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Module 3

Advanced Investment
Products and
Strategies
Craig Kinnunen, MS, CFP®

Cindy Shnaider, MSF

7722
© 2010–2018, College for Financial Planning, all rights reserved.
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Table of Contents
Introduction ............................................................................ 1
Chapter 1: Investment Strategy ............................................. 3
The Requirements of Strategy ............................................. 3
Buy-and-Hold: The Benchmark Strategy ............................. 4
Investing With Economic Cycles ........................................ 7
The Contrarian Strategy .................................................... 12
Small Stock Investing ....................................................... 15
Active versus Passive Management ................................... 18
The Enemies of Effective Strategy .................................... 21
Chapter 1 Review ............................................................. 25
Chapter 2: Real Estate .......................................................... 27
Real Estate as an Investment ............................................. 27
Types of Real Estate ......................................................... 27
Advantages and Disadvantages of Real Estate Investing ... 28
Common Forms of Real Estate Ownership ........................ 30
Types of Publicly Traded REITs ....................................... 34
Factors to Consider in Selecting REITs ............................. 36
Income Property Valuation ............................................... 40
Nontraded REITs .............................................................. 48
Private REITs ................................................................... 52
Summary .......................................................................... 56
Chapter 2 Review ............................................................. 57
Chapter 3: Hedge Funds ........................................................ 58
What is a hedge fund? ....................................................... 58
Minimum Investment and Investor Qualifications .............. 59
Regulations ....................................................................... 60
Hedge Fund Costs/Fees ..................................................... 62
Risks of Investing in a Hedge Fund ................................... 63
Hedge Fund Strategies ....................................................... 65
Hedge Fund Collapse Example .......................................... 71
Summary ........................................................................... 73
Chapter 3 Review .............................................................. 74
Chapter 4: Private Equity and Managed Futures ................ 75
Venture Capital ................................................................. 76
Leveraged Buyouts ............................................................ 80
Mezzanine Debt ................................................................. 82
Distressed Debt ................................................................. 83
Private Equity Summary .................................................... 84
Managed Futures ............................................................... 86
Chapter 4 Review .............................................................. 90
Chapter 5: Addressing the Impact of Behavioral Finance ... 91
Loss Aversion .................................................................... 92
Fear of Regret .................................................................... 93
Overconfidence (or Optimism Bias) ................................... 94
Representativeness ............................................................ 96
Framing ............................................................................. 98
Rationalization or Confirmation Bias ............................... 100
Hindsight Bias ................................................................. 100
Anchoring ........................................................................ 101
Recency (or Availability Bias) ......................................... 102
Mental Accounting .......................................................... 103
Status Quo Bias ............................................................... 105
Illusion of Control Bias.................................................... 106
Endowment Bias .............................................................. 106
Summary ......................................................................... 107
Chapter 5 Review ............................................................ 108
Summary .............................................................................. 109
Chapter Review Answers ..................................................... 110
Chapter 1 ......................................................................... 110
Chapter 2 ......................................................................... 112
Chapter 3 ......................................................................... 114
Chapter 4 ......................................................................... 116
Chapter 5 ......................................................................... 118
References ............................................................................ 121
About the Author ................................................................. 123
Index ..................................................................................... 124
Introduction

H
igh net worth investors are no different from any other investor with
respect to the fact that an investment strategy must be in place and
followed in order for the investor to succeed. We begin this module
with a review of the requirements of a successful investment strategy and then
take a look at several prominent strategies in use, as well as the roadblocks that
can derail an investor’s strategy. We then look at the alternative investments that
high net worth clients seek out in order to boost portfolio returns. In this module
you will learn the basics of several alternative investments, including futures
contracts, hedge funds, private equity, and real estate. The module then
concludes with a discussion of how behavioral finance impacts investor decisions
and ways that an adviser can help clients overcome behavioral biases.

The chapters in this module are:

Investment Strategy
Real Estate
Hedge Funds
Private Equity and Managed Futures
Addressing the Impact of Behavioral Finance

The material in this module focuses on the importance of investment strategy and
the implications of behavioral finance on investment results. It also focuses on
futures contracts, hedge funds, private equity, and real estate investing.

Upon completion of this module, you should be able to understand the basic
elements of investment strategy, the use of alternative investments, and the
behavioral finance aspects of investing. You should also be familiar with the
benefits and risks associated with the alternative investment vehicles
presented in the module.

Introduction  1
© 2010–2018, College for Financial Planning, all rights reserved.
To enable you to reach the goal of this module, material is structured around the
following learning objectives:

3–1 Explain the importance of strategy in achieving investment goals.

3–2 Explain terminology, characteristics, risks, concepts, and strategies


for the use and valuation of various types of alternative investments.

3–3 Explain the impact of behavioral finance and other factors that have
been shown to influence investor results.

Look for the boxed objectives throughout this module to guide your studies.

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© 2010–2018, College for Financial Planning, all rights reserved.
Chapter 1: Investment Strategy
Reading this chapter will enable you to:

3–1 Explain the importance of strategy in achieving investment goals.

E
very serious endeavor should begin with a strategy—that is, with a plan
or set of activities aimed at getting us to our chosen goal. Strategy
focuses our attention and energies on those actions that systematically
move us closer to our goal, and it helps us tune out the many distractions that
otherwise dissipate that attention and energy. One of the most common
investment mistakes is to chase what is “hot” in the current investment
environment. The more thoughtful investment adviser rejects this “rearview
mirror” investing and instead, with the client, creates a sensible long-term plan to
achieve the client’s goals.

Strategy is critical in any undertaking, and investing is no exception. The investor


who lacks a strategy reacts with undifferentiated attention to every unanticipated
event. Before long, he or she is going everywhere within the portfolio, but not
anywhere in particular. This is one reason that you often see investors at all
levels of wealth holding a collection of seemingly random investments and
financial products. Advisers who can communicate a well-thought-out strategy to
their clients, and also stick to that strategy, will set themselves apart from less
competent advisers. In the words of investment manager J. Peter Skirkanich, “An
investment strategy is not worth much if you constantly change due to a lack of
underlying confidence or comfort. That is the difference between investing and
playing the market.”

The Requirements of Strategy


As a planned course of action, strategy is dependent upon three key elements:

 an identifiable goal,

 a method to attain that goal, and

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© 2010–2018, College for Financial Planning, all rights reserved.
 the competencies and resources to sustain the strategy.

With a stock investment strategy, the goal may be to outperform some suitable
performance benchmark; the method may be the identification and purchase of
undervalued stocks; the competencies and resources required may be knowledge
of security analysis principles and availability of investment capital.

Investment Strategy and Investment Policy


Investment strategy must operate within the framework of the client’s investment
policy and must always be its servant. Investment policy sets forth the financial
goals of the client as well as the risk parameters within which the client’s assets
may be managed. It also defines the categories of assets deemed suitable.
Investment strategy works within these parameters to attain those goals. While
there is one investment policy for a client, there can be several investment
strategies employed for the client. The strategies, however, are consistent with
the provisions of the investment policy. The policy can even contain specific
strategies to be used or not used, depending on the wishes of the client. It remains
for the investment adviser to work with the client to develop strategies that will
reach the stated goals within constraints defined by the policy.

Since most client portfolios will have a stock component, this module now turns
toward stock investment strategies.

Buy-and-Hold: The Benchmark Strategy


After spending many years in Wall Street and after making and losing
millions of dollars, I want to tell you this: It never was my thinking that made
the big money for me. It was always my sitting. Got that? My sitting tight.
(Jesse Livermore in Train 1980, 132)

Performance data for various categories of assets over time indicates that a
diversified portfolio of common stocks, if purchased and held with all dividends
reinvested, usually provides a return well above inflation. This passive buy-and-
hold approach to investing is, in effect, a benchmark strategy against which other

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© 2010–2018, College for Financial Planning, all rights reserved.
investment strategies are typically measured, and shows itself through index
mutual funds. Once assets are purchased, they normally are not sold unless there
is a compelling need to do so, such as when the client’s objectives, risk tolerance
level, or other major circumstances have changed.

With the bear markets of 2000–2002 and 2008–2009, some investors have come
to question the wisdom of a buy-and-hold strategy, especially with respect to
stocks. The large losses from these two periods wiped out any gains from the up
years during 2000 through 2009, leaving this decade to be called the “lost
decade,” as reflected in a –0.95% compound annual rate of return for the S&P
500 stock index during those 10 years. Nevertheless, there are direct benefits of a
buy-and-hold strategy. Low transaction costs are one benefit, both in terms of
direct commissions and in the difference in bid and ask prices at which securities
are sold. For large investors, transactions of significant size can also move the
bid and ask prices—another cost to the investor. Even if an investor makes the
right call and gets out of the stock market before it falls, the issue becomes when
to get back into the market. By the time a bullish trend is confirmed, a sizable
rise in the market has already occurred.

A buy-and-hold strategy also is tax efficient in that capital gains taxes are not
incurred until securities are sold. In contrast, for individual investors, selling
securities at a profit creates capital gains taxes. If securities are held one year or
less and then sold, the transaction is considered short-term capital gains that are
taxed at the individual’s marginal tax bracket. A common mistake that investors
make is failing to think in terms of after-tax returns.

A major advantage of the buy-and-hold strategy is simply not being out of the
market during its best days. The importance of this has been illustrated in various
market studies. One such study performed by Index Fund Advisors
(www.ifa.com) utilized the S&P 500 Index and covers the 20-year period ending
December 31, 2013.

An investor who stayed in the market for the full 20-year period realized a 9.22%
annualized return on their investment. By comparison, the investor would have
received only a 7.00% annualized gain by being out of the market for the best

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© 2010–2018, College for Financial Planning, all rights reserved.
five days. Being out of the market for the best 10 days resulted in a 5.49%
annualized return. Furthermore, missing the best 20 days resulted in earning
annualized returns of only 3.02%. If an investor had missed the 40 best days
during this two-decade period, then his or her annualized return would have been
negative (-1.02%).

Few investors ever follow the buy-and-hold strategy to the letter—that is, make a
single lump-sum stock purchase of a diversified portfolio and then wait patiently
for a long period of time. Ideally, new capital is added to the portfolio, and assets
are sold in order to take advantage of better investment opportunities, to prevent
further erosion in market value during a bear market, and so on. Still, the buy-
and-hold strategy is a useful standard against which other strategies can be
measured. If time, money, and energy are spent on research, charting, and trading
costs, other active strategies should outperform a buy-and-hold strategy at a
minimum if they are to be taken seriously.

Evidence and Explanation


Back in the early 1970s, financial scholars first began examining the data that
underlie long-term performance evaluations. At that time, buy-and-hold
performance was used to debunk trading strategies based upon technical
analysis—a favorite target for academics of the time. Burton G. Malkiel made
much of the superiority of the buy-and-hold strategy in his landmark book, A
Random Walk Down Wall Street, which was the first to bring the findings of
academic research to the larger investing public. “A simple policy of buying and
holding,” wrote Malkiel, “will be at least as good as any technical procedure”
(Malkiel 1999, 164). Of the many technical trading methods popular at the time,
all were found to be inferior to buy-and-hold with the single exception of the
Value Line timing approach, which produced slightly better results that the
scholars could not explain. Malkiel went on to note other benefits of this passive
strategy: low transaction costs and the deferral of capital gains taxes on profits.

The purported superiority of the buy-and-hold strategy is based upon the efficient
market hypothesis (EMH), which holds that current market prices of securities
reflect all the information available about issuers and the future expectations of

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© 2010–2018, College for Financial Planning, all rights reserved.
their investors. A necessary consequence of this hypothesis is the belief that
attempts to find undervalued securities in an efficient market are a waste of time.
The failure of highly skilled institutional investors to outperform “unmanaged”
benchmarks such as the S&P 500 stocks on a regular basis seems to confirm the
EMH and strengthen the argument for a buy-and-hold strategy. The big
institutions are so diversified that they, in effect, are the market, and their trading
costs and management fees merely reduce their overall return to slightly below
the benchmark level.

By late 2002, after more than two years of a bear market (and, as mentioned,
after 2008) more investors were challenging the concept of buy and hold. This is
especially true when considering individual stocks, where large capital gains
accumulated in the late 1990s in numerous stocks—telecommunication and
technology stocks in particular—melted into oblivion. Clearly there is risk with a
buy-and-hold strategy with a portfolio of stocks. That strategy can be very high
risk when used with individual stocks because companies can go out of business
or have severe business problems. For example, in 2001 Enron imploded and at
one time General Motors and Citicorp were considered among the bluest of blue
chip stocks. In late 2008 Citicorp was saved by a government bailout and GM
filed for bankruptcy protection on June 1, 2009. Although both companies have
since rebounded from these problems, investors’ confidence in them was shaken.

If one accepts this assumption of market efficiency, then no other strategy would
seem worthy of our time or effort. The stock client’s best interest would be to
buy and hold a fund indexed to the market. Even scholars are coming to
recognize, however, that securities markets are not entirely efficient, but that
pockets of inefficiency and tides of investor emotions create opportunities to beat
the buy-and-hold benchmark. Some investors do regularly outperform the
market. And for many clients and investment professionals alike, the challenge of
finding a winning investment is practically irresistible.

Investing With Economic Cycles


Many investors employ a strategy based upon economic cycles, attempting to be
in the market at a time when stock prices are expected to move upward in

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© 2010–2018, College for Financial Planning, all rights reserved.
anticipation of economic expansion and out of the market (or in particular sectors
of it) in anticipation of market declines. This strategy is practiced by market
timers, but the broad sweeps of the economic cycle—which typically take several
years from peak to peak—set the economic cycle timer apart from most market
timers.

