-askspread, the greater the liquidity risk.

Exchange Rate or Currency Risk

An asset whose cash fl ows are not in the investor’s domestic currency has un-known cash fl ows in the domestic currency. The cash fl ows in the investor’sdomestic currency are dependent on the exchange rate at the time the pay-ments are received from the asset. For example, suppose an investor’s domes-tic currency is the U.S. dollar and that the investor purchases an asset whosepayments are in euros. If the euro depreciates relative to the U.S. dollar atthe time a euro payment is received, then fewer U.S. dollars will be received.

The risk of receiving less of the domestic currency than is expected atthe time of purchase when an asset makes payments in a currency other than the investor’s domestic currency is called exchange rate risk or currency risk.

ASSET CLASSES

In most developed countries, the four major asset classes are (1) commonstocks, (2) bonds, (3) cash equivalents, and (4) real estate. Why are theyreferred to as asset classes? That is, how do we defi ne an asset class? Thereare several ways to do so. The fi rst is in terms of the investment attributesthat the members of an asset class have in common. These investment char-acteristics include

■ The major economic factors that infl uence the value of the asset classand, as a result, correlate highly with the returns of each member includedin the asset class.

■ Risk and return characteristics that are similar.■ A common legal or regulatory structure.

8 THE HANDBOOK OF TRADITIONAL AND ALTERNATIVE INVESTMENT VEHICLES

Based on this way of defi ning an asset class, the correlation between thereturns of two different asset classes—the key statistical measure for suc-cessful diversifi cation—would be low.

Mark Kritzman offers a second way of defi ning an asset class based sim-ply on a group of assets that is treated as an asset class by asset managers.3

He writes:

some investments take on the status of an asset class simply becausethe managers of these assets promote them as an asset class. Theybelieve that investors will be more inclined to allocate funds to theirproducts if they are viewed as an asset class rather than merely asan investment strategy. (p. 79)

Kritzman then goes on to propose criteria for determining asset class statuswhich includes the attributes that we mentioned above and that will be de-scribed in more detail in later chapters.

Based on these two ways of defi ning asset classes, the four major assetclasses above can be extended to create other asset classes. From the perspec-tive of a U.S. investor, for example, the four major asset classes listed earlierhave been expanded as follows by separating foreign securities from U.S.securities: (1) U.S. common stocks, (2) non-U.S. (or foreign) common stocks,(3) U.S. bonds, (4) non-U.S. bonds, (5) cash equivalents, and (6) real estate.

Common stocks and bonds are commonly further partitioned into moreasset classes. For U.S. common stocks (also referred to as U.S. equities), assetclasses are based on market capitalization and style (growth versus value).

The market capitalization of a fi rm, commonly referred to as “marketcap,” is the total market value of its common stock outstanding. For example,suppose that a corporation has 400 million shares of common stock outstand-ing and each share has a market value of $100. Then the market capitaliza-tion of this company is $40 billion (400 million shares times $100 per share).The categories of common stock based on market capitalization are mega-cap(greater than $200 billion), large cap ($10 billion to $200 billion), mid-cap($1 billion to $10 billion), small cap ($300 million to $1 billion), micro-cap($50 million to $300 million), and nano-cap (less than $50 million).

While the market cap of a company is easy to determine given the marketprice per share and the number of shares outstanding, how does one defi ne“value” and “growth” stocks? We describe how this done in Chapter 3.

For U.S. bonds, also referred to as fi xed income securities, the follow-ing are classifi ed as asset classes: (1) U.S. government bonds, (2) corporatebonds, (3) U.S. municipal bonds (i.e., state and local bonds), (4) residential

3Mark Kritzman, “Toward Defi ning an Asset Class,” Journal of Alternative Invest-ments 2, no. 1 (1999): 79–82.

Introduction 9

mortgage-backed securities, (5) commercial mortgage-backed securities, and(6) asset-backed securities. In turn, several of these asset classes are furthersegmented by the credit rating of the issuer. For example, for corporate bonds, investment-grade (i.e., high credit quality) corporate bonds and non-investment grade corporate bonds (i.e., speculative quality) are treated astwo asset classes.

