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Abstract
In the present day rapidly changing market environments, it has become critically important for investors to take a deliberate approach for capturing opportunities to enhance returns and at the same time to manage their portfolio volatility efficiently. While prudent investing calls for taking calculated risks a disciplined asset allocation aids the process. Alternative investments have increasingly been looked at as one of the effective ways to reduce portfolio volatility. Alternative investments of late have come to mean every investment category other than long-only publicly traded stocks and bonds, real estate, venture capital, private equity, natural resources, commodities, distressed debt, private fixed income, absolute return strategies, event-driven strategies and any other asset hedged or levered. Of these assets, real estate has been considered a hard asset and has been preferred as an attractive alternative asset till the subprime crisis started. The objective of this paper is to analyze the reasons why alternative investments have become a significant segment in the asset allocation strategies of investment and fund managers. The paper also presents a detailed review of the impact of the subprime crisis on the asset allocation of alternative investments.
Introduction
The financial market crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression, inflicting heavy damage on markets and institutions at the core of the financial system.
International Monetary Fund, World Economic Outlook, 2008.
[George Soros] noted, the financial crisis is beginning to have serious effects on the real economy, adding: The extent of that is not, in my opinion, yet fully recognized.
Reuters (New York), 2008.
It has been observed during the recent past, that the globally prevalent investment scenario necessarily called for an asset allocation that invariably includes various alternative assets. From an efficient investment perspective, this has made a modern investment portfolio unthinkable without alternative investments as they have encompassed a wide range of assets as attractive investment products. The importance of these assets has increasingly been felt as this asset class has the capability of diversifying a portfolio with their inherent character of not getting linked to the performance of the traditional class of assets. For instance, in the case of hedge funds and private equity funds, it has been often the case that the investments are limited to a few qualified investors representing individuals with a particular level of income or net worth. However depending on ones own net worth, liquidity needs, and risk tolerance the investor would like to consider diversifying his/her portfolio with suitable alternative investments. However, it needs to be considered that this scenario has evolved during the past decade only as there was the generation of various classes of investment vehicles to enhance investment variety during this period only. The objective of this study is to analyze how the alternative investment segment became one of the important and powerful elements in asset allocation. The study also explores the impact of the subprime crisis on alternative investments.
Asset Allocation an Overview
For quite some time traditional asset classes like stocks, bonds and cash or cash equivalents were the main class of assets on which the investors focused their attention. Out of these traditional classes of assets investments in equity have been regarded as most aggressive and the investments in equities were able to provide attractive returns to the investors in the form of dividends as well as capital appreciation. Bonds as against the stocks though provided lower returns were having lower volatility. Cash in dollars as deposits or other forms of cash equivalent investments produced still lower returns. With the expansion of the economies and increase in the disposable surplus of the individuals and corporations there emerged the necessity to find alternative investments for increasing the returns and at the same time to invest with reduced risks.
With the evolution of new and innovative investment vehicles, it was made possible to change the investment portfolio with the overall objective of increasing the return and reducing the risks.
This has made the investors choose among all available alternatives that led to the development of the concept of asset allocation. Asset allocation is the process of distributing investment capital across various classes of assets. In this, the distinct possibility of the different asset classes behaving differently at various points of time needs to be taken into account. Through adopting the process of asset allocation the investors would be able to diversify their portfolios and reduce their dependence on the performance of individual investments. The objective of the process of asset allocation is not only to protect the downside of the investments but also to reduce the volatility of the investments and thereby to increase the compounded return.
Asset allocation has been considered as a wise strategy all along for efficiently monitoring the investments. During recent periods this has become even more essential amidst a growing array of international and domestic investment options which has made the process of constructing the portfolio more complex. At the same time expanding choices of investments opportunities offer potential ways to optimize the returns. With a better and proper understanding of asset allocation, it is possible to enhance the efficiency of risk management so that the investment goals can be achieved with maximum effectiveness. With this background, this study through an exploratory approach analyzes the significance of alternative investments in the asset allocation process. A descriptive note on the impact of the recently occurred subprime crisis on alternative investments is also presented as a part of the paper.
Aims and Objectives
The broad aim of the study is to examine the role and significance of alternative investments in the asset allocation process and the impact of the recent subprime crisis on the efficiency and adaptability of the alternative investment asset classes. Through exploratory research, while finding plausible answers for the main research questions the study also extends to present a full picture of the alternative investments examining the history to arrive at the current significance in the asset allocation. This is done with a view to providing a wider view of the diversity of alternative investments. The other objectives of the study include the analysis of issues relating to the subprime crisis including the consequences of the crisis with respect to hedge funds and other financial service products and services that resulted in the most serious financial crisis of the century.