Top-Down Analysis
Attempts to time the broad movements of the economy typically begin with top-
down analysis. This is a forecast of the economy as a whole, followed by the
identification of sectors of the economy (or industries) that should logically benefit
from that forecast and finally, identification of particular firms within the favored
sectors or industries that stand to be market leaders. Most brokerage research
departments provide just this type of analysis to their investment professionals.

When the Top-Down Forecast and Securities Selection


Work Together
The degree to which large returns can be produced from the marriage of an
accurate economic forecast and artful selection of securities was amply
demonstrated in mid-1993 by the 101.6% annual return of Thematic
Investment Partners, a private fund managed by economist A. Gary Shilling.

A long-standing market bear, Shilling correctly forecasted the economic


troubles afflicting the major world economics and arranged his portfolio to be
long in bonds and short in futures contracts in many currencies and
commodities. The Wall Street Journal described the economist’s style as
follows:

A classic “top-down investor,” Mr. Shilling first identifies what he thinks


are major trends that will last for a year or more. Then he looks for stocks
and other investments that embody those themes.

Shilling’s use of futures contracts makes returns of these proportions possible


in a way that using stocks and bonds alone cannot. They also make it possible

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© 2010–2018, College for Financial Planning, all rights reserved.
to lose money in equally dramatic fashion, which serves to demonstrate the
importance of an accurate top-down analysis to anticipate investment
outcomes.
Source: John R. Dorfman. “Super-Bear’s Fund Returns Sweet 101.6%” The Wall Street Journal,
July 12, 1993, C1–C2.

Sector Rotation
Sector rotation is a timing strategy that shifts portfolio assets from one sector of
the economy to another in anticipation of broad-based economic developments.

Past performance indicates that some sectors of the economy do better or worse
than others at different phases in the economic cycle. These are called cyclical
sectors or industries; their levels of sales and profits are sensitive to changes in
the general economy. Consumer durables, such as automobiles and appliances,
are highly sensitive to the current state of the national economy. Because these
consumer durables represent discretionary purchases for most consumers, the
uncertainty, lower incomes, and lack of confidence that go hand in hand with
recessionary periods induce many would-be consumers to cancel or postpone
purchasing plans for this class of products, thus cutting revenues and earnings for
many cyclical firms. Very often, the first hint of economic trouble causes deep
cuts in this form of consumer spending. Consumer nondurables, such as food,
pharmaceuticals, and liquor, on the other hand, are relatively unaffected by the
economic cycle; many investors rotate their funds to stocks in the consumer
nondurable sector in anticipation of recession.

Table 1, produced by the American Association of Individual Investors, identifies


the stages of the economic cycle, the characteristics of the various stages, and the
industries that tend to do well in each. You should study this table carefully and
become familiar with the relationships between different sectors or industries and
how they are affected by cycles of economic activity.

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© 2010–2018, College for Financial Planning, all rights reserved.
Table 1: The Economic Cycle and Industry Groups

Economic Cycle Business Cycle

Economic Economic Industries That Do Well in


Stage Characteristics This Stage Examples
Expansion: Low, increasing Cyclical
inflation
Early Stage Low, increasing Consumer Credit: Firms Savings and loans
interest rates that are tied to the housing
industry
High unused capacity Transportation: Airlines, trucking,
Companies that transport railroads
Low inventory
goods and passengers
Energy: Companies that Oil, coal
produce energy-related
products
Consumer Cyclicals: Advertising,
Manufacturers of consumer apparel, auto
products that respond to manufacturers,
the changes in disposable media, retailers
income
Expansion: Moderate inflation
Middle Stage Moderate interest Basic Materials: Chemicals,
rates Companies manufacturing plastics, paper,
materials (not machinery) wood, metals
Moderate unused
used to produce finished
capacity
goods
Moderate inventory
Expansion: High inflation
Late Stage High interest rates Capital Goods: Equipment and
Companies manufacturing machinery
Low unused capacity
machinery used to produce manufacturers
High inventory finished goods

Recession: Decreasing inflation Defensive


Decreasing interest Consumer Staples: Food, drugs,
rates Manufacturers of basic cosmetics,
consumer products that are tobacco, liquor
Increasing unused
purchased at largely the
capacity
same level through all
Decreasing inventory economic cycles

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© 2010–2018, College for Financial Planning, all rights reserved.
Economic Cycle Business Cycle

Economic Economic Industries That Do Well in


Stage Characteristics This Stage Examples
Utilities: Regulated Electric, gas,
companies providing water
products and services such
as electricity
Independent Varied economic Growth
of Economic circumstances
Industries and Biotechnology
Cycles
companies in early
stage of life cycle:
Expanding quickly and not
subject to economic cycles
Source: AAII Journal, March 1992, 35. Used with permission.

Acting Ahead of Outcomes

The term “anticipation” has been used several times during this discussion. Stock
prices anticipate economic events—acting, in effect, as leading indicators of
future economic activity (generally by six to nine months). This was
demonstrated in 2009 as stocks began their rally from their March 9 lows during
the worst economic period since the Great Depression and well before any
evidence appeared that the economy was turning around. About six months later,
in Q3 of 2009, GDP growth was reported to be up 2.2%, and up 5.7% in Q4.
Correctly anticipating changes in the economy of the nation and its sectors and
companies is a formula for outperforming the passive buy-and-hold strategy. But,
anticipation implies action ahead of visible confirmation that the forecast of the
future is on target. The perfectly accurate cycle timer would then be

 in defensive stocks or interest-producing securities ahead of indications of


recession,

 in consumer durable stocks ahead of official confirmation that the economy


is rebounding from recession and is easing into the early stages of recovery
and expansion,

 in basic materials stocks ahead of the middle stage of economic expansion,


and

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© 2010–2018, College for Financial Planning, all rights reserved.
 in capital goods stocks ahead of the late stage of economic expansion.

Obviously, one would have to be a seer of superhuman abilities to rotate through


these sectors at just the right moments. In reality, economic forecasting is neither
scientific nor a reliable art. Even with sophisticated computer-generated
forecasting models, economists have mixed results in predicting economic
growth, inflation, and interest rates. And picking the right companies in
industries favored by the economic cycle is another activity fraught with
uncertainty.

The development of sector funds by the mutual fund industry has simplified this
form of investing for the client and the investment professional in terms of
security selection. Here, the difficult job of picking the right companies is taken
care of by professional managers, but the challenge of picking and timing the
right sectors remains.

The Contrarian Strategy


“To buy when others are despondently selling, and to sell when others are avidly
buying” is described by John Templeton as an investment method requiring
patience, discipline, and courage (Berryessa 1988). It is also one of the primary
ingredients of successful investing. Whether you call it acting counter to the
accepted wisdom or going against the crowd, being a “contrarian” is a strategy
practiced to some extent by most, if not all, super-investors. To do otherwise
would naturally result in market performance no different than that of other
money managers. So universally recognized are the merits of this approach that
one institutional money manager remarked, “We’re all contrarians now.”

Logically, however, we cannot all be contrarians—now or ever. A contrarian is,


by definition, someone who acts counter to the majority; therefore, contrarians
can never be the majority. This does not prevent the majority from recognizing
the value of the contrarian investing strategy, but it is human nature that most
who pay lip service to its value cannot bring themselves to follow it. Contrarian

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investing requires patience and courage of one’s convictions, which are difficult
to exercise when a more aggressive strategy is making much higher returns.

Psychology and Markets


Contrarian investing strategy—the willingness to buy securities that are out of
favor and to sell those that have become popular—is based heavily upon the
psychology of group behavior. While Humphrey Neill is generally credited as the
father of this investment strategy, Wall Street money manager David Dreman has
done more than anyone else to draw together its academic underpinnings and
develop its methodology.

Dreman has compiled a number of studies conducted by social psychologists that


address the behavior of individuals within groups. For the most part, these studies
indicate the extent to which the objective opinions of even highly trained
individuals are influenced by the opinions of other members of the group. These
studies point out that in situations of uncertainty, individuals will modify their
opinions—even those based upon empirical data or direct observation—to avoid
differing too much from the opinions of their peers. The result is a convergence
of opinion, or groupthink, in areas such as economic forecasting, earnings and
stock price forecasting, investment opinion, and other areas in which uncertainty
is a major factor.

Human psychology, according to contrarians, is such that when any element of


doubt or ambiguity exists, the independent opinions of individuals are easily
swayed by the opinion of the group—the herd instinct. Add the emotions of
greed and fear to this human herding tendency and you have the makings of stock
market behaviors that drive P/E ratios of “glamour” stocks to 100 or more and
induce investors to buy certain stocks at any price—often well above their
intrinsic values. In retrospect, this certainly happened with technology stocks in
1999 and early 2000. In fact, one study of stock performance in 1999 indicated
that stocks without earnings outperformed stocks with earnings. According to
Dreman and other contrarians, professional money managers are as susceptible to
the herd instinct as anyone else; indeed, some are driven to it by their clients.

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© 2010–2018, College for Financial Planning, all rights reserved.
A number of technical indicators have been devised to measure the level of
converging opinion; contrarians often use them as cues for their own buying and
selling. These indicators include the following:

 Short selling. The volume of short selling is taken to be an indication of


optimism or pessimism about future stock prices. A common measure of
short selling is the short-interest ratio. The short interest is the number of
shares sold short but not yet bought back. The short-interest ratio is the total
shares sold short divided by the average daily trading volume. Historically,
this ratio has been between 1.0 and 2.0 for the New York Stock Exchange,
although it has been between 3.0 and 6.0 in recent years. This ratio has also
been distorted by hedging techniques that have become more common. From
the contrarian’s point of view, increasing short selling in a stock indicates a
growing herd consensus that the market will decline—and he or she should
consider an opposite move.

 Specialists’ sentiment. Unlike short sellers, who are thought by contrarians


to follow the herd, specialists are considered to be the “smart money.”
Increased bullishness by specialists in a stock makes contrarians bullish, and
vice versa. Thus, pessimism by specialists is interpreted in a direct—and not
an opposite—way by contrarian investors. As a guideline, if the specialists’
proportion of total short sales is 65% or more, that is a bearish sign. A ratio
of 40% or less is a bullish sign.

 Mutual fund cash positions. Both mutual fund managers and investment
advisers are generally considered by contrarians to be members of the herd.
When mutual funds have low and decreasing cash positions (meaning that
they are bullishly putting the fund’s money into the market) and when
investment advisers are urging greater stock market exposure, contrarians
take these to be sell signals. When mutual funds have large cash positions,
say 10% and more, and when advisers are all doom and gloom, contrarians
grow bullish. More recently, mutual fund cash positions have been less
reliable as a contrarian indicator because of the trend with mutual funds to
stay close to fully invested rather than time the market.

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 Investment advisory opinions. This theory suggests that the aggregate
opinion of investment advisers is often wrong. That is, when the majority of
investment advisers are bullish (bearish), a contrarian should sell (buy)
securities. This ties in with the concept of groupthink mentioned earlier in
that it is easy to accept the prevailing market sentiment.

 Put-call ratio. Technical researchers have observed that the ratio of put
volume to call volume on optionable stocks increases near market tops and
market bottoms. Thus, near market bottoms, as traders grow increasingly
pessimistic, there is an increase in put activity, sending the put-call ratio
higher. Near market tops, trader optimism grows along with call activity,
driving the ratio lower. Contrarians, as you might expect, take the opposing
view in these instances, so that higher put-call ratios suggest buying
opportunities, and lower put-call ratios suggest the opposite. Extreme
readings of this indicator are considered important. As a guideline, numbers
below 0.7 and above 0.9 are considered sell and buy signals, respectively, for
a contrarian.

Small Stock Investing


In 1978, a graduate student at the University of Chicago, Rolf Banz, conducted a
study with conclusions that have altered the strategies of a great number of
investors. Banz found that small company stocks provided a rate of return higher
than their risk would have predicted (Banz 1981). Small company stocks are
defined by their market capitalizations, which is the number of shares
outstanding times the price per share. While there is no one standard definition of
small stocks, they are generally those with market capitalizations of $1 billion to
$2 billion or less.

The Small Firm Effect


The concept of risk-adjusted return states that in an efficient market, the
diversified investor expects to receive a return commensurate with the risk
taken—no more, no less. Banz’s study pointed to an anomaly: small-cap
(capitalization) stock investors were getting more bang for their bucks! This

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© 2010–2018, College for Financial Planning, all rights reserved.
anomaly has since been dubbed the small firm effect. Securities performance data
included in the previous module had already verified what many investors have
known intuitively for years—that small firms provide a higher level of returns
than do large company stocks over the long term, or any other class of market
securities for that matter. Banz showed that there was icing on this cake.

Other studies followed. All confirmed Banz’s findings but differed in explaining
this divergence from financial theory. Professor Avner Arbel suggested that
small stocks were “neglected stocks,” hidden from the peering eyes of most stock
analysts and that the resulting information deficiency made small stocks seem
riskier than, in fact, they were (Arbel and Strebel 1983).

In Banz’s study, small firms are defined as the bottom 20% of NYSE firms in
terms of total market value (total outstanding shares times current market price).