For non-U.S. stocks and bonds, the following are classifi ed as assetclasses: (1) developed market foreign stocks, (2) developed market foreignbonds, (3) emerging market foreign stocks, and (4) emerging market foreignbonds. The characteristics that market participants use to describe emergingmarkets is that the countries in this group:

■ Have economies that are in transition but have started implementingpolitical, economic, and fi nancial market reforms in order to participatein the global capital market.

■ May expose investors to signifi cant price volatility attributable to politi-cal risk and the unstable value of their currency.

■ Have a short period over which their fi nancial markets have operated.

Loucks, Penicook, and Schillhorn describe what is meant by an emerg-ing market as follows:4

Emerging market issuers rely on international investors for capi-tal. Emerging markets cannot fi nance their fi scal defi cits domesti-cally because domestic capital markets are poorly developed andlocal investors are unable or unwilling to lend to the government.Although emerging market issuers differ greatly in terms of creditrisk, dependence on foreign capital is the most basic characteristicof the asset class. (p. 340)

The asset classes above are referred to as traditional asset classes. Otherasset classes are referred to as nontraditional asset classes or alternativeasset classes. They include hedge funds, private equity, and commodities and are discussed later.

Real Estate

Before we discuss alternative asset classes, we provide a brief digression toconsider where real estate belongs in our classifi cation scheme. Real estate

4Maria Mednikov Loucks, John A. Penicook, and Uwe Schillhorn, “Emerging Mar-kets Debt,” Chapter 31 in Handbook of Finance: Vol. I, Financial Markets and Instruments, edited by Frank J. Fabozzi (Hoboken, N.J.: John Wiley & Sons, 2008).

10 THE HANDBOOK OF TRADITIONAL AND ALTERNATIVE INVESTMENT VEHICLES

is a distinct asset class, but is it an alternative asset class? There are threereasons why we do not consider real estate to be an alternative asset class.

First, real estate was an asset class long before stocks and bonds becamethe investment of choice. In fact, in times past, land was the single mostimportant asset class. Kings, queens, lords, and nobles measured theirwealth by the amount of property that they owned. “Land barons” wereaptly named. Ownership of land was reserved only for the wealthiest of society. However, over the past 200 years, our economic society changedfrom one based on the ownership of property to the ownership of legal enti-ties. This transformation occurred as society moved from the agriculturalage to the industrial age. Production of goods and services became the newsource of wealth and power.

Stocks and bonds evolved to support the fi nancing needs of new enter-prises that manufactured material goods and services. In fact, stocks andbonds became the “alternatives” to real estate instead of vice versa. With general acceptance of owning equity or debt stakes in companies, it is some-times forgotten that real estate was the original and primary asset class of society. In fact, it was less than 30 years ago that in the United States realestate was the major asset class of most individual investors. This exposurewas the result of owning a primary residence. It was not until around 1983that investors began to diversify their wealth into the “alternative” assets of stocks and bonds.

Second, given the long-term presence of real estate as an asset class, mod-els have been developed based on expected cash fl ows for valuing real estate.

Finally, real estate is not an alternative to stocks and bonds—it is afundamental asset class that should be included within every diversifi edportfolio. The alternative assets that we describe in this book are meant todiversify the stock-and-bond holdings within a portfolio context.

What Is an Alternative Asset Class?

Part of the diffi culty of working with alternative asset classes is defi ningthem. Are they a separate asset class or a subset of an existing asset class? Dothey hedge the investment opportunity set or expand it? That is, in terms of Markowitz diversifi cation, do they improve the effi cient portfolio for a givenlevel of risk? This means that for a given level of risk, do they allow for agreater expected return than by just investing in traditional asset classes? Arethey listed on an exchange or do they trade in the over-the-counter market?

In most cases, alternative assets are a subset of an existing asset class.This may run contrary to the popular view that alternative assets are sep-arate asset classes. However, we take the view that what many consider separate “classes” are really just different investment strategies within an

Introduction 11

existing asset class. In most cases, they expand the investment opportunityset, rather than hedge it. Finally, alternative assets are generally purchased in the private markets, outside of any exchange. While hedge funds and pri-vate equity meet these criteria, commodity futures prove to be the exceptionto these general rules.