The rationale behind the Study
With the present-day economic meltdown can easily be traced back to the aftermath of the subprime crisis which rocked not only the US economy but many of the world economies during the second half of 2007. While there is every attempt to regain control over the economic conditions, it is necessary that detailed knowledge is acquired on the development of the situations that led to the present-day economic crisis. From that perspective, the objective of this study in analyzing the asset allocation and alternative investment strategies and the impact of the subprime crisis on the alternative investments would bring out the root causes of the worst economic crisis after the Great Depression. This study is expected to provide the reader with descriptive knowledge on alternative investments and the impact of the subprime crisis on them.
To ensure a comprehensive presentation this presentation is structured to have different chapters with the first chapter providing an overview of the topic along with the aims and objectives of the study. The second chapter is devoted to presenting a detailed review of the available literature to enable the readers to get an in-depth understanding of the topic under study. In chapter three the methods adopted to conduct the study are described with the fourth chapter dealing with the findings and analysis of the study. Chapter five concludes the paper with a few remarks as a recap of the issues dealt with by the text and a few recommendations for further research on the subject. This chapter also details the limitations faced by this study.
Literature Review
The objective of this chapter is to provide a detailed review of the available literature in published documents, papers, presentations in professional journals contained in print and electronic media. Since there is an abundance of literature available on the topic this paper strived to present the most relevant information without sacrificing the focus on different viewpoints.
The term alternative investments would convey a different meaning for those people outside the financial investment community. It might be so that even within the financial investor groups not all of them would be aware of these new vehicles of investment that is available in the hands of the funds managers and investment managers. With the rapid increase in the number of investment opportunities and vehicles available a number of investors including high net worth individuals have started realizing the significance of the alternative investments and their ability in compounding the returns at reduced risk levels. With the advancement in information technology, the information gap gets narrowed down and this leads to enhancement in the level of investor sophistication. As a consequence, there is more number alternative investment opportunities develop. It has been observed that during the last five years alternative assets class has been found to be the fastest-growing asset class with five to seven percent of allocation going towards this class of assets. In the case of endowments and funds, this percentage is found to be more with the percentage allocation reaching 20 at times.
Asset Allocation and Alternative Investments
It is interesting to note that institutional investors have been increasingly exposed to issues relating to Liability Driven Investment, Alpha Transportation and the role of alternative investment in the asset allocation. (Pierre Sequier, 2006) These topics have come to the fore due to the changing institutional landscape in the recent past. The reason for the exposure of the institutions to these newer ideas can be traced primarily due to two reasons.
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The combination of lower interest rates and below-average equity performance that prevailed at the start of this century has created a number of bona fide funding issues for a large number of pension funds. This was the result of the mismatch between the risk exposure of the liabilities of these funds and their relative assets. This has also caused a number of countries to alter their regulatory positions with respect to the valuation of liabilities which ultimately had an impact on the investment and asset portfolio of these funds relative to their liabilities. In order to integrate into this new regulatory regime, the pension assets had to be deconstructed into a hedging portfolio. This separation of assets is the root cause for the development of the concepts of liability-driven investments. Performance enhancement objectives of these investment requirements led to alpha transportation techniques and an enhanced role of the alternative investments.
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Another change that occurred during this period is the significant development of alternative investments. The rapid growth of the private equity sector and the hedging fund industry has opened up a number of performance sources that is available to investors to choose from. The strong development in these sectors coupled with lower rates of interest and poor performance of the equity market led to a considerable increase in demand for alternative investment strategies. (Pierre Sequier, 2006)
It has been found that the asset allocation framework has to necessarily adapt to this new context. It has also been observed that the traditional way of separating the strategic asset allocation to manage the beta from the tactical asset allocation (this method uses the concept of generating alpha within an asset class) was found to be ineffective to handle the new investment opportunities which are spread over various asset class. In addition, the traditional basis cannot address the strategic role of alternative investments within an institutional portfolio. It is important that alternative investments are to be used only as opportunistic positions as they do not offer any exposure to traditional betas. (Pierre Sequier, 2006)
Alternative Investments
Alternative investments in general are those investments that are a departure from the traditional form of investments. A traditional investment, on the other hand, can be defined to include an investment strategy or asset class that is mainstream and in most cases, the asset is traded in major exchanges of the world. Examples of traditional assets include domestic large-cap stocks, small-cap stocks or bonds. It may be remembered that sometimes back Real Estate Investment Trusts (REITS) and international bonds and equities were considered as alternative investments. However, with the advent of globalization and increased use of the internet, there has been tremendous improvement in investor sophistication. This improvement in sophistication has enabled the investors to invest more in early forms of alternative investments like REITs. As such the early class of alternative investments has become mainstream investments in due course of time. With the new class of assets gaining recognition from a large number of investors, and more research has been made available, more and more new investors have started looking for alternative investments to make extra earnings. Another impact of the increase in the number of investors was the decline in the profits for large fund managers to some extent which made them look for more profitable alternative investment avenues. With every new find of such investment strategies, they get added to alternative investments.