Investing in Small Firms


Most individual investors and many investment professionals couldn’t care less
about the academic heat generated from the small firm effect; they already
understand that the lack of attention given to small companies by the institutional
investors who move the price creates underpricing situations on which they can
capitalize. They also understand that once these firms catch the eye of Wall
Street analysts, many of them will find their way onto “recommended” lists and
demand for their shares will quickly increase. The result, of course, is higher
share prices. Successful small firms that remain neglected by Wall Street often
catch the eye of larger firms, which buy them outright as corporate acquisitions,
typically at generous premiums. In the neighborhood of 5% of all small firms are
acquired by other firms during the course of the typical year (Perritt 1988, 201).

The strategy of small firm investing has been clearly articulated by Gerald Perritt
in Small Stocks, Big Profits (1988), and these guidelines still are worth following.
Perritt recommends the following to the small firm investor:

 Have a long time horizon (three to five years).

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© 2010–2018, College for Financial Planning, all rights reserved.
 Be prepared to live with volatility.

 Diversify the small stock portion of your portfolio to include between 20 and
30 different issues.

 Acquire shares over time (using the dollar cost averaging strategy) and on
weakness.

 Be aware that transaction costs for small firms are high, so avoid turning
over more than 30% of a portfolio during a given year.

 Look for firms where management has a tangible ownership stake in the
business.

 Do not be reluctant to sell when and if the company’s fundamentals change


adversely; but do sell if and when 40% of the company’s shares become
owned by institutional investors.

 Be on your guard when considering mutual funds that claim to invest in


small firms; most use the term “small” loosely. Invest in companies with
$400 million to $500 million capitalizations. (Note: Since these guidelines
came out, small-cap stocks currently are more often defined as being up to
$1 billion to $2 billion in capitalization.)

Client Suitability
The small stock strategy makes sense for clients with higher risk tolerances. The
high volatility of small stocks, as indicated by data in the previous module,
makes it clear that the client should have a medium- to long-term investment
horizon. In almost all cases, small company stocks should represent just a portion
of the client’s overall portfolio.

Investment professionals with regional firms, or those with wire-houses


employing field analysts, can use their firms’ research resources to good effect with
this strategy. These firms take the time to investigate and report on the neglected
small firms that Wall Street analysts have never heard of—at least not yet.

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Active versus Passive Management
All of the prior investment strategies are based on active management. Active
management implies that a manager (or individual investor) can beat the market
through skill in security selection and/or market timing. Passive management
implies that a manager can beat most active managers (not the market) via low
costs and primarily a buy-and-hold approach. Indexing can be considered the
most common type of passive management where the manager does not make
active trading decisions, but instead tries to duplicate an index such as the
Standard & Poor’s 500. Here is a short summary of the pros for each type of
philosophy.

Reasons to use active management:

 The potential for increased returns

 The potential for downside protection

 Psychological benefits for the client (the client is more involved in the
investment process)

Reasons to use passive management:

 The markets are fairly efficient

 Long-term returns, in some cases, seem to indicate most active managers fail
to outperform the market indexes

 Lower expenses than active management

 Not missing the best days of the market

 Fewer transactions can result in lower expenses and lower capital gain taxes

There is a multitude of studies supporting the superiority of either philosophy


over differing periods of time. Lakonishok, Shleifer, and Vishny (1992) found in

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their study that actively managed funds do not outperform the market and that
fund performance persistence (last year’s winner staying a winner this year and
last year’s loser continuing to be a loser this year) basically does not exist. Kahn
and Rudd (1995) did find evidence of performance persistence, but only for
fixed-income managers; even so, they conclude that indexing makes the most
sense for equity and fixed-income investing. A study by Sorensen, Miller, and
Samak (1998) concluded that some indexing is appropriate for funds in most risk
objective classes.

The jump in popularity of index funds, in particular those tied to the S&P 500
index, during the mid to late 1990s was due to the fact that the S&P 500 index
funds outperformed the large majority of stock mutual funds. Part of this better
performance was due to large stocks (which this index contains) outperforming
smaller stocks during this period. While comparing the performance of large
stock funds to small stock funds is not a fair comparison, many investors focused
only on the better performance, resulting in billions of dollars flowing into these
index funds.

Table 2 provides some perspective of returns from actively managed stock funds
in comparison to indexes. Again, using Morningstar Mutual Funds data, returns
of the large-cap index (S&P 500) were somewhat more than that of large-cap
blend, actively managed funds. In the mid-cap blend category, the S&P Midcap
400 index had better results than the composite performance of actively managed
funds. In the small-cap sector, the Russell 2000 index somewhat underperformed
the actively managed funds. Therefore, in the aggregate, the results indicate that
in most cases the indexes outperformed the actively managed funds. A major
reason for this is that the expense ratios of actively managed funds are typically
1.00% to 1.50%; this is not reflected in the indexes. However, these results
should be used with caution because, when considering actively managed funds,
obviously some funds outperformed their category numbers and some
underperformed them. So, if using managed funds, the key lies in the ability to
select actively managed funds that outperform their category and their
corresponding index fund—not an easy task.

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© 2010–2018, College for Financial Planning, all rights reserved.
Table 2: Small-Cap, Mid-Cap, and Large-Cap Growth
Categories Periods Through December 31, 2011

3-Year 5-Year 10-Year


Total Total Annualized
Fund Return Return Return
S&P 500 index 14.11% –0.25% 2.92%

Large-cap blend (1,878 13.18% –0.99% 2.60%


funds)

S&P Midcap 400 index 19.57% 3.32% 7.04%

Morningstar mid-cap 17.41% 0.46% 5.62%


blend (442 funds)

Russell 2000 index 15.63% 0.15% 5.62%

Morningstar small-cap 16.77% 0.16% 5.96%


blend (677 funds)

One argument that supporters of actively managed funds make is that in bear
markets managers can provide some protection that index funds cannot. This
argument cannot be supported based on the bear market years of 2002 and 2008,
as seen in Table 3.

Table 3: Small-Cap and Large-Cap Growth


and Value Categories for 2002 and 2008

Fund 2002 2008


S&P 500 index –22.10% –37.00%

Large-cap blend –22.25% –37.80%


(2,233 funds in 2008)

S&P Midcap 400 index –14.53% –36.23%

Morningstar mid-cap –16.55% –39.21%


blend (553 funds)

Russell 2000 index –20.48% –33.79%

Morningstar small-cap –16.22% –36.57%


blend (707 funds)

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Of course, certain individual funds have had better bear market performance than
their indexes; but in the aggregate this does not seem to be the case.

Since there appears to be no “right” answer regarding the active versus passive
debate, an adviser can pursue one of three strategies: purely active, purely
passive, or a combination of active and passive. Proponents of combining the two
strategies suggest using index funds as a core holding, especially where the
market is highly efficient (for example, large-cap stocks) and active management
where the market appears to be less efficient (for example, small-cap and
emerging market stocks). This same approach can be applied to fixed income
(index funds for short-duration, high-quality bond funds and actively managed
funds for long-duration, lower-quality bond funds). Whatever mix an adviser
may suggest, it is important to communicate the rationale, as well as the risk and
return expectations, to the client.

The Enemies of Effective Strategy


The adoption of an investment strategy implies a commitment to a particular
approach to the market over time. Every super-investor has had such a
commitment and has stuck to it. Charles Ellis has written that

The important test of an investment concept or philosophy is the manager’s


ability to adhere to it for valid, long-term reasons—even when short-term
results are most disagreeable and disheartening. Persistence can lead to
mastery and development of an important distinctive competence in the
particular kind of investing in which the manager specializes (Ellis 1993, 18).

It is the persistence of highly successful money managers, and their staying the
course, that often separates them from competitors with mediocre results. This
section discusses the forces that tend to undermine persistence and how they can
be managed.

While the enemies of effective strategy may be many, three that any experienced
investment professional will quickly recognize are (1) unrealistic expectations;

Chapter 1: Investment Strategy  21


© 2010–2018, College for Financial Planning, all rights reserved.
(2) emotional, undisciplined investing; and (3) an inadequate time horizon. The
first is generally the product of ignorance; the second stems from emotions; the
third results from both ignorance and impatience.

Unrealistic Expectations
Most novice investors—and some inexperienced investment professionals—
develop unrealistic expectations, especially during strong bull markets, as was
seen in the 1990s. In the absence of experience or proper education, they lack a
sense of what is reasonable in terms of future returns, the pace of progress, and
market volatility. One important function of the investment professional is to
manage client expectations. Returns from common stocks over the long term
have been between 9.5% and 12.6%. Yet an article in The Wall Street Journal of
April 30, 2001, quoted an investor survey that indicated that about one in five
surveyed thought a gain of more than 20% from stocks was normal. Chances are
that a new client may have read something or knew someone who had made a
great deal of money through his own investment professional. And, chances are,
he expects the same, even though he does not necessarily mention these
expectations with you. Any strategy you develop for this client, then, may be
undermined by a set of inappropriate expectations.

Strongly tied to unrealistic expectations is the underestimation of risk. Every


investment has risk, and controlling risk is a key factor in obtaining good long-
term investment performance. If a client expects a 20% return each year from his
or her portfolio, some investment professionals might be tempted to take higher
risks in an attempt to achieve that type of performance. Very often, this attempt
leads to “investment landmines” that make it not only more difficult to achieve
the expected return, but can result in a setback to the portfolio that could take a
significant amount of time from which to recover. Then, either greater risks must
be taken or there must be a realization that those expectations cannot be met. A
far better approach is to counsel the client on what expectations are realistic and,
from that, develop a portfolio that provides a sensible balance between risk and
return.

There is, of course, a general relationship between risk and return, and you
should never assume that a client has much understanding of the facts relative to

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these two issues. Because this understanding is lacking, it should be no surprise
that so many clients have unreasonable expectations. And indeed, unreasonable
expectations became prevalent in periods of exceptionally high stock returns. The
best approach in all cases is to determine the client’s expectations and, when
necessary, provide education about risk-return relationships and the historical
returns of the market. The more unrealistic the expectations of a client are, the
more difficult it will be to satisfy that client. Therefore, educating the client will
benefit the investment professional as well as the client.

The Emotional, Undisciplined Client


The market is topsy-turvy, but the investment professional is unflustered. She
and her client have agreed to follow a strategy of investing in a portfolio of 15
growth stocks and then holding them through their years of most rapid growth.
The economy has been caught in recession for the past six months, and the stock
market has just reached a new two-year low. The client’s stocks have been on a roller
coaster during this period, and, with the exception of three issues, all are down.

“If I had just stayed in bonds, I’d be way ahead now,” the client laments over the
phone. “I’m thinking that I should cut my losses—take a tax loss—and go back
into bonds before things get worse.”

Does this sound familiar? Lack of discipline on the part of the client is often
borne of emotions and is the greatest enemy of investment strategy, forcing the
investment professional to sell at market lows. Assuming that the stocks still
retain the fundamental soundness that drew you and the client to them, stocks
should never be sold because of short-term fluctuations in the market. Doing so
merely provides a profitable situation for other investors. Indeed, John
Templeton, one of the greatest stock investors of the century, made a fortune for
his clients by buying what others were selling, then holding them through ups
and downs in the market.

The emotional, undisciplined client also can induce purchases that are counter to
strategy and that destroy investment results. “Why don’t we buy some Global
Data?” your client asks. “It’s really on a roll now, and Business Week just did a
feature story on it.” You know that by the time your client and the rest of the

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© 2010–2018, College for Financial Planning, all rights reserved.
Western world learn about Global Data, just about every ounce of bargain will
have been squeezed out of the stock by the market. Peter Lynch, who managed
the Fidelity Magellan Fund to a 21.7% annual compound return between 1971
and 1985, has just the response for your client: “If I could avoid a single stock, it
would be the hottest stock in the hottest industry, the one that gets the most
favorable publicity, the one that every investor hears about in the car pool or on
the commuter train—and, succumbing to social pressure, often buys” (Lynch
1989, 141).

Related to this is the action of following investment fads. When a certain


segment of the market is providing outstanding returns, most investors want to
buy into that segment so they will not be “left out.” The problem with this
approach is that, by the time the high returns from these segments are identified,
often most of those high returns are in the past. “Chasing performance” is a
common, but poor, investment strategy that appeals to the emotional client. In
other words, following the crowd is a strategy that leads to poor long-term
investment results.

Perhaps the best way to manage the emotions of the client (and your own) is to
talk out the issues of volatility and the dangers of impulsive buying and selling at
the very beginning. Investment strategy needs to be clearly articulated and
understood by both parties and can be written into the investment policy.

Inadequate Time Horizons


None of the strategies described in this module naturally lead to good short-term
results—although it does happen. Formula timing strategies require that the
investor enter the market (or leave the market) over a number of time periods.
The economic cycles that animate some investors take years to unfold.
Contrarians and value investors are both attracted to out of favor and undervalued
securities that, over time, other markets will grow to appreciate and reevaluate.
Growth investors likewise must allow sufficient time for their investments to
appreciate, which might include time to recover from the bear markets that will
occur from time to time. As for small stocks, it can be many years before
institutional investors recognize them and bid up their prices.

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John Templeton ascribed much of his own success to patience—to the fact that
he held stocks for an average of four years, while the average for other mutual
funds was around six months. Warren Buffett, another of the “money masters,”
has demonstrated patience in buying and selling. He believes the holding period
for any new stock he purchases is “forever.” John Train described him this way:
“He often repeats that you should never buy a stock unless you would be happy
with it if the stock exchange closed down for the next 10 years” (Train 1980, 17).

