How Risk is Measured

When I think about risk I think about the chance I'll lose money. This is how most people think about it and this being the case, why do so many investment texts teach standard deviation as the primary measurement of risk? Standard deviation incorporates both upside and downside variation and most people would agree they have no problem with an above average return or a slightly below average return given the average is positive. What we hate to do is lose money, i.e. negative return. This brings up two points: should the average be used in the calculation of standard deviation or some other benchmark (I might would suggest zero, the S&P or NASDAQ or some other minimum hurdle rate) rather than the average, which is used in standard deviation.

Secondly, does incorporating the full spectrum of deviation (positive and negative) into the calculation make as much sense as only incorporating the variation below your benchmark or hurdle? Since investors are typically more concerned about losing money, it makes sense to separate the negative and positive deviation. This calculation is referred to as semi-deviation (upside and/or downside).

Using a benchmark or minimum hurdle instead of the average in the deviation calculation makes more sense because you are then framing the deviation around the return "tipping point" you actually care about. Calculating the semi-deviations instead of the general standard deviation makes more sense because you then understand which way your deviation is coming from, upside which most people are happy with or downside which is the real deviation people are trying to avoid.

What is Absolute Return?

I remember in college coming across this term and trying to google it (given this was a number of years ago), but nothing pulled up that gave a really good definition. For all of you who are still wondering, absolute returns is simply that, a predetermined rate of return for a given time period that a fund seeks to achieve regardless of the overall market condition. For example, a fund might say they target 15% annual return regardless of whether the year was an overall bear or bull market.

Absolute return strategies are different than investments that benchmark their performance against an index, which varies from year to year, such as the S&P or NASDAQ 100.

When Redemption Limitations Make Sense

Hedge funds have redemption limitation which limits when you can withdraw your holdings in the fund. Some of these take the form of long term commitment requirements while others are a simply minimum notice period, i.e. kind of like the standard "two weeks notice" before quiting a job.

The limitation require the fund managers to focus on investing, not asset management and invest in illiquid assets. The important thing to remember when evaluating a fund is the redemption limitation should be reasonalbe in realation to the expected holding period and the underlying assets.

Hang on for a second and I'll explain. If the fund expects to invest in illiquid investments, such as private equity etc, then you would expect a lockup period similar to a private equity fund which is years, but if the underlying investments are being make in simple index funds, then the period should be daily or ever couple days. The middle case is the fund invests in very liquid assets however their hedges are such that unwinding their hedges to liquidate investors in a short period of time would cause undue losses to remaining investors in the fund. In this case, the fund might have a more stringent redemption limitation to protect the remaining investors in the fund.

In the end, as I said before the redemption limitation should be resonable given the investment assets of the fund and the corresponding hedges.

What is a Hedge Fund?

If you ask 10 people what a hedge fund is, you'll likely get different answers from many of them. In general a hedge fund is a professionally managed, private investment vehicle (not available to the public) and loosely regulated.

However, in Europe the term refers to a fund with the following characteristics:
1. Offshore investment vehicle;
2. Strategy goes beyond buying and selling stocks; and
3. Performance is measured in absolute terms.

In the US, a hedge fund is:
1. A domestic limited partnership;
2. Allowed to investment in many different types of securities with many different types of strategies;
3. Managers are rewarded with an incentive fee; and
4. Does not have to register with the SEC.

Hegde funds are attractive to many investors because of their ability to long, short and hedge their investments (though many "hedge funds" don't actually hedge).

State of the Private Equity Market

I decided that I would contribute what I see happening in the private equity markets. There are so many things going on, but I’ll focus on a couple issues at present and then some forecasts of future movements.

Presently, I think the hottest issue in private equity is what are people doing with their money, LPs and GPs alike. LPs just finished off commitments for the year, but aren’t in nearly the rush to commit that they have been the last couple years. I believe this is fueled generally by market turmoil, but more importantly it’s a matter of portfolio allocation. As the public markets were hot portfolios increased, in addition a number of institutional investors also increased their asset allocation to the PE class, this created the need to rebalance portfolios and put money to work in places other than traditional equity and bonds. GPs on the other hand are flush with cash for the most part, coming off the last couple years that were great for fundraising, but with credit in its present state they are less aggressive and the deal sized have come down. The question is, there are still a large number of funds who need to put their money to work.