Alternative assets, then, are just alternative investments within an exist-ing asset class. Specifi cally, most alternative assets derive their value from either the debt or equity markets. For instance, most hedge fund strategiesinvolve the purchase and sale of either equity or debt securities. Addition-ally, hedge fund managers may invest in derivative instruments whose valueis derived from the equity or debt market.

SUPER ASSET CLASSES

Although we have defi ned the general attributes of an asset class, it wouldhelp clarify alternative assets if we fi rst defi ne a super asset classes. There are three super asset classes: capital assets, assets that are used as inputs tocreating economic value, and assets that are a store of value.5

Capital Assets

Capital assets are defi ned by their claim on the future cash fl ows of an en-terprise. They provide a source of ongoing value. As a result, capital assetsmay be valued based on discounted cash fl ow models; that is, models that compute the present of the expected cash fl ow from a capital asset.

Corporate fi nancial theory demonstrates that the value of the fi rm isdependent on its cash fl ows. How those cash fl ows are divided up betweenshareholders and bondholders in a perfect capital market is irrelevant to fi rm value.6 Capital assets, then, are distinguished not by their possession of physical assets, but rather, by their claim on the cash fl ows of an underlying enterprise. Hedge funds and private equity funds, for example, fall withinthe super asset class of capital assets because the value of their funds areall determined by the present value of expected future cash fl ows from the assets in which the fund manager invests.

Consequently, we can conclude that it is not the types of assets in which they invest that distinguish alternative asset classes such as hedge funds and

5Robert Greer, “What is an Asset Class Anyway?” Journal of Portfolio Management23, no. 2 (1997): 83–91.6This is the well-known Modigliani-Miller theory of capital structure. See Franco Modigliani and Merton Miller, “The Cost of Capital, Corporation Finance, and theTheory of Investment,” American Economic Review 48, no. 3 (1958): 433–443.

12 THE HANDBOOK OF TRADITIONAL AND ALTERNATIVE INVESTMENT VEHICLES

private equity funds from traditional asset classes. Rather, it is the alterna-tive investment strategies that are pursued by the managers of these assetclasses that distinguish them from traditional asset classes such as stocksand bonds.

Assets that Can be Used as Economic Inputs

Certain assets can be consumed as part of the production cycle. Consumableor transformable assets can be converted into another asset. Generally, this class of asset consists of the physical commodities: grains, metals, energyproducts, and livestock. These assets are used as economic inputs into theproduction cycle to produce other assets, such as automobiles, skyscrapers,new homes, and appliances.

These assets generally cannot be valued using the traditional discountedcash fl ow approaches used for common stocks and bonds. For example, apound of copper, by itself, does not yield an economic stream of revenues.Nor does it have much value for capital appreciation. However, the coppercan be transformed into copper piping that is used in an offi ce building oras part of the circuitry of an electronic appliance.

While consumable assets cannot produce a stream of cash fl ows, thisasset class has excellent diversifi cation properties for an investment portfo-lio. In fact, the lack of dependency on future cash fl ows to generate value is one of the reasons why commodities have important diversifi cation poten-tial vis-à-vis capital assets.

Assets that Are a Store of Value

Art is considered the classic asset that stores value. It is not a capital as-set because there are no cash fl ows associated with owning a painting or a sculpture. Consequently, art cannot be valued using a discounted cash fl owanalysis. It is also not an asset that is used as an economic input becauseit is a fi nished product. Instead, art requires ownership and possession. Itsvalue can be realized only through its sale and transfer of possession. In themeantime, the owner retains the artwork with the expectation that it willyield a price at least equal to that which the owner paid for it.

There is no rational way to gauge whether the price of art will increaseor decrease because its value is derived purely from the subjective (and pri-vate) visual enjoyment that the right of ownership conveys. Therefore, toan owner, art is a store of value. It neither conveys economic benefi ts nor isused as an economic input, but retains the value paid for it.

Gold and precious metals are another example of a store-of-value asset.In the emerging parts of the world, gold and silver are a signifi cant means