In discussing investment strategy with clients, the importance of adequate time


horizons needs to be emphasized. Time horizons and client emotions are
inevitably linked. The client who has no sense of what is an adequate time
horizon for his or her strategy will look at the returns a month subsequent to an
investment and, seeing little price appreciation, will worry and will call you. “A
whole month has gone by and I haven’t made a dime on my investment. What’s
wrong?” Chances are that nothing is wrong except your initial failure to prepare
the client to understand that time horizon is part and parcel of any proven stock
investment strategy. Deal with this issue up front and you will save yourself and
your client much grief.

Chapter 1 Review
1. List three key elements of an investment strategy.
Go to answer.

2. List benefits of the buy-and-hold strategy.


Go to answer.

3. For each of the following economic stages, list the industries that are
expected to do well.
a. expansion: early stage
Go to answer.

b. expansion: middle stage


Go to answer.

Chapter 1: Investment Strategy  25


© 2010–2018, College for Financial Planning, all rights reserved.
c. expansion: late stage
Go to answer.

d. recession
Go to answer.

4. Describe the following technical indicators used by contrarians.


a. short selling
Go to answer.

b. specialists’ sentiment
Go to answer.

c. mutual fund cash positions


Go to answer.

d. investment advisory opinions


Go to answer.

e. put-call ratio
Go to answer.

26  Advanced Investment Products and Strategies


© 2010–2018, College for Financial Planning, all rights reserved.
Chapter 2: Real Estate
Reading the next three chapters will enable you to:

3–2 Explain terminology, characteristics, risks, concepts, and strategies


for the use and valuation of various types of alternative investments.

R
eal estate is an important element of the investment portfolios of many
wealthy individuals. Many financial advisers recommend that their
clients include investment real estate in their portfolios. Therefore, a
basic understanding of real estate features and valuation is important.

Real Estate as an Investment


Within the realm of real assets, more investors choose real estate over other
tangible investments. One reason for this may be due to the familiarity that
most people have with real estate, as the result of owning their own home. In
addition, the favorable tax consequence that flows from real estate
investments motivates many. One thing to keep in mind when discussing real
estate as an investment is that generally one’s primary residence is not
considered an investment.

Types of Real Estate


Real estate generally is classified by the following types:

 Land. Land can be unimproved (raw land), or improved. Improved land


includes farm and ranch land, lots with curbs and gutters awaiting further
improvement, or recreational property such as a lake with campgrounds.

 Residential real estate. Residential real estate includes any type of building
in which people live and pay rent to an owner. Types of residential real estate
include single-family homes, apartments, condominiums, hotels, and motels.

Chapter 2: Real Estate  27


© 2010–2018, College for Financial Planning, all rights reserved.
 Commercial real estate. Commercial real estate includes any type of
building that is rented to a business. Types of commercial real estate include
office buildings, shopping centers, banks, restaurants, retail stores, and
football stadiums. Hotels, motels, and apartments might also fall into the
commercial category, since many are owned by publicly traded corporations
run as businesses rather than as investments.

 Industrial real estate. Industrial real estate includes any type of building that
is rented to an individual or business for a plant, factory, industrial park,
power plant, or warehouse.

Advantages and Disadvantages of Real


Estate Investing
Investors can invest directly or indirectly in real estate. Direct investment is
through outright ownership or a general partnership. Indirect investment is
through a limited partnership, a corporation, or a real estate investment trust
(REIT). Direct investment in real estate has both advantages and disadvantages.

Major advantages include the following:

 Tax advantages. In addition to the opportunity to earn a capital gain on the


sale of real estate, investors can deduct operating expenses, depreciation of
the buildings, and interest expense on the loans used to finance the property
(subject to tax limitations beyond the scope of this treatment).

 Inflation hedge. Real estate has a relatively strong correlation with inflation,
especially when inflation rises. When inflation is low, real estate generally
will rise at a rate higher than inflation. Regional factors are important in real
estate, causing properties in some parts of the country to appreciate at higher
rates than properties in other parts of the country.

 Psychic income. Just as with a home, many investors prefer to own real
estate for the psychic income that comes with being able to walk on the

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© 2010–2018, College for Financial Planning, all rights reserved.
property, market the property, handle maintenance issues, and deal directly
with the people who rent the property.

 Leverage. Few investors pay 100% cash when they buy a real estate property.
Lenders willingly lend the majority of cash required to buy a real estate
property because they are able to secure their loan with the property itself. Real
estate loans typically are greater than the maximum margin requirement for
stocks, giving investors much greater leverage and potentially higher returns
on their equity invested.

Major disadvantages include the following:

 Illiquidity. Like other real assets, real estate is difficult to convert to cash
quickly. There is no national or regional market, as there is for stocks and
bonds. Investors who purchase real estate must realize that they may have to
wait a year or more to convert some properties to cash after they make the
decision to sell.

 Management. Unlike stocks, which have professional managers making


daily business decisions, investment real estate requires a hands-on approach.
Property management includes accounting, marketing, maintenance, and
time. Real estate investors must be willing to engage in these activities or
hire someone to do so for them.

 High minimum investment. Even if the majority of dollars required to invest


in a real estate property are loaned to the investor, the typical real estate
investor must make a significant dollar commitment to an investment.
Furthermore, because most lenders require a personal guarantee for the loan,
the investor must consider the fact that he or she may be on the hook for the
total amount of the investment.

 High transaction costs. Real estate commissions may be as high as 7% of


the gross purchase price. Other costs, such as appraisal fees, lending
commitment fee, and closing costs can make the initial costs 10% or more. A
similar cost structure on the sale means that the property must appreciate
20% or more just to overcome the transaction costs.

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© 2010–2018, College for Financial Planning, all rights reserved.
 Immobility of asset. Real estate cannot be moved from Silicon Valley during
a recession in the technology industry to Houston during an oil boom. Also,
if the investor lives in one city and the property is in another, the investor
cannot change the property’s circumstances to make it more convenient.

 Fixity. Conversion of a real estate property from one use to another is


relatively costly. If an industrial building has been purchased and
manufacturing business has declined, it may not be cost effective to convert
the building to an apartment house. Note, however, that old industrial
buildings in many cities are being converted to lofts. The timing must be
right for these types of conversions; many old industrial buildings sit idle for
years until a city’s leaders decide to promote redevelopment.

 Economic and tax risks. Because the holding period of a real estate investment
is long, economic booms and busts and outside economic shocks—such as the
oil shock of 1973, the crash of 1987, the World Trade Center attack of 2001,
and the crisis of subprime mortgages from 2007 to 2008—are likely to occur
sometime during the holding period. These events and cycles cannot be
accurately anticipated. Nor can changes in the tax laws be anticipated, which
often are subject to the whims of political forces in Washington. Any of these
can quickly and significantly affect the cash flows, risks, and returns of real
estate investments.

Common Forms of Real Estate Ownership


Real estate is owned in every legal form of business, though there is one form of
ownership that exists for real estate investments and not for other businesses.
That form is the real estate investment trust (REIT). A brief summary of the
features of each of the forms of ownership follows.

Outright Ownership

 Unlimited personal liability for all aspects of the operation of the real estate
business.

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© 2010–2018, College for Financial Planning, all rights reserved.
 Debts incurred in the operation of the property are the obligation of the
owner.

 Management of the property is the responsibility of the owner.

 All tax benefits and liabilities accrue to the owner.

 The owner may sell the property at any time without restriction.

 Death of the owner terminates ownership and passes ownership to heirs.

 Death may result in a step-up in tax basis to the heirs.

General Partnership/Joint Venture

 Joint and several liability for all obligations of the partnership, including the
partnership’s debts.

 Each partner has a right to bind the partnership and has an equal voice in
partnership matters, unless the partnership agreement specifies otherwise.

 Tax benefits flow through to each general partner.

 Partner’s right to transfer the partnership interest is restricted by the terms of


the partnership agreement.

 Death of a partner might cause the partnership to terminate, unless the


partnership agreement states otherwise.

Real Estate Limited Partnerships (RELPs)

 Limited partners are prohibited from engaging in the active management of


the partnership; if they do so, they may lose their limited partner status and
become full general partners.

 Limited partners have a financial liability that is limited to the amount of


investment in the partnership.

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© 2010–2018, College for Financial Planning, all rights reserved.
 Tax benefits flow through to each limited partner.

 The limited partner’s right to transfer the partnership interest is restricted by


the terms of the partnership agreement.

 The partnership does not terminate on the death of a limited partner.

 A corporate general partner is commonly used to avoid the termination of the


partnership on the death of an individual general partner.

Corporation

 There is limited liability for corporate owners.

 Corporate debt is the liability of the corporation only (although most lenders
require personal guarantees from the owners of closely held corporations).

 Continuity of life in the event of the death of an owner is present.

 There is centralized management.

 Owners are free to transfer ownership to anyone they wish, unless restricted
by a shareholder agreement (C corporation).

 The corporation is taxed separately from its owners, and owners are taxed on
distributions made to them, resulting in double taxation of corporate income
(C corporation).

 S corporation owners may not transfer ownership to certain individuals or


entities.

 S corporation owners are taxed like general partners, with income and losses
passed through to the owners.

32  Advanced Investment Products and Strategies


© 2010–2018, College for Financial Planning, all rights reserved.
Real Estate Investment Trust (REIT)

 REITs are publicly traded, closed-end, securitized real estate investment


corporations that are purchased on major stock exchanges, such as the
NYSE, AMEX, and the OTC markets. This provides liquidity to an
otherwise illiquid investment.

 REITs must invest at least 75% of total assets in real estate assets, and derive
at least 75% of gross income from rents.

 Of earnings, at least 90% must be distributed to shareholders, thereby


avoiding the double taxation of the corporate form of business. The REIT is
not taxed on the net income it earns. However, tax losses are not passed
through to investors.

 Since REIT earnings are not taxed on the corporate level, these earnings are
taxed as ordinary income to the investor, and are not eligible for the
preferential long-term capital gains rate.

 Personal liability is limited to the amount invested.

 REITs allow investors to invest in real estate with the investment of


relatively modest sums of money. This was why REITs were created by
Congress in 1960, to make large-scale income-producing real estate available
to average investors.

 Professional management of the real estate properties owned by the REIT


relieves investors of any management responsibility, including the purchase
and sale of property, day-to-day management, and record keeping.

 REIT investors have no management input, thereby having no control over


purchase or sale decisions or management decisions.

 REIT current yields generally are higher than the yields of many fixed
income investments. However, the net income may vary greatly from year to
year.

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© 2010–2018, College for Financial Planning, all rights reserved.
 Generally, REITs sell at a discount to the estimated net asset value (NAV) of
the underlying properties.

 Individual REITs purchase many properties, providing diversification


benefits to the REIT investor.

 REIT share prices are more volatile than the prices of most real estate
properties, and their prices are reported in the daily financial press.

 Although REITs are stocks, their underlying assets are real estate properties,
giving investors a way to invest in real estate and diversify their portfolios.

Types of Publicly Traded REITs


Most publicly traded REITs fall into one of two basic categories: equity or
mortgage. There are also non-exchange-traded REITs (that file with the SEC but
whose shares do not trade on national stock exchanges) and private REITs (that
do not file with the SEC, and whose shares do not trade on national stock
exchanges). According to the National Association of Real Estate Investment
Trusts, in 1971 there were 34 REITs with a market capitalization of just under
$1.5 billion; fast-forward to year-end 2016, and there were 224 REITs with a
market capitalization of just over $1 trillion.

As of March 2017 the average yield for the FTSE NAREIT Equity REITs was
4.01% while the dividend yield for FTSE NAREIT Mortgage REITs was 9.87%.
This compares with a yield of approximately 2.0% for the S&P 500.

 Equity REITs. Equity REITs own real estate properties and earn income
from rents, and made up 94.25% of the REIT market (by capitalization) at
the end of 2016. Upon the sale of the properties, a capital gain is earned.
Generally, income from rents can be expected to increase each year. Equity
REITs are appropriate when one objective is to provide an inflation hedge.

 Mortgage REITs. Mortgage REITs are similar to bond mutual funds, and
make up approximately 5.75% of the REIT market. No ownership interest in
the underlying real estate property exists. Instead, the fund invests in

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mortgages used by equity owners of the real estate properties to finance their
acquisition of the properties. Mortgage REITs may also invest in GNMA
pools or other mortgage-backed securities. They generally do not participate
in capital gains on the sale of real estate properties, but their income is higher
than that of equity REITs. Mortgage REITs do not provide inflation
protection.

Investing in REITs requires a good understanding of the nature of the business


that a particular REIT engages in. Certain REITs may be more appropriate than
others at given points of the economic cycle. Also, the geographic location of the
REIT’s investments may have a bearing on the investment decision given the
economic climate in that area of the country. There are several different
subsectors of REITs that are available for investment, as shown in the following
table, which also indicates the percentage of total REITs that subsector occupies
by equity market capitalization.

Table 4: REIT Subsectors and Percent of Total at December 31, 2016

Percent of Percent
Total REIT Subsector of Total REIT Subsector
10.9% Apartments 5.8% Mortgage REITs

9.7% Healthcare properties 4.9% Lodging/resorts

9.8% Office buildings 6.1% Industrial facilities

7.0% Shopping centers 5.2% Data centers

9.6% Regional malls 3.4% Free-standing retail

5.7% Self-storage 1.2% Manufactured homes

5.8% Diversified properties 2.7% Timber

4.2% Specialty/other 8.0% Infrastructure


Source: National Association of Real Estate Investment Trusts, REITWatch January 2017

The specialty properties are intriguing because REITs that fall in this category
often are below the radar of many of the typical REIT investors. These REITs
may include such investments as land and timber or diversified property
investing. This category may contain REITs that are not subject to the same

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economic influences that other REITs are at given points in the economic cycle.
Consequently, they may make excellent portfolio diversifiers when other types of
REITs are not in favor.

