asset classes 2
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Introduction to Asset Classes
Shalin VyasMarch 2013
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Asset Classes
Risk
Return
Cash
Gilts
Corporate bonds
Hedge funds
UK equity
Global equity
Private equity
Emerging market
equity
Infrastructure
Commodities
High yield/
EM debtProperty
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Components of asset return
AssetReturn
Risk-FreeRate
ActiveReturn
MarketExposure
+ +
excess return,
over the risk free rate,
of each asset class
index
excess return over
the asset class
index achieved by
skilled investment
management
return on risk-free
bonds
(beta) (alpha)Rf
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Cash
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Cash What are they?
UK Base rates
0
1
2
3
4
5
6
7
Jan
2007
May
2007
Sep
2007
Jan
2008
May
2008
Sep
2008
Jan
2009
May
2009
Sep
2009
Jan
2010
May
2010
Sep
2010
Jan
2011
May
2011
UK CLEARING BANKS BASE RATE UK LIBOR 3 Month
Cash or highly liquid holdings
Income variable
Historically: perceived as no risk!
Actually: lower risk & lower return
Risk from inflation eroding the real value of the investment
Advantages
Liquid
Low risk
Simple
Disadvantages
Low return
Really cash?
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Equities
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Equities What Are They?
Share of ownership of a company
Voting rights
Returns gained from:
Dividends from company profits
Capital growth in share price
Why do pension funds hold equities?
Expect greater return than bonds in the long-term
Expected to outperform liabilities
Provide diversification versus other assets
However, equities are also higher risk Volatile capital values
Dealing costs higher than bonds
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Equities Typical Features
Passive managers aim to match index returns
Enhanced passive aim to outperform an index benchmark by between 0.5% -
1% p.a.
Core Active managers aim to outperform an index benchmark by between 1 -
2.5% p.a.
Unconstrained managers portfolio is built without direct reference to a market
index. Relative returns are less relevant with managers focusing more on
absolute returns
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Equities Advantages and Disadvantages
Superior long term performance (historically)
Equity returns have consistently stayedahead of inflation
Provides diversification versus other assets
Expected to outperform liabilities
Very volatile
Overseas equity bring additional risk
Dealing costs higher than bonds
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Bonds
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Bonds What are they?
Bonds basically IOUs, i.e. a loan
You might agree to lend me 100 today
In exchange for 10 every year (usually paid 5 every 6 months)
And the return of your 100 after 10 years
Not really different to a bank loan
A bond pays a Coupon rate on its face orPrincipal value
Yield is the annual return on a bond if held to maturity
Price of a bond changes with market yields
Here the coupon (per 100 nominal lent) is 10% and maturity is in 10 years
110
10
-100
10 10 10 10 10 10 10 10
0 1 2 3 4 5 6 7 8 9 10Years
's
Cash Flow
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Gilts
Issued by the Government, essentially considered to have no default risk
Advantages
low risk
Liability matching (fixed)
Liability matching (inflation)
Disadvantages
Low expected returns
Often residual interest rate risk due to duration mismatch between pooled funds and
liabilities
Perceived currently to be over priced due to demand for high quality bonds
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Corporate Bonds risk over gilts
The additional risk within a corporate bond contains
a default premium
a liquidity premium
AAA:Exceptionallystrong
AA: Very strong
A: Strong
BBB: Reasonably strong
BB: Adequate
B: Balance sheet stretched
CCC: Vulnerable
CC: Highly vulnerable
C: A bankruptcy petition may have been filed
D: Default on interest payments to bond holders
Sub investment
grade/High yield /
Junk
Investment grade
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BondsRelationship between price and yield of a bond
Yield Price
Yield Price
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Property
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Property What are they?
Return: Capital Growth + Rental Income
Comprises of a number of main sub-sectors
Traditionally pension schemes invested in retail, office and industrial in the UK
Schemes now considering investing to a small extent in other sectors, such as residential, hotels and
leisure, long lease property
RetailOffice
Industrial
FisheriesSuper-markets
HealthcareRetirement
HomesFarms
Vineyards
ForestsSelf
StorageGardenCentres
StudentHousing
MainstreamResidential
RestaurantCinemas
GymsBingo Halls Service
Stations
Hotels
DataCentres
LEISURE -RESIDENTIAL AGRICULTURAL
MAINSTREAM ALTERNATIVESource: ING
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Property Typical Features
Benchmark/target
Relative return
Absolute return
Style of investment
Value/Growth Gearing
Direct investment:
Active management
requirement
Index replication impossible
Passive approach is not
possible
Core-plus
Income producing
with active
managementpotentialCore
Fully leased
property
Re
turn
Risk
Value-added
Repositioning,
moderate
redevelopment
Opportunistic
Distressed sellers,
development,
financial
engineering,
emerging sectors
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Property Advantages and Disadvantages
High yielding Stable and diverse income stream
Competitive historical returns
Low correlation with other asset classes
Tangible not paper investments
Inefficient market
Alpha potential through asset management
Expensive to trade and manage Valuations are subjective, imprecise,
irregular, unreliable
Illiquidity
Large lot sizes
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Hedge Funds
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Hedge Funds What are they?
An asset manager . . .
Accessing the same markets as others . . .
But is unconstrained. . .
And is incentivised . . .