Objectives of Alternative Investments
Generally the alternative investments are resorted to by the investors with threefold objectives. They are: (i) to attempt to diversify an investment portfolio by engaging innovative investment strategies, (ii) to aim for higher than normal returns that they can expect from other forms of investments and (iii) to reduce the volatility and risk in the investment portfolio through low or negative correlation of returns with the traditional asset class or by correlating returns within inflation. One major source of attraction that may be associated with alternative investments is the complexity in their nature which makes it difficult to be analyzed thoroughly. This results in market inefficiencies which are exploited by firms having the mindset and willingness to employ time and efforts to undertake the required research to bring out a financial asset that is acceptable as an alternative investment. Diversification thus is the primary benefit that the alternative investments extend to the investors in comparison with the traditional class of assets. It has been found that many of the alternative investment strategies are embedded with extremely low correlation to the price movements in the more traditional forms of financial securities. Under circumstances when the financial markets remain overvalued, from the overall risk perspective, maintaining a portfolio the returns which are independent of the financial market can really be enticing. While there are abundant opportunities available for making higher returns with alternative investments, such investments are looked at favorably even from the angle of risk control and diversification.
Forms of Alternative Investments
Although newer investment strategies and products are developed and introduced in the market every now and then the following are some of the common types of alternative investments recognized by the financial investment community. Even though these investment strategies are generally classified as alternative investments, each one of them possesses unique characteristic features.
Hedge Funds
Hedge funds cannot be defined as a particular alternative investment strategy since the funds constitute different investment vehicles that are employed by many types of non-traditional investing strategies. Hedge funds have the flexibility to invest in any asset class they wish. The hedge funds are limited by their own creativity and the willingness of the investors to part with their money with the confidence placed on the funds. Hedge funds are usually structured as limited partnership interests and the hedging funds sell these interests to qualified investors. Therefore these funds enjoy only limited flexibility. They remain largely unregulated which is quite contrasting to the operations of mutual funds. (IIM Calcutta)
Private Equity
This investment strategy involves a kind of equity investment in non-public companies. Although this alternative investment is practiced in many different ways, buyouts and venture capital are the most important forms of investment adopted by this strategy. Buyouts take place when the investors indulge in purchasing all or a part of a firm exclusively with the intention of reselling in the future with a profit margin. Leveraged Buyout (LBO) is one of the important variants of this investment strategy where the debt to equity is very low and the success of such deals is largely dependent on the capabilities of the management team to create value for the firms. Venture capital is another large variant of this alternative investment strategy which involves investing in the companies that are in the start-up or early stages but with a high potential for growth. (IIM Calcutta)
Other Types of Alternative Investments
There are other types of alternative investments like commodities, direct real estate, arbitrage strategies, market neutral, managed futures, global macro, distressed securities, fund of funds and the like with each one of them having its own characteristics in terms of associated risks and returns. (IIM Calcutta)
Causes of Financial Crisis
Recent crisis in the financial sector in the United States as well as in other parts of the world including Europe clearly prompts a reassessment of some of the principles and practices in the policymaking with respect to the financial sector. Such changes could result in further crucial changes in the structure and oversight of the financial system worldwide. Abundant liquidity that existed for a longer period of time and the prevalence of lower interest rates are the important causes that led to the global search for higher yield and under-pricing of risk by the investors.
Background to the Crisis
The longer duration of the liquidity that was available with the financial institutions and other investors in general, rising asset prices especially the real estate prices and continued lower rates of interest amidst international financial integration and innovation has resulted in serious global macroeconomic imbalances. Bates, Kahle and Stulz (2007) have documented the abundance of cash held by the non-finance firms prior to the crisis. According to the authors, the net debt ratio (debt minus cash, divided by assets) exhibits a sharp secular decrease and most of this decrease in net debt is explained by the increase in cash holdings. The fall in net debt is so dramatic that the average net debt for U.S. firms is negative in 2004. In other words, on average, firms could have paid off their debt with their cash holdings.