Factors to Consider in Selecting REITs


The first question asked should always be related to the needs of the investor.
REITs can be justified on many investor need factors, including the need for a
high level of income, diversification benefits, and portfolio risk reduction due to
low correlations with financial assets (stocks and bonds).

Since publicly traded REITs are purchased on one of the organized stock
exchanges, their acquisition costs are relatively modest compared to direct
investment in real estate. Commission costs and spreads are similar to other
stocks purchased on one of the same exchanges.

When investors need a higher level of income than is possible through fixed
income investments, REITs may be appropriate. There are times in an economic
cycle when equity REIT income may be substantially higher than the income level
on bonds and other fixed-income investments. Mortgage REIT income may be
even higher than the income level of an equity REIT.

Correlation with Portfolio


Since the underlying investment in an equity REIT is real estate, REIT shares can
lower the risk level of a portfolio because generally there is a low correlation of
real estate with stocks and bonds. The long-term correlation between the FTSE
NAREIT Equity index and the S&P 500 index (from October 1982 to October
2012) was just 0.57. But correlations do change over time, and you have to be
careful with correlations, especially over short periods of time, such as one year.
For example, in 2008 the S&P 500 declined 37%, and the average total return for
all publicly traded REITs in 2008 was a decline of 37.3%. So in 2008 REITs
moved in step with the stock market—the correlation was very high.

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More recently, the NAREIT Equity REIT Index has demonstrated a correlation
of 0.79% to the S&P 500 Index for the 10 years ending June 30, 2017 (J.P.
Morgan Asset Management Guide to the Markets).

Inflation Hedge
Particularly in periods of high inflation, equity REITs can provide an excellent
inflation hedge. The opposite may be true of shares of a mortgage REIT, since
fixed income investments generally fall in price when inflation rises.

Diversification
In equity REITs, diversification concerning the type of property (commercial,
industrial, residential) and location (West Coast, East Coast, the South, etc.) is
important. Some REITs diversify within the fund; others are specialized. Before
purchase, the investor should determine the extent to which the fund does diversify.
If the fund specializes, then several funds with different properties and locations
may have to be purchased. Lists of various REIT mutual funds, closed-end funds,
and ETFs can be found at www.reit.com.

Global Reach

The United States is the largest real estate market, but real estate is global and more
investment opportunities are becoming available internationally. More than 30
other countries now have REIT legislation, and other countries are exploring it.
There is a comprehensive index for the global listed property market, which was
created jointly by the FTSE group index provider NAREIT (National Association
of Real Estate Investment Trusts) and EPRA (European Public Real Estate
Association). (Note: FTSE was originally started as a joint venture between the
Financial Times and the London Stock Exchange.)

The FTSE EPRA/NAREIT Developed Market Real Estate Index tracks the global
real estate markets (“FFR” is an ETF that tracks this index). There is also an ETF
offered by iShares that invests only in non-U.S. REITs, the iShares International
Developed Real Estate ETF (ticker symbol is IFGL; information available at

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www.iShares.com). Global real estate investment opportunities will continue to
grow along with the global economy.

Investment Management Philosophy

Consideration of management philosophy is important when considering


individual REITs, especially regarding the types of properties and locations in
which management typically invests, the degree of leverage they use, the limits
on investment in one type of property, their real estate experience, and the degree
to which management prefers to invest for income or capital gain.

Most of the same analytical factors that apply to stocks and bonds apply to REIT
analysis. Cash flow, historical performance in various types of markets and
business cycles, management tenure, purchase and sales discipline, and expense
ratios are among the other factors that should be considered.

REITs as an Asset Class

REITs are considered by many to be another asset class. Clearly, real estate
should be considered an asset class (or at least part of the alternative assets class),
just as stocks and bonds are asset classes. REITs are not pure real estate, in that
they have been securitized. In some respects, they may behave more like a stock
than like real estate.

If an investor has the time, knowledge, temperament, and money to invest in real
estate directly, then he or she should probably do so. Few investors have these
tangible and intangible resources to the extent required to successfully invest
directly in real estate. In addition, few investors meet the financial requirements
needed to invest in real estate through limited partnerships.

Therefore, REITs may be the only way that the vast majority of investors can
invest in real estate other than through home ownership. Even though a REIT
may act more like a stock than a direct real estate investment, the underlying
assets are real estate properties. Because a REIT is required to pass through
almost all of its taxable income, investors are in a position similar to that of direct

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real estate investors. In the long run, they should be compensated for the results
of the underlying real estate investments, even though, in the short run, they may
see their REIT investments fluctuate more like a stock fund.

The practical answer to the question above is that REITs, at a minimum, should
be considered as a critical element of a separate asset class—alternative
investments—and not just as another sector fund category. Real estate does have
a long-term low correlation with financial assets; other sector investments may
also have low correlations with other financial assets in the short term, but their long-
term correlations are relatively high with other financial assets. REITs should be
included in a client’s asset allocation decision if the client is not otherwise heavily
invested in real estate directly. Investors need to realize, though, that real estate, just
like any asset class, has risks and will go through cycles.

Total returns for the overall REIT markets have been impressive over time. The
compound annual return percentages for REITs compared with various
benchmarks from July 1997 to July 2017 are as follows:

Figure 1: Total Returns, REITs vs. Other Investments, July 1997-July 2017

15.00%

10.00%

5.00%

0.00%
FTSE NAREIT All Equity REITs NASDAQ Composite
FTSE NAREIT All REITs Russell 2000 Value
DJ US Total Stock Market S&P 500
S&P Utilities Russell 2000 Growth
Domestic Hi-Yield ML Corp/Govt

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The National Association of Real Estate Investment Trusts (www.reit.com)
publishes a free monthly report, “REITWatch,” which is available online. It is a
comprehensive report that contains the latest statistics concerning REITs,
including comparative charts and a correlation table comparing the FTSE
NAREIT Equity index with various other benchmarks.

Income Property Valuation


Computing the value of a real estate property is an important element in
investment decision making. Unless the intrinsic value of an investment is
known, investors have no way of knowing if they are paying a fair value for the
investment or if they are overpaying.

Investment properties generally are valued using two approaches. One approach
considers the value of a property to be a function of the asset’s ability to earn a
return on investment that is equal to, or superior to, those of other similar
investments. Another approach considers how much similar investment assets
have sold for recently. This section discusses those two approaches to the
valuation of investment real estate.

NOI Capitalization Approach


Income properties include residential rental, commercial, and industrial
properties. The valuation of these properties is similar to the methods used to
value securities, such as the dividend discount model, which is used to calculate
the intrinsic value of a stock. In that approach, next year’s estimated dividend is
divided by a capitalization rate (the spread between the required return k and the
dividend growth rate g). The intrinsic value of a real estate property can be
computed in a similar way by dividing the property’s net operating income by a
capitalization rate.

Net operating income computation. Net operating income for a real estate
property is computed as follows:

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Gross rental receipts (GRR)
+ Nonrental income (laundry, etc.)
= Potential gross income (PGI)
− Vacancy and collection losses
= Effective gross income (EGI)
− Operating expenses
= Net operating income (NOI)

The objective of this analysis is to arrive at a “stabilized” NOI. Therefore,


unusual and infrequently occurring income and expenses are smoothed out by
estimating their average annual impact over several years. The stabilized NOI, as
computed, may or may not equal the most recent year’s actual NOI.

“Gross rental receipts” is an estimate of the total gross rental receipts that can be
expected if the property is 100% occupied for the entire 12-month period.
Vacancies are not considered in this figure. “Nonrental income” generally will be
relatively small compared to gross rental receipts. Vending machine income,
garage rental, and similar receipts are included. “Vacancy and collection losses”
may be computed using an average percentage of gross rental receipts (PGI) over
the past several years or by estimating an expected future percentage if the past
percentage is unusually high or low due to economic conditions.

“Operating expenses” include only the cash expenses of the real estate property
itself. Depreciation and amortization expenses are not included in operating
expenses. Also not included is debt service (interest expense) on mortgages on
the property. Property financing is a financing decision, not an operating
decision. An owner’s decision to employ a high percentage of mortgage debt
relative to value during an economic recession (a time when rents fall, rent
concessions are made, and vacancies are high) could cause a property to be
repossessed by the lender. Without that debt, the property might have had a
positive cash flow from operations. The focus of operating expenses is on the
property’s cash flow, not on the investor’s cash flow.

Other than normal cash operating expenses such as taxes, maintenance, utilities,
management fees, and so forth, an allowance should be added to each year’s

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operating expenses to allow for periodic replacement of improvements such as
new stoves, air conditioners, and other items.

Capitalization rate. Once NOI has been computed, it must be divided by a


capitalization rate to arrive at a property’s intrinsic value. Choosing an
appropriate cap rate is subjective, and the buyer prefers to use a higher rate than
the seller.

The appropriate cap rate is a function of many factors, including the type,
location, and age of the property; the quality of the property’s tenants; and the
stability of the NOI and its components. The more stable the factors, the lower
the cap rate; the more speculative the factors, the higher the cap rate. In general,
the cap rate for a particular property can be approximated by examining the
implied cap rates of recent sales of comparable properties. This overall cap rate
can then be adjusted for differences in the factors between the subject property
and the comparable properties.

A second way to consider the cap rate is with the same process used to determine
a required return for stocks. A real return is added to an inflation estimate; a risk
premium is then added to this sum to account for the factors identified in the
previous paragraph; finally, a recapture premium is added. This last factor differs
from the method used for stocks. It accounts for the fact that real estate assets
(other than land) depreciate over time. At some point, the building will be so
obsolete that it is destroyed and replaced by a new one. You will not be asked to
develop a cap rate in this course, but you should understand what it is used for.

Gross Income Multiplier (GIM) Approach


Another valuation method for income properties is the gross income multiplier
approach. This involves multiplying either the gross rental receipts, the potential
gross income, or the effective gross income by a multiplier. The multiplier is
determined by comparing the multipliers used for recent comparable sales of
similar properties. This approach is similar to the price/sales ratio used to
compute the value of a stock when the company has no dividends or earnings.

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Before applying the multiplier, the analyst should be certain which of the three
revenue numbers from comparable properties is used to determine the multiplier.

Once the multiplier for comparable properties is determined, those multipliers are
averaged together and the result is applied to the income estimate (either gross
income, potential gross income, or effective gross income) of the property being
considered for purchase to estimate the value of the property.

Examples

Example 1: NOI Capitalization Approach

The following information pertains to Seven Oaks Apartments.

Gross rental receipts $150,000


Other income (laundry, parking, etc.) $3,000
Average vacancy rate 8%
Operating expenses $48,000
Mortgage loan payments $120,000
Depreciation expense $15,000

Calculate the property’s net operating income based on this information.

Answer:

$150,000 Gross rents (GRR)


+ 3,000 Other income
= $153,000 Potential gross income (PGI)
− 12,240 Vacancy and collection losses (8% of PGI)
= $140,760 Effective gross income
− 48,000 Operating expenses

= $ 92,760 Net operating income (NOI)

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Example 2: NOI Capitalization Approach

The following information pertains to Aspen Leaf Apartments.

Aspen Leaf Apartments is a 25-unit apartment complex: 15 one-bedroom


apartments and 10 two-bedroom apartments, renting for $350 and $450 per
month, respectively.

Other income $1,000 per year


Vacancy and collection losses 7% of potential gross
income (PGI)
OPERATING EXPENSES:
Property taxes $12,000
Property insurance $3,000
Management fee $5,200
Utilities $9,800
Accounting/legal $2,000
Advertising/license $2,500
Repairs and maintenance $7,500
Snow removal/security $1,500
Miscellaneous $750

No major repairs are expected over the next five years. Potential gross income
will increase by 4% annually. Vacancy and collection losses will remain at 7% of
PGI. Operating expenses will average 35% of PGI.

The cost of the project is $700,000. Land is valued at $100,000, and


improvements are valued at $600,000.

A mortgage of $550,000 is available at 11% for 30 years (annual payments),


fully amortized.

Improvements will be depreciated using the straight-line method over 27.5 years.
Assume the property is purchased on January 1 of the current year, allowing a
full year’s depreciation in year 1. The investor’s marginal tax bracket is 28%.

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The investor has an after-tax required rate of return of 12% and expects to sell
the property at the end of five years for $850,000, incurring selling costs of
$25,000.

Calculate the net operating income for Aspen Leaf Apartments.

Answer:

Gross rental income $117,000


Other income 1,000
Potential gross income $118,000
Less vacancy and collection losses (8,260)
Effective gross income $109,740
Less operating expenses (44,250)
Net operating income $ 65,490

Example 3: NOI Capitalization Approach

If the cap rate for determining the value of Aspen Leaf Apartments (in the
previous example) is 9%, did the investor make a good purchase?

Answer:

NOI $65,490
V= = = $727,667
Cap rate .09

The investor paid $700,000 for a property valued at $727,000. The cost was
approximately equal to the computed fair market value. The investor did not
overpay for the property.

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Example 4: Gross Income Multiplier (GIM) Approach

Based on the following information, calculate the gross income multiplier for the
two properties.