For the future, there are a couple things happening that I see developing more down the line. For one, secondary interest have increased. This is not new, but what it leads to is something quite interesting. There are a number of banks who have already put together trading platforms for unregistered equities. These include companies that want to have liquidity for their equity, but don’t want to have the restrictions and regulations of publicly traded companies. This may have a large effect on the private equity market, giving GPs another route to exit companies. How it affects me in my job, is I can see the day that when a private equity fund wants to raise money they will do it through one of these unregistered equity platforms instead of the traditional fund raise. Why would they do this? For the liquidity of course. There are a number of funds that are already displaying how much they want liquidity, take The Blackstone Group, or Fortress, don’t forget that KKR still wants to take his fund public, but now at the “right time.” If this becomes the norm, we might see a market develop for hedge funds and private equity funds where they become like mutual funds in the public markets. Of course this is a ways away, but that’s the purpose of forecasting.

I welcome any comments and questions,

-Michael

Economic Indicators Most Sensitive to Stocks

I have recently read a new book that is very interesting. It is titled The Secrets of Economic Indicators and is written by Bernard Baumohl. One of the things that I found interesting is on page 12 and is a table showing economic indicators that stocks are most sensitive to. I've updated the website with these and can be found on the homepage on the right of the page title "Stocks, Economic Indicators." I'll be doing more research on each of these indicators and hopefully writing more on them. I hope to have time to write a little on these, but if not enjoy the links on the right.

Damodaran Online

Introducing...Damodaran Online. This website, by one of the most intelligent financial minds in the world, is incredible and will keep you busy for days. Not only can you find loads and loads of information regarding valuation, but you can also find all the books that he has written and podcasts of his classes at NYU. (From his homepage, on the lefthand column, click on "Books and Support" or "Web Casts")

One of my favorite books is Investment Philosophies. If you are looking for a good general overview of strategies this is the book. After reading this book, not only will you better understand different strategies, but you'll better understand what strategy is best for you.

I highly recommend spending some time on this website. Read some books. Watch some webcasts. You'll be happy you did and you'll be smarter after doing it!

Keyword Searches

I was contemplating the other day a good way of finding stocks that will benefit from industry growth, or shortages of some kind and I thought about doing a google search for "shortages 2010 forecasts." The search brings up some interesting things and it's a good way to find interesting articles about demand and supply. I haven't tried it yet, but searching for increase supply or increase demand might be good too. The next couple posts will probably be using this method. So long for now. Look forward to the coming posts.

The Size of the IPO Company Matters When Investing

So in class today we had an interesting conversation about IPO investments. Based on the conversation, IPO investments for the first 4 years seem to significantly underperform the market. Here's the catch though, if the IPO company is venture backed that works in favor of the IPO company and if it is a large company going public, then that is positive for the company. There is an ETF that looks for these criteria and has done very well. It mirrors the IPOX-100. It's ticker is FPX. Something else that is interesting to read is an article in the Journal of Finance, Dec. 1997, called Myth or Reality? The Long Run Underperformance of IPOs: Evidence from Venture and Nonventure Capital Backed Companies. It's definitely a good read.

Industries with the most IPOs

This may also lead to be very interesting. In order to determine what I think are some of the hottest industries, I'm looking to see what industries are having the most IPO filings. I'm getting this information from Yahoo Finance. From what I saw, the industries with the most IPOs are: Commercial Banking, Insurance, Investment Funds, Leisure, MANUFACTURING, Natural Resource, REITS, Radio, Retail, Telephone, and Transportation. These are the industries I saw with just a quick scan. CNNMoney had an interesting article on IPO markets to watch. Really they're what you would think. Finance, Healthcare and technology, and alternative energy. Another sight you might find interesting is MSNBC Money. They have a section for IPOs, In and Out of Favor Industries, best and worst performing industries over the last month. It might be a good place to start for 'dashboard investing.'

Freight andTransportation

Today I read something very interesting and it may lead to an investment idea, my good friend Stephen Jeffries pointed it out to my investment class. I never knew the amount of freight that is transported by trains. In addition, I never knew that trains were such technological giants. If you don't know what I'm talking about read this article that was on the cover of Popular Mechanics.