As a consequence, the US current account deficit had swelled with capital inflows from Asian and oil-producing nations. In addition, there was a general trend of a global search for higher yield and this led to the underestimating of the risk factors in the alternative investment opportunities. Regulators on the other hand took policy decisions that either facilitated the imbalances or were ineffective in some cases to be a proper response for the adverse impact of the imbalances.
The abundant liquidity resulted in a rapid expansion of credit both in developed as well as emerging nations. The mortgage financing was found to be one of the high growth areas not only in the United States but also in many other countries which contributed to a bubble in the real estate prices. (World Bank)
Financial innovations in the form of alternative investment strategies have created systematic vulnerability in different ways. The best fitting example is the growth of the mortgage market which took the form of originate and distribute implying the creation of mortgages for the purpose of selling them in the market. This model was overwhelmingly supported by new innovations in structured finance and credit derivatives. In addition, there existed an active secondary market for mortgage-related securities. The most serious part of the crisis is the becoming interconnected of both regulated and unregulated financial institutions through OTC markets. In fact, these institutions because of the interconnections had established bilateral clearing and settlement arrangements. (World Bank)
On the other hand, the favorable macroeconomic conditions that existed like the enhanced competition, advancement in technological standards and rising asset prices prompted the financial institutions to focus down-market. In order to maximize their earnings, the financial institutions indulged in practices like lowering credit underwriting standards, engaging in riskier trading activities with security mismatches and relying excessively on quantitative risk models. To meet these objectives the financial institutions also practiced the wrong principle of funding long-term investments using short-term instruments. (World Bank)
All these factors have created complacency among the capital market investors. As a result, they failed to employ adequate monitoring of the risks and proper reexamination of their investment portfolios. The slowdown and the subsequent decline in the US home prices since the year 2005 led to the unraveling of the highly leveraged and unsound lending practices that have been built over the period of time. These weaknesses in the lending practices were brought to light first in subprime lending. The other market segments like prime mortgage loans, commercial real estate, leveraged loans, etc were subsequently subjected to the brunt of the financial crisis.
According to Bloomberg (June 2008), the total write-offs since January 2007 on account of financial crisis stood at $ 245 billion with much more to follow. Dr. Jeffrey R. Bohn (2008) identifies the following factors as responsible for the creation of the subprime crisis. They are (i) Faulty risk assessment systems (VaR), (ii) flawed originate and distribute business model, (iii) ineffective credit rating given by the rating agencies, (iv) lax regulators who failed to anticipate the repercussions, (v) manipulative bankers who used the faulty systems to their advantage, (vi) fraudulent brokers taking the borrowers and lenders for a ride, (vii) mark-to-market accounting practice, (viii) greedy borrowers interested in getting free finance, (ix) greedy lenders interested in only higher returns, (x) faulty market structure, (xi) weakly structured finance, (xii) complications created by the derivatives and (xiii) lax monetary policy that proved ineffective to monitor the financial sector. Thus the crisis has been found to be the culmination of several factors; some of which are interrelated to each other.
Role of Hedge Funds in Subprime Crisis
An article entitled Subprime: Tentacles of a Crisis by Randall Dodd, a senior financial expert in the IMFs Monetary and Capital Markets department has examined the role of hedging funds in the subprime crisis that unfolded recently. He is of the opinion that the Fitch ratings forewarned about the risks of hedge funds even as early in the year 2005 by stating Hedge funds have quickly become important sources of capital to the credit market, but there are legitimate concerns that these funds may end up inadvertently exacerbating risks. According to Dodd there are obvious reasons for the warning issued by Fitch rating as the hedge funds making investments in largely high-risk ventures are not basically transparent as they need to be. There are no public disclosures of their assets, liabilities and trading activities. Moreover, the hedging funds are found to be highly leveraged in that they make use of several derivative instruments or heavily borrowed funds to make their investments. It is very hard for other investors and regulators to know much about the activities of these hedging funds and because of their higher leverage, their impact on the global credit markets is higher in proportion than the total assets under their management.
Dodd has identified a number of weaknesses that contributed to the market failure. The impact of the crisis is that it resulted in a 3 percentage point increase in serious delinquency rates on a subsection of US mortgages. This in fact has thrown the $ 57 trillion US financial system into turmoil and has caused economic shudders across many countries of the world. (Randall Dodd, 2007). They are
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The first call of the turmoil arose at the point where the highest-risk tranches of subprime debt were placed with highly leveraged investors. Hedge funds were one among them with no capital adequacy requirements (since they remained unregulated in this regard) and the industry practice of investments with high leverage has prompted them to take excessive risks.