Comparable 1: 20 units @ $500 per month


Sales price = $1,026,000
Comparable 2: 30 units @ $525 per month
Sales price = $1,669,815

Answer:

Comparable 1: 20 × $500 × 12 = $120,000

$1,026,000 ÷ $120,000 = 8.55 times (GIM)

Comparable 2: 30 × $525 × 12 = $189,000

$1,669,815 ÷ $189,000 = 8.84 times (GIM)

Example 5: Gross Income Multiplier (GIM) Approach

Based on the calculations you did for the first two properties in Example 4, what
is the estimated value of a third property, Castle Oaks Apartments, which has 25
units that rent for $550 per month?

Answer:

Comparable 1: $1,026,000 ÷ $120,000 = 8.55 times (GIM)

Comparable 2: $1,669,815 ÷ $189,000 = 8.84 times (GIM)

Average GIM (8.55 + 8.84)/2 = 8.70

Castle Oaks: 25 × $550 × 12 = $165,000 gross rental income

$165,000 x 8.70 = $1,435,500 estimated


value

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In real estate valuation, we compute these values using the sale of several
comparable properties in the area and using the gross income or net operating
income of the property. In each approach, information about the recent sales of
comparable properties is necessary. The gross income multiplier and the cap rate
are determined by reference to recent comparable sales.

Using the cap rate and the property’s NOI is a bit more difficult than using the gross
income multiplier approach. It is difficult to determine a property’s NOI without
knowing details about the property’s actual expenses. That information generally is
not available unless a confidentiality agreement is signed by a prospective buyer who
has demonstrated the financial ability to complete the purchase.

Information on a property’s gross income is more readily available. The number


of units in an apartment building can be obtained easily, as can the rent per unit.
The number of square feet in a commercial building, as well as the rental rate per
square foot, is also readily available.

The gross income multiplier approach can be used to obtain a reasonably quick
rough estimate of a property’s fair market value. The computed value can then be
compared with other properties’ values (provided that the properties being
analyzed are similar) to determine if the asking price is low, reasonable, or high.
Several properties under consideration can be compared in this way to determine
which ones make the first cut.

Once the list of eligible properties is narrowed down, each property’s NOI can be
computed from property financial records to determine its value based on this
more precise approach.

During a recession, a property may not have a positive NOI. The property’s value
that is computed using the gross income multiplier approach may be reasonable,
but the prospective buyer may not be able to support a negative NOI for several
years until the economy improves. Therefore, valuation measures that focus on
gross revenue should not be used by themselves. It is a property’s income after
expenses that is important to an investor.

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Nontraded REITs
Nontraded REITs are registered and regulated by the SEC, but their shares are
not listed and traded on a securities exchange. Nontraded REITs have become
very popular in the last few years because investors have been seeking higher
yields in a low interest environment. According to the Wall Street Journal,
capital inflows into nontraded REITs for 2013 were $20 billion, and in 2014 they
were about $15 billion. Results from nontraded REITs have been mixed.

Like publicly traded REITs, nontraded REITs are real estate companies that own
income-producing real estate, such as apartments, office buildings, etc. These
investments enable small investors to diversify their portfolios by owning shares
in real estate and offer a good hedge against inflation. Nontraded REITs provide
investors the same kinds of tax advantages as publicly traded REITs, but with
several unique features, which we will discuss in more detail.

Minimum Investment
There is no required minimum to invest in nontraded REITs. Some firms set their
own investment minimum. For example, Merrill Lynch offered the Jones Lang
LaSalle REIT, a nontraded REIT, in 2013, and set the minimum for investment at
$10,000, making it attractive to mass-affluent investors.

Costs/Taxation
Nontraded REITs are sold by broker-dealers. Investors typically have to pay 13%
to 15% in front-end fees, which include sales commission, management, and
administrative costs. For example, a 15% front-end fee on a $10,000 investment
means that $8,500 is going to work for you at the time of investment. These costs
can add up and erode the rate of return.

Tax treatments for investors of nontraded REITs are similar to those of publicly
traded REITs.

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Benefits
Nontraded REITs provide investors with many benefits similar to publicly traded
REITs, such as income, inflation hedging, and global reach. One unique benefit
nontraded REITs may appear to have is lower volatility. There is no daily share
price volatility because shares are repriced only 18 months after the close of an
offering period. However, it is important to realize that the underlying value of
the real estate asset will fluctuate.

Risks
Nontraded REITs face some risks similar to publicly traded REITs, such as
interest rate risk and real estate market risk. Nontraded REITs also come with
some unique risks.

Illiquidity. Most nontraded REITs are set up for a time period of 8–10 years, so
they are considered an illiquid investment. Since nontraded REITs are not traded
on a stock exchange and there is a very limited secondary market, investors
generally cannot sell their shares until a liquidity event occurs. A portion of total
outstanding shares may be redeemable annually. (See “Redemption.”) In
addition, there are redemption restrictions, so investors may not be able to get
their investment back when they need it.

Pricing. Because nontraded REITs are typically sold over a period of years
(normally referred to as the offering period) at a fixed price per share, and there
is no trading market through which shares are valued, the offering prices don’t
always reflect the true net asset value (NAV). After a period of 18 months
following the close of a nontraded REIT offering, FINRA Regulatory Notice 09-
09 triggers an updated share valuation to then be calculated at least every 18
months thereafter, until the REIT program has a liquidity event through sale,
merger, exchange listing, or an alternative strategy.

In addition, share prices of nontraded REITs can be diluted over time, either as a
result of operating losses, a decrease in the value of the underlying real estate
assets, or a sale of equity at below fair value due to redemption requests.

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Therefore, investors must make their own assessments of the true value of shares
they own.

Transparency. Lack of trading in public exchanges also creates several


transparency issues. There is no independent information about the real valuation
of share value. Some nontraded REITs do not specify any of the properties to be
purchased. Others may specify a portion of properties to be purchased. The more
investors know about properties to be purchased, the better they can assess the
nature and quality of the assets of REITs before investing.

Redemption. Only a limited number of shares may be redeemable each year.


Redemption provisions often limit annual redemption to 3%–5% of the weighted
average number of shares outstanding during the previous year. In addition, the
redemption price may be below the purchase price or current share price.

Distribution. Many investors are attracted to nontraded REITs because of the


monthly income distribution. However, distributions from nontraded REITs are
not guaranteed. Distributions are funded by cash from investor capital, rents, sale
of properties, or borrowing. Distributions can be suspended for a period of time
or halted altogether. For example, during the housing market crash in 2008, many
nontraded REITs suspended monthly distributions for a while. A REIT’s board of
directors has the full discretion to suspend distributions.

Another aspect of distribution is that the target distribution is set at a level of


approximately 100% of the earnings of the portfolio after fees. Early in the life of
the REIT, there may be substantial cash in the portfolio waiting to be deployed.
The cash creates a drag on overall returns during this time, which may result in
the REIT “over-distributing” to investors early in its life. A mature, fully invested
portfolio should have 100% of distributions covered by the operating income
generated by the portfolio.

Overleveraging. Some REITs borrow in excess of 100% of their net assets. This
level of overleveraging can place the REITs at a greater risk of default and
devaluation. Under a distressed financial situation, an overleveraged REIT may
be forced to liquidate assets at an unfavorable valuation in order to pay off debt.

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Regulatory Concerns
FINRA Investor Alert states:

Broker-dealers involved in the sale of these products to investors are required


to provide valuations within 18 months after cessation of a nontraded REIT’s
offering of shares, and they must comply with FINRA Rule 2340 and
FINRA’s Notice to Members (09-09) regarding timeliness of data supporting
account statement valuations. Nontraded REITs must also provide annual
valuation guidance for ERISA custodians to comply with IRS and
Department of Labor rules.

FINRA also points out that “during extended periods of low interest rates,
investors often seek products offering more attractive yields.” It is important that
investors not get blinded by the potential yields of nontraded REITs and
understand the liquidity trade-off when striving for more yield.

Suitability
REITs should be included in a client’s asset allocation decision if the client is not
otherwise heavily invested in real estate directly. Nontraded REITs are illiquid
investments, appropriate only for more affluent investors who do not need
liquidity from the investments for 8-12 years.

According to FINRA Investor Alert:

Nontraded REITs are rarely, if ever, suitable for short-term investors and
even long-term investors must be willing to bear the risks of illiquidity. You
should consider the front-end cost relative to the sales costs you would incur
to buy and sell other securities during the same holding period as the life of
the REIT. You may also want to consider how much share price appreciation
and distributions you will need to receive to overcome these front-end
charges.

However, the high front-end fee of nontraded REITs prompted some advisers and
firms to solicit unsophisticated and elderly investors who are not suitable for this

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product. In 2011, FINRA charged the firm David Lerner & Associates with
soliciting investors to purchase REITs without fully investigating suitability.
Advisers/brokers should be very careful when recommending nontraded REITs
to investors.

Private REITs
Private REITs, unlike nontraded REITs, are not registered with the SEC;
however, they are similar to nontraded REITs in that their shares are not listed
and traded on any exchange. They bear many risks similar to nontraded REITs.
FINRA Investor Alert issued the following warning about private REITs:

There is another type of REIT—a private REIT, or private-placement


REIT—that also does not trade on an exchange. Private REITs carry
significant risk to investors. Not only are they unlisted, making them hard to
value and trade, but they also generally are exempt from Securities Act
registration. As such, private REITs are not subject to the same disclosure
requirements as public nontraded REITs. The lack of disclosure documents
makes it extremely difficult for investors to make an informed decision about
the investment. Private REITs generally can be sold only to accredited
investors, for instance those with a net worth in excess of $1 million. As with
any private investment, it is a good idea to have the investment reviewed by
an investment professional who understands the product and can offer
impartial advice.

Private real estate investments tend to use one of three investment strategies:
core, value-added, or opportunistic.

Core Properties

Investing in core properties is the most conservative strategy of the three private
real estate strategies. Core property investments are more liquid, less leveraged,
and contain more standard type properties, such as office buildings and
apartments, than will be found in the other two strategies. This means that core
properties have lower returns, but also lower risk. Core properties tend to be held

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for long periods of time in order to take full advantage of the cash flows from
rents and leases. Since very little leverage is usually applied, most of the return
comes from income and not capital appreciation.

Examples of core properties include high occupancy offices, apartments, retail,


and industrial property types.

Value-Added Properties

Value-added properties enter the moderate risk and return category. Types of
properties can include hotels, outlet malls, assisted care living, low-income
housing, and hospitals. A typical strategy will be to buy a property, make
strategic improvements, and then sell the property. Since this involves finding
value with an eye toward improvements, this part of the market tends to require
specialization. For example, a particular manager may specialize in value-added
investments in outlet malls. When compared with core properties, value-added
properties tend to use more leverage and generate less income, relying more on
capital appreciation.

Examples of value-added properties could include a strip mall that needs a


facelift to bring back customers, or a new strip mall that could ultimately become
a core property but is not fully leased. Value-added investors look for
inefficiencies in how a particular property is being managed, or they see
unrealized opportunities to improve a property that could lead to increased
occupancy rates. There may also be opportunities in various emerging real estate
markets—markets that are not as established as you will find in core properties.

Opportunistic Properties

Opportunistic properties are considered to be the most aggressive and highest


risk of the three approaches, and investors primarily strive for capital
appreciation. Volatility is a concern with this category since there can be a high
degree of leverage and development and leasing risk. The majority of returns
typically come from capital appreciation over a three-to-five-year period. A way
to access this market is through a private equity real estate (PERE) fund.

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Types of opportunistic property include speculative developments for sale or
rent, or undeveloped land. International real estate is even a possibility.

The National Council of Real Estate Investment Fiduciaries (NCREIF) has


created style boxes that reflect these three approaches, so there are benchmarks
against which each category can be measured. Table 5 provides a summary of the
three approaches.

Table 5: Types of Private Real Estate Funds

Core Value-Added Opportunistic


Leverage low medium high

Turnover low moderate high

Investment time 8 to 12 years 4 to 8 years 3 to 5 years


horizon*

Volatility low moderate high

Income/cap mostly income both mostly cap


appreciation appreciation

Target total returns 9%–10% 10%–13% greater than 13%


*Time horizons for funds can vary greatly

Regulatory Concerns
A private real estate fund qualifies as a “private placement,” so the fund cannot
engage in general solicitation and advertising. Within 15 days of the receipt of
the first subscription for investment, the fund sponsor must electronically file a
form under Regulation D summarizing some key data about the fund and the
offering.

Costs/Taxation
Like any other investment, there are fees associated with private real estate funds.

Fund set-up costs. This is a straightforward fee, where the costs of setting up and
structuring the fund are paid by the investors.

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Management fee. This fee is designed to cover the day-to-day costs of investing,
managing, and eventually selling real estate properties. It is charged as a certain
percentage on commitments to the funds. The level and basis of a management
fee varies among funds. For example, some core funds may charge 1.5% on net
asset value (NAV).

Transaction fee. This is to cover the transaction cost of either acquisition or


disposition of real estate properties.

Performance fee. Like hedge funds, real estate funds also have a hurdle rate,
normally between 8%–11%. Once the fund’s return is over and above the hurdle
rate, the performance fee will kick in. Typically, a fund sponsor may get 20% of
profits over a hurdle rate.