To be a skill based investor . . .
but with fewer constraints
but with theirchoice of equities, bonds, currency
and commodities
so can use leverage, short selling and derivatives
so performance related fees
allowing investors to access some of the best talent
in money management
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Hedge Funds Typical Features
Single Hedge Fund
Good
Access the best managers for each strategy
Ability to create a bespoke portfolio
Ability to identify closely the source of return
One layer of fees
Not so good
Concentration risk if only a few managers
Monitoring burden as number of managers
increases
Greater investment judgement required
Fund of Hedge Funds
Good
Access to a large number of hedge funds
Diversifies manager risk across several types
of hedge funds
Reduced monitoring and due diligence burden
for Trustees
High levels of manager expertise in finding
good quality hedge funds
Not so good
More difficult to identify sources of return
Diversification of managers could lower
overall FoHF expected return Extra layer of fees
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Hedge Funds Advantages and Disadvantages
Can offer attractive risk reduction
Returns not typically correlated with themarket
Cover a variety of instruments and markets
Attract top investment talent
Managers aligned with clients, often have
own money at stake
Success is measured by great performance,not asset gathering
High management and performance fees
Lock-ups, notice periods and infrequentdealing
Capacity constrained
Lack of transparency
Light regulation
Use of leverage can magnify losses
Additional governance and legal fees
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Emerging Market Equities
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Emerging Market Equities (EME) What are they?
There is no set economic or geographical region or area that defines emerging markets.
Investing in emerging market equity involves investment in the equity of companies
domiciled in emerging economies.
Emerging market economies include rapidly growing countries such as Brazil, Russia,
India, and China also known as BRIC countries
. but can also include countries as diverse as Thailand, South Africa, South Korea,
Chile or Bulgaria.
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EME Geographical Spread
Source: MSCI
Developed markets in pink
Emerging markets in blue
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EME Opportunities
Emerging economies continue to drive global growth
Changing global economic balance of power wealth transfer to emergingmarkets
Increasing importance of trade between emerging market blocs
Low household debt, strong corporate balance sheets, stronger fiscal position
Ongoing structural shifts in emerging markets driving growth forward
Population effects demographic dividend
Infrastructure demand to meet growth and replace obsolete equipment
Power investment critical to facilitate ongoing economic growth
Rise of the consumer growth of the middle class and increasing income
Resource intensive convergence of resource intensity per capita
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EME Advantages and Disadvantages
Economic strength
Wider opportunity set
Expected outperformance of developedmarkets
Volatile returns
Slowdown in global growth
Country specific risks
Flight to quality
Currency risk
Current uncertainty over equity markets ingeneral
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Diversified Growth Funds
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Diversified Growth Funds (DGFs) What Are They?
A DGF is a balanced fund which typically invests in multiple asset classes
Aim to deliver close to "equity-type" returns over the medium term
Aim to have significantly lower volatility than equities
Managers aim to achieve their objective by creating diversified portfolios, which
aim to generate returns by combining good asset allocation decisions with strong
stock selection (or manager selection) in each asset class.
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Equity
39%
Convertible Bonds
4%
Commodities
7%
Property
2%
Cash
4%
Absolute Return
5%Private Equity
2%Infrastructure
2%
Corporate Bonds
35%
DGF Typical Features
The chart to the right shows an example asset
allocation mix of a DGF.
Most funds typically hold a high percentage of
equities. This explains why most DGFs target
a similar return to equities.
DGFs have the ability to adjust these
allocations as the economic environment
changes.
They tend to be measured against cash or
inflation indices, plus an outperformance target
(e.g. LIBOR +3-5%).
DGFs are not immune to market downturns,
however should provide better protected then
long only equity funds.
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DGF Advantages and Disadvantages
Reduces the need to have in depth knowledgeof all asset classes
Allow access to asset classes where a directholding may not be possible
Dynamic asset allocation, if successful, can
produce positive returns in all markets
Delegation of underlying fund selection atasset class level
Range of options or portfolios to consider
Asset allocation decisions are not in the controlof the investor
May have additional fees
Unlikely to have strong capability in all theunderlying asset classes
Funds tend to have relatively short track recordof around 3-4 years
May be allocations to illiquid assets and thiscan mean less regular dealing frequencies
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Private Equity
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Private Equity What are they?
Equity investment in an asset, in which the equity is not freely traded on the public stockexchange
Important source of capital for start-up and young companies, for firms in financial
distress and those seeking growth or buyout financing
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Private Equity Sectors
Venture Capital Special Situations
Seed
Early
Expansion
Late
Growth Equity
Mezzanine
Distressed Debt
Secondaries
Royalty
Sector-Focused (i.e.
Clean Technology andEnergy)
Buyouts
Small
Medium
Large
Mega
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Private Equity Typical Features
Private Equity Characteristics
Lock-up / Liquidity Fund term 10-12 years
Secondary market for partnership interests
inefficient
Structure Limited partnership structure
Complex legal documents negotiated with side
letters
Cash Flows Commitment drawdown over 3-4 years
Capital calls have 10 days notice
Fee Structure c2% investment fee
c20% carried interest (incentive fee) with c8%
preferred return hurdle
Leverage Venture capital: none
Growth equity: none to low
Buyout: 50-70% debt/total capitalization,
depending on strategy
10704 Private Equity April 2011
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Private Equity Advantages and Disadvantages
Attractive long-term returns in the past
Opportunities for talented managers to addsignificant value over the long term
Diversification from quoted equity markets
Opportunity to invest in companies beforetheir potential value is realised through saleor flotation on a recognised stock exchange
Very wide dispersion in returns (survivorshipbias impacts PE indices)
Tend to be heavily leveraged, potentiallyexposed to interest rates
Liquidity on investment/disinvestment
Commitment to an investment will lead tocash calls on the fund potentially at shortnotice
Funds are committed, exiting can be hardtherefore causing liquidity issues
Performance measurement is very difficultand subjective
Fees are very high
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Questions
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