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Another reason for the busting of the market is due to the reason that the unregulated and undercapitalized financial institutions were the primary liquidity providers to the OTC markets in the form of subprime collateralized debt obligations (CDOs) and other forms of credit derivatives. At the moment when trouble ensued in the solvency of those markets, those assets became illiquid and it led to the seizure of trading in them ultimately.
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The presence of unregulated and undercapitalized mortgage originators was also responsible for the crunch. The originators like hedge funds were operating with a lesser amount of capital and they mainly used monies borrowed on short-term for funding the subprime mortgages they originated which were expected to be held by them only briefly. However, when a situation arose that it was no any more possible for them to sell such mortgages to those firms who packaged them into securities, many of these originators had to close down their shows which added to the crisis.
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Lack of transparency in the transactions of OTC markets still exacerbated the crisis situation. Since the market participants were unable to identify the nature and location of the subprime mortgage it led to a sudden shift in the assessment of associated risks. At one point in time, the investors were overly optimistic about the risks associated with a subprime mortgage. With the turn of events in the negative direction in the subprime sector, those investors who were optimistic became scared and confused. As the result, the investors panicked and overestimated risk and shunned even senior investment-grade opportunities.
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The liquidity crunch also affected the operations of the OTC markets. Instead of showing resilience in the face of greater price volatility, these markets ceased trading as counterparties became untrustworthy and buyers fled. (Randoll Dodd, 2007)
Thus hedge funds and other high-yield investors played a critical role in spreading the impact of the crisis to nations across the world. With the downfall in the prices of high-risk tranches, the investors could not trade out of their long positions. This made them resort to selling other assets, especially those with large unrealized appreciation such as equities in emerging markets to meet their obligations of margin calls or to offset the losses made in subprime deals. With the result the equity markets allover the world met a declining trend though they recovered quickly. The effect was there on the currencies of the emerging markets also. (Randoll Dodd, 2007)
Impact of Sub-Prime Crisis on Alternative Investments
The subprime crisis has taken the toll with at least 25 large subprime lenders declaring bankruptcy and substantial losses being announced by many financial institutions, bond insurers and special purpose enterprises. The impact on the US economy has been found to be significant resulting in lower levels of consumer spending, subdued levels of consumer confidence, lessened asset prices, and a significant decline in the projected growth levels and considerable rise in unemployment level. (AMUNC Background Paper, 2008)
When the crisis hit the subprime mortgage and credit markets the impact on the credit markets was that the markets dried up with deal volumes going to significantly low levels and this made the financial services firms to start thinking on their alternative moves. One of the victims of the crisis is Lehman Brothers which was made to file bankruptcy. Other institution like Washington Mutual had to increase the loan-loss reserves up to $ 2.2 billion to cover the mortgage exposure. Same is the case with some of the major financial services firms with five of them (Merrill Lynch ($ 3.4 billion), UBS ($ 3.3 billion), Citigroup ($ 3.1 billion), Deutsch Bank ($ 2.4 billion) and Morgan Stanley, JPMorgan Chase and Bank of America put together $ 3 billion) made to write-down $ 17 billion collectively. (Berkshire Capital Securities, 2007)
While the impact of the subprime crisis on the traditional long-only assets market is mixed, the biggest impact was felt on the alternative investment vehicles of hedge funds and private equity.
Impact on Hedge Funds
Theoretically hedge funds is to derive benefits from financial volatility as they are designed strategically to make their earnings both from rising and declining prices of assets. Of course, those hedge funds which were not overexposed to the subprime mortgage debts behaved according to this theory. But hedge funds that indulged themselves in more subprime mortgage debts have been found to be the prime victims of the liquidity crisis created by the crisis. The collapse of several hedge funds had a cascading effect on various banking and other financial institutions connected with them.
Just as the private equity funds the hedging funds are also subjected to the disadvantage of frequent reporting obligations and they also provide the investors the facility to withdraw their money with ease. Nervous investors are awaiting monthly numbers, which most hedge funds provide. If the investors want out, and they have fulfilled any requirement to keep the money in the fund for a certain amount of time, they can pull their capital. Too many redemptions can force funds to sell [assets] into a bad market, resulting in worse losses. (Jenny Anderson, 2007)
One of the biggest casualties of the subprime crisis happened in the case of UBS a leading bank in Switzerland. UBS after making a first-quarter (2007) loss of $ 123 million on US subprime mortgage investments had announced the folding of Dillon Read Capital Management back into its investment banking arm. This move cost the bank an additional $ 300 million by way of restructuring charges. The bank also indicated very weak profits for the second half of 2007. (Fi
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