Catch-up fee. This fee is more popular in the opportunity fund sector. For
example, a catch-up split of 50/50 means that once a fund’s return is over and
above the hurdle rate, for every dollar of profit over and above the hurdle rate,
50% will go to the fund sponsor and 50% will go to the investors.

Taxation. Most private real estate funds are structured as partnerships because of
the tax benefits associated with pass-through entities. There is no federal income
tax at the entity level. If the fund’s partners are individuals and the portfolio
investment has been held for more than one year, individual partners will pay
long-term capital gain tax for any gains they receive.

For institutional investors, there are no federal income taxes at the limited partner
level if the equity owners are tax-exempt organizations and they receive passive
income sources such as interest, dividends, capital gains, rents, etc. However, if
the tax-exempt organization receives any unrelated business taxable income
(UBTI), such as “debt-financed” income from borrowing money to finance the
purchase of an investment, then they are subject to federal income taxes. Funds
organized as corporations would pay federal income taxes on capital gains at the
applicable corporate tax rate, followed by taxation at the shareholder level upon
the distribution of the net gains as a dividend.

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Individuals, as well institutional investors, should consult tax experts and fully
understand all tax consequences before engaging in any investment of any
private real estate fund.

Risks/Suitability
Private real estate funds are not listed and traded on any exchange, which makes
them hard to value and trade. They are exempt from SEC registration, so they are
not subject to the same disclosure requirements as public REITs.

Private real estate funds share many similar risks with nontraded and private
REITs, such as illiquidity, lack of transparency, etc. These funds carry significant
risks to investors and can be sold only to accredited investors—individuals
having a net worth of at least $1 million (excluding the primary residence) or a
regular annual income of at least $200,000 ($300,000 when combined with a
spouse), business organizations that have total assets of at least $5 million, and
other less common qualifications involving trusts, benefit plans, and executive
officers and directors of the fund (i.e., those with a net worth in excess of
$1 million).

As we have seen, there are numerous ways in which investors can invest in real
estate, both publicly and privately. Generally, most investors are best advised to
start with publicly traded funds, such as REITs, and should only consider private
equity investments if they have sufficient net worth, diversification already in
place, and they understand the risks associated with these investments.

Summary
Real assets frequently have a low correlation with financial assets, making their
inclusion in a portfolio good for portfolio diversification.

Investors tend to be familiar with real estate because many own a personal residence.
Yet investment real estate is more complex than many believe. As a consequence of
the high cost and inherent illiquidity of investing in real estate, real estate limited
partnerships and REITs were devised. As a result, many investors are now able to
invest in real estate with relatively modest amounts of money and with a high degree

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of liquidity. There are also less liquid ways to invest in real estate, namely nontraded
and private REITs.

Valuation of real estate is as important as valuation of other securities.


Techniques for determining the intrinsic value of a real estate property have been
devised to enable investors to make decisions about the overvaluation and
undervaluation of specific real estate properties. Know how to calculate potential
gross income (PGI), net operating income (NOI), and intrinsic value as it relates
to investing in real estate.

Chapter 2 Review
1. What are some of the major disadvantages of investing directly in real estate?
Go to answer.
2. Identify factors that affect the cash flow projections and the valuation of a
real estate investment.
Go to answer.

3. The following information pertains to Spacious and Gracious Apartments.

Gross rental receipts $750,000


Other income (laundry, parking, etc.) $22,000
Average vacancy rate 6% of PGI
Operating expenses $210,000
Mortgage loan payments $362,000
Depreciation expense $131,000
Cap rate 12%

a. Calculate the property’s net operating income based on this information.


Go to answer.
b. Calculate the property’s value.
Go to answer.

4. What are some of the risks and regulatory concerns regarding nontraded and
private REITs, and private real estate funds?
Go to answer.

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Chapter 3: Hedge Funds

J
ust about everyone has heard the term hedge fund, but many do not know
what hedge funds are or how they are structured. This is not unusual or
unexpected since there are numerous types of hedge funds, and hedge fund
managers can invest in just about any manner they desire.

The term “hedge fund” is said to have originated in 1949 when Alfred Winslow
Jones combined a leveraged long stock position with a portfolio of short stock
positions. Jones also had some sort of incentive fee structure in place. The word
“hedge” suggests some sort of offsetting position, as was the case with Jones, and
this can be how hedge funds are put together. However, there are numerous
variations of hedge fund construction, and you can even have a hedge fund that
has only long positions, which means there is no hedging going on at all.

What is a hedge fund?


BlackRock defines a hedge fund as the following:

 Hedge funds are private pools of investment capital with flexibility to buy or
sell a wide range of assets.

 They seek to profit from market inefficiencies, rather than relying purely on
economic growth to drive returns.

 There is no “one-size-fits-all,” and the types of investment strategies pursued


by individual hedge funds are extremely diverse.

Hedge funds are often structured as partnerships, with the managers being the
general partners, and thereby having control over any investment decisions. Any
investors in the fund would be limited partners, meaning they could participate in
any potential growth, but do not have the control, or liability, that the general
partners have.

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According to the Chartered Alternative Investment Analyst Association (CAIA),
there are six key elements that separate hedge funds from mutual funds:

1. Hedge funds are private investment vehicles that pool the resources of
sophisticated investors.

2. Hedge funds tend to have portfolios that are more heavily concentrated than
mutual funds. They are not measured to, or tied to, a particular benchmark—
they are being measured by the return they achieve. Oftentimes, hedge funds
have very narrow and specialized investment strategies, which are not
necessarily dependent on the overall direction of the financial markets.

3. Hedge funds use derivatives extensively, something that mutual funds use
much more sparingly.

4. Hedge funds may go both long and short securities and derivatives.
Traditional mutual fund managers are tied to long-only benchmarks.

5. Hedge funds often invest in nonpublic and illiquid securities. Many bonds
are issued as 144A securities, which are often convertible and high-yield
bonds issued in a private transaction rather than a public offering.

6. Hedge funds often use leverage, and often in quite large amounts. It is not
unusual for some hedge funds to be leveraged up to 10 times their asset base
or more.

Minimum Investment and Investor


Qualifications
Since hedge funds tend to use speculative investment practices, which present
higher risks, hedge funds traditionally are only available to accredited investors
with net worth in excess of $1 million (not including the value of the primary
residence) or income in the past two years of $200,000 ($300,000 if married),
with the expectation of earning at least the same amount or more in the current
year. Hedge funds may accept no more than 500 qualified purchasers—
individuals or institutions with net worth of over $5 million.

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The hedge funds industry has experienced phenomenal growth in the last decade.
Even though hedge funds were originally created for high net worth institutions
and investors, many hedge funds are increasingly targeting less-sophisticated
investors as well. New offerings have investment minimums as low as $25,000,
compared to a traditional minimum of $250,000. Charles Schwab has introduced
a new share class for its Hedged Equity Fund, allowing investments of as little as
$2,500.

There is also a hedge fund vehicle aimed at the broader population of investors,
known as a fund of hedge funds. The fund of hedge funds will have lower
minimums and lower fees (perhaps 1% management fee and 10% incentive fee),
but these lower fees are still an additional level of expense for the investor.

However, hedge fund investors should know that they do not receive all of the
federal and state law protections that commonly apply to most mutual funds. For
example, hedge funds are not required to provide the same level of disclosure as
mutual funds, which will make it more difficult for investors to evaluate if a
hedge fund is a suitable investment for them. The general prohibitions against
securities fraud do apply to hedge funds.

Regulations
Historically, hedge funds were lightly regulated and hedge fund advisers were
not required to register with the SEC. This has changed since the 2008 economic
crisis. The regulations can be broken down into three sub-segments: heightened
regulatory oversights, adviser registration, and advertising.

Heightened Regulatory Oversights


Regulation D offerings. The Securities Act of 1933 requires any offer to sell
securities to either be registered with the SEC or meet an exemption. Reg. D
provides certain exemptions that allow some companies to offer and sell their
securities without having to register the securities with the SEC. According to the
SEC’s website, “While companies using a Reg. D (17 CFR § 230.501 et seq.)
exemption do not have to register their securities and usually do not have to file

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reports with the SEC, they must file what’s known as a ‘Form D’ after they first
sell their securities.” In 2008, the SEC adopted amendments to Form D and
requires Form D to be filed electronically. Investors who want to invest in a Reg.
D company are advised to access the EDGAR database to determine if the
company has filed a Form D.

SEC’s Division of Economic and Risk Analysis (DERA). DERA was created in
September 2009 to “integrate financial economics and rigorous data analytics
into the core mission of the SEC.” One example of DERA’s oversight is that it
launched the Aberrational Performance Inquiry in 2009 to proactively identify
atypical hedge fund performance. This led to eight enforcement actions, and is
one of the tools used by the Division of Enforcement to assess private funds.

Not all regulations are restrictive. Some regulations created opportunities for
hedge funds. The Jumpstart Our Business Startups Act (JOBS), which was
signed into law on April 5, 2012, aims for easy access to capital for startup
companies. It requires the SEC to revise existing rules and write new rules on
registration, capital formation, and disclosure requirements.

Adviser registration. The likelihood that a hedge fund manager will have to
register with the SEC is greater today than before July 2011, which is when the
Dodd-Frank Act introduced a new investment adviser provision. The provision
exempted from SEC registration any investment adviser who during the previous
12 months had fewer than 15 clients and didn’t hold himself or herself out to the
public as an investment adviser. Under Dodd-Frank, assets under management
(AUM) became the key to determine if a hedge fund adviser has to register with
the SEC. Hedge fund managers with less than $25 million of AUM may not
register with SEC; hedge fund managers with AUM of $100 million or more
MUST register with the SEC. The exception to the rule is when the AUM
between $100 million and $150 million qualifies for the Private Fund Adviser
Exemption. For details, please see “Guide to SEC Investment Adviser
Registration For Hedge Fund And Private Equity Fund Managers.”

Advertising. In the past, hedge fund advertising was very limited. FINRA Rule
03-07 gives clear guidance on the promotion of hedge funds. It states that “the
promotion of hedge funds must be balanced by a fair presentation of the risks and

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potential disadvantages of hedge fund investing.” In addition, it reminds
advertisers and their firms that “providing investors a prospectus does not satisfy
the duty to provide balanced sales materials and oral presentations.”

Recently, both the Commodity Futures Trading Commission (CFTC) and the
SEC have eased restrictions on advertising by hedge fund managers. This change
was required by the JOBS act. The objective is to increase the number of firms
participating in the general solicitation of funds. However, only a few hedge
funds are taking advantage of these more liberal marketing rules due to their
concern about other compliance requirements imposed on firms that register for
general solicitation. Thus, most hedge funds remain cautious about advertising.
There is a concern that a proliferation of advertisements may lure unsophisticated
investors into investments that they do not fully understand.

Hedge Fund Costs/Fees


Hedge funds differ from traditional mutual funds in how they charge fees. Their
fee structure is one of the main reasons why talented money managers want to
join hedge funds or start their own hedge funds.

Management fee. The management fee for a hedge fund is similar to the one
charged by a mutual fund, except a hedge fund typically charges a management
fee of 2% of assets managed—sometimes even higher if the hedge fund manager
is in high demand. In comparison, mutual funds have expense ratios averaging
1.36%.

Incentive/performance fee. Most hedge funds charge an incentive fee between


10%–20% of fund profits. For example, a hedge fund has $100 million in assets,
and this increases to $110 million. With a 10% incentive fee, the manager would
receive 10% of the $10 million increase, or $1 million. The caveat of the
incentive fee is that a hedge fund manager collects incentive fees only if the
profits exceed the fund’s previous high, which is called a high-water mark. Using
the previous example, the threshold of $110 million is the high-water mark. If
this fund loses 2% from its previous high, the manager cannot collect an
incentive fee until he or she first makes up the 2% loss.

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Hurdle rate. If there is a hurdle rate, then the fund would have to earn a certain
minimum amount before the manager is paid any sort of incentive fee. Returning
to our example, let’s say that there is a 5% hurdle rate. In that case, any amount
over the first 5% of return would be subject to the incentive fee. Since the hedge
fund in our example made $10 million on $100 million, it would be an increase
of 10%. The first 5% (or $5 million) would not be subject to any fee, and an
incentive fee would only be charged on any gain above $5 million. In this case,
that would be $5 million, and if the incentive fee was 10%, the fund manager
would earn $500,000.

Surrender fee. This fee is assessed as a percentage of the amount of redemption


requested by an investor for the cost of liquidating assets to meet the redemption.

Lookback. Lookback refunds a portion of the performance fee to investors if a


loss is taken shortly after the performance fee was assessed.

The cost of investing in hedge funds has been slowly coming down. Some newer
funds charge a management fee of 1.4% and a performance fee of 17%. Hedge
funds that are registered with the SEC may also charge some typical fees and
expenses like traditional mutual funds do, such as the 12b-1 fee. For detailed
mutual fund fees and expense reports and trends, please see the SEC’s Report of
Mutual Fund Fees and Expenses.

Risks of Investing in a Hedge Fund


Illiquidity. Most hedge funds are illiquid investments and are subject to
restrictions on redemption, transferability, and resale. Illiquidity presents
investors with at least two issues. First, it is difficult to get the true market
pricing of a particular hedge fund when there is no secondary market. There is
also no required methodology for pricing. Second, investors are restricted on the
timing, as well as pricing, of their redemptions when they can get their money
back.

Risky investment strategies. Hedge funds often use speculative investment and
trading strategies, such as leveraging. It is important to understand the use of
leverage, how leveraged the fund may become, and the limits on leverage, if any.

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Even if there are limits on leverage, it can still get out of control and bring down
a hedge fund, such as what happened to Long Term Capital Management in the
1990s. The typical scenario of overleverage consists of margin calls forcing the
firm to sell assets into an illiquid market, which forces prices down further and
weakens its net asset value. It becomes a vicious downward spiral and can wipe
out an entire investment.

Besides overleveraging, some hedge funds lack diversification in their


investment strategies. In addition, many hedge funds’ investment strategies are
tied to different mechanisms, markets, or underlying reference assets that may
not be transparent or well understood by investors.

Manager risk. Since many hedge funds are absolute return-driven and are not
necessarily tied to any benchmark, it is extremely important that the adviser or
investor has confidence in the ability of the fund manager to deliver. This means
that in addition to having a great deal of knowledge in the industry, the hedge
fund manager must have a clear vision of what he or she is doing. Getting this
information is not necessarily easy, since many managers would be happy simply
operating within a “black box” and sharing as little as possible, and may not want
others to know what they are doing lest they try to do the same thing, or figure
out ways to bet against and take advantage of them.

A good case study of manager risk is the Peloton hedge fund fallout example
(discussed in more detail later). Ron Beller, chief of Peloton Partners LLP, was
once one of the world’s best-performing hedge fund managers. He bet heavily on
the U.S. mortgage market and made an 87.6% return in 2007, but for every dollar
he invested, nine dollars were borrowed. In March 2008, he failed to fully factor
in broader risks and lost $17 billion, and Peloton Partners LLP ceased to exist.

The other kind of manager risk is when a fund is substantially dependent on the
service of one or more key individuals—the performance of the fund will suffer
in the event of the death, incapacity, departure, or withdrawal of an individual.

Headline/regulatory risks. FINRA (formerly known as NASD) issued a notice in


2003 to remind members of their obligations when selling hedge funds, including
(1) providing balanced disclosure in promotional efforts; (2) performing a

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reasonable-basis suitability determination; (3) performing a customer-specific
suitability determination; (4) supervising associated persons selling hedge funds
and funds of hedge funds; and (5) training associated persons regarding the
features, risks, and suitability of hedge funds.

Advisers and their firms who failed their obligations were not only subject to
legal consequences, but also damaged their own reputations. For example, in
2003, FINRA (NASD) fined Altegris Investments Inc. $175,000 for failing to
disclose the risks associated with hedge funds when marketing them to investors.
Some of the firm’s sales literature also contained exaggerated and unwarranted
statements about these products. Altegris chief compliance officer Robert
Amedeo was fined $20,000 for failing to adequately supervise the firm’s
advertising practices in this area.

Therefore, advisers should be very careful when recommending any hedge funds
to clients, even if clients are accredited investors. An adviser should always be
truthful and make sure clients truly understand the risks/rewards of each
investment.

Adverse tax consequences. The tax structure of hedge funds can be complex, and
sometimes there may be delays in receiving/sending tax information. Investors
may have to request extensions to file their income tax return or they may have to
file additional tax forms, such as a Schedule K-1.

Hedge Fund Strategies


There are several kinds of strategies hedge funds use, and some approaches can
be categorized. The CAIA divides hedge funds into four main categories:

1. market directional,

2. corporate restructuring,

3. convergence trading, and

4. opportunistic.

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There are various types of funds found in each of these four categories, as we
will discuss in the following sections.

Market Directional
In the market directional category there are four main types of funds: equity or
sector long/short, emerging markets, short-selling/short bias, and activist funds.

Equity (sector) long/short. This is your classic hedge fund approach, where the
fund manager goes long a core group of stocks while also being short other
stocks, and/or futures or stock index options. At any given time the fund manager
may be net long or net short. For example, in bull markets, managers tend to be
net long, and in a bear market they may be net short. Sector long/short funds are
just that—where a fund manager specializes in a particular sector of the market,
such as technology or health care. The fund manager would go long stocks in the
category he or she believes will go up more in bull markets than the stocks he or
she is short, and in bear markets the expectation would be that the short stock
positions would go down more than the long stock positions.

Emerging markets. Investing in emerging markets primarily involves long


positions, and the inefficiencies in terms of market and company information in
emerging markets may give hedge fund managers an edge if they study and get to
know the market. Specialized knowledge can be gained by having a presence in a
country and becoming an expert on various investment alternatives available
from that country. Emerging markets are more volatile than developed markets
because they are less developed and less liquid, but more risk can provide more
opportunity.

Short-selling. Short-selling hedge funds are on the opposite side of the market of
long-only funds, and obviously make money when the market goes down. Even
though these funds will be net short, they may also contain long positions.
Market timing is often used, and short positions will be increased in down
markets and lightened up when the market is going through a bull phase.

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Activist funds. This is a corporate governance approach where the fund tends to
have highly concentrated positions (5 to 15 stocks, for example), and takes a very
active role in working with the board of directors and CEO of the company. The
goal is to have influence in looking out for the shareholders’ interests, and to
make sure that the company has an effective business plan in place. If necessary,
the fund will work for the removal of the CEO. This approach has become more
popular and is used by such entities as the California State Teachers Retirement
System.

Corporate Restructuring
The next category of funds is so-called corporate restructuring funds. The funds
themselves may call these event-driven or risk arbitrage strategies, but it is
typically some sort of corporate restructuring that is occurring, such as a merger,
acquisition, or bankruptcy.

Distressed securities. As the name implies, hedge funds that invest in this area
are looking for distressed securities—securities that are trading below their
intrinsic value. Oftentimes, when companies experience financial difficulty there
can be a lack of interest or buyers for that particular company’s securities, which
provides opportunities for the hedge fund manager. Since debtholders have
priority over common stock shareholders in bankruptcies, there may be
opportunities in buying the distressed debt of a company and then benefitting
when the company reorganizes. It is not unusual for the hedge fund to be actively
involved in the bankruptcy proceedings in order to work toward the best possible
outcome for the creditors of the company, one of which would be the hedge fund.

Merger arbitrage. Hedge funds that carry out merger arbitrage are attempting to
take advantage of price disparities that can occur when one company is acquiring
another. In this case, the fund will buy the common stock of the company being
acquired and sell short the common stock of the acquiring company. Typically,
the stock of the company being acquired will sell at a discount due to the risk in
the deal. Until the deal is completed, there is typically a spread between the
prices of the two stocks, which is a reflection of the market’s uncertainty about
the deal (event risk) and the time value of money.

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Event-driven. Hedge fund managers in the event-driven space are investing
based upon anticipated outcomes of significant events that can occur during the
life cycle of companies—events such as restructurings, mergers and acquisitions,
spin-offs, reorganizations, share buybacks, special write-offs or dividends, or any
other significant market event. These tend to be special events that are
nonrecurring.

Regulation D. There are different strategies that can be employed with Reg. D
offerings, but the main advantage these funds have is that they often will be
priced lower than similar publicly traded securities. The fund can either hold the
securities outright, or short similar but more highly priced public securities
against the long position.

Convergence Trading
Convergence trading is essentially arbitrage—but not necessarily “true
arbitrage,” which is namely riskless profits. Oftentimes, a fund manager may be
long one security and short a similar, but not identical, security. There can be
credit and liquidity risk, and the timing of transactions may come into play.
Rather than thinking of these strategies as “riskless,” they are typically “low-
risk.”

Fixed-income arbitrage. There are several strategies that can be used here, and
they do not necessarily have to be that complex. For example, there are often
slight discrepancies between U.S. Treasuries that have just been issued that are
very liquid (called on-the-run Treasuries), and similar, less-liquid Treasuries that
are currently outstanding. Buying the lower-priced outstanding securities and
shorting the on-the-run securities will eventually yield a profit since both will
mature at the same price. The returns can be magnified using leverage. Fixed-
income arbitrage is buying one fixed-income investment and simultaneously
selling another similar fixed-income investment, with the expectation that the
prices will converge in the future. This strategy can be used not only with
Treasuries, but also with mortgage-backed securities, foreign debt, and municipal
and corporate bonds.

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Convertible bond arbitrage. Convertible bonds are essentially a bond and an
equity call option, enabling the bond owner to buy the company stock at a certain
price (this is referred to as an “embedded option”). Hedge fund managers who do
convertible bond arbitrage typically buy the convertible bonds, and then hedge by
selling the underlying stock or selling options on the stock. Managers make their
money by looking for pricing discrepancies among the bond, its conversion
value, and the current value of the company’s stock. As with fixed-income
arbitrage, leverage can magnify the returns and losses.

Equity market-neutral. As the name implies, market-neutral funds go long and


short the market. The goal is to completely neutralize the market and industry
risk, and concentrate solely on stock selection. One way to think of it is that there
is no beta risk in the portfolio—all that is left is alpha, reflecting the stock
selection. Using bottom-up analysis, the fund manager will use models in order
to come up with stocks to select. Since these returns are market-neutral, we
would expect the returns to be independent of the overall market direction. The
potential total return is the spread between long and short position pairs. Some
funds may use leverage to enhance returns.

Relative value arbitrage. Relative value arbitrage is wide open, and these funds
can invest in a variety of arbitrage strategies, including those we have just
covered. The term relative value arbitrage comes from the fact that the fund
manager is comparing one security and seeing how cheap or expensive it may be
compared to a second security. Relative value arbitrage is not betting on the
direction of the market, but rather what will happen with the pricing between two
securities. One variation of this is stub trading, which is taking advantage of
underpricing when one company acquires a majority stake in another company.
After the acquisition, the acquiring company’s stock may not fully reflect the
value of the acquisition. If this is the case, then the fund manager would purchase
the acquiring company’s stock and sell the appropriate ratio of the acquired
company’s stock.

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Opportunistic Trading
Finally, we are going to take a look at opportunistic funds. These include global
macro funds and funds of funds (FOFs).

Global macro funds. Global macro funds are just what their name implies—
these are funds that take the “big picture” macroeconomic approach to investing.
These are top-down managers who look for opportunities wherever they may
be—in different countries and markets by factors such as global economy,
government policies, interest rates, inflation, and market trends. These funds are
not restricted by asset class. A good example of a global macro hedge fund
manager is George Soros, who made an extremely successful and profitable bet
against the British pound in 1992. These funds tend to be large, as they require a
good amount of capital to carry out their strategies, and since they are large they
receive a lot of attention relative to the other types of hedge funds.

Funds of funds. Hedge fund of funds managers invest in other hedge funds.
These may offer investors access to hedge funds that are closed to new investors.
Funds of funds is a tactical asset allocation approach, trying to be in whatever
parts of the hedge fund universe are doing best at any given time. In theory this
may sound good, but there are two major obstacles to overcome. First, the
manager has to be good at picking which funds are best to be in at any given
time. Second, there is an extra layer of fees the investor has to pay, on top of the
typical hedge fund 2% management fee and 20% of any new profits (per our
discussion earlier under “Hedge Fund Costs/Fees”). On top of these fees, the
fund of funds charges its own investment management and performance fee. A
common FOF fee structure is a 1% management fee and 10% of new profits.
There can also be a selling commission and redemption fee.

In addition to management and incentive fees, there can also be lock-up periods
and liquidity constraints. Mutual funds offer daily liquidity, whereas hedge funds
typically offer monthly or quarterly liquidity. There can also be lock-up periods
where all or some of the funds are not available, sometimes for years. For
example, some hedge funds set up “side pockets” for illiquid assets. One can see

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that hedge funds, and hedge funds of funds, are not cheap and have limited
liquidity.

Hedge Fund Collapse Example


Investors often hear about some hedge fund managers who have done
extraordinarily well, but it is a difficult and competitive business, and it is hard to
stay on top. Let’s take a look at the rise and fall of a hedge fund—the Peloton
fund.

The Peloton hedge fund collapse is an example of a collapse due to excessive


leverage and being on the wrong side of the trade. Hedge fund collapses tend to
fall into two categories: excessive leverage with unexpected events occurring (as
was the case with the case with the Peloton fund), or fraud, as was the case with
Bernie Madoff.

Peloton was founded in 2005 by former Goldman Sachs stars Geoff Grant and
Ron Beller. They made stellar returns in 2007, earning their fundholders an
87.6% return by engaging in mortgage-backed securities arbitrage. The fund
bought the most senior AAA-rated securities, and shorted the riskiest securities,
those rated BBB or below. The bet was that the riskier part of the market would
decline more in value than the higher-rated tranches (the word “tranche” is
French for “slice,” and different tranches are created with different levels of risk).
This worked spectacularly well in 2007, earning high returns for investors and
also for Grant and Beller. Of the 20 awards handed out at the EuroHedge Awards
in early 2008, two of them went to Peloton, including the top award for new fund
of the year for non-equity strategies. However, just five weeks after winning this
honor, the fund had to suspend redemptions, and quickly went into a death spiral,
losing $17 billion within a matter of days. Not only had the spreads that worked
so well in 2007 now turned against them, but a change in strategy also
accelerated their demise. The fact that the fund had more in long positions ($16
billion) versus short positions ($3.2 billion) did not help as the mortgage-backed
securities and housing markets began to erode. The fund went under in March
2008, a harbinger of worse things to come in the mortgage-backed securities
markets that year.

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In hindsight, there were a couple of red flags with Peloton. First, a fund does not
achieve an 87.6% return in one year without taking on a lot of risk, which in this
case was the use of too much leverage, and they still could not meet their margin
calls once they started receiving them in February 2008. A fund that can go up so
dramatically can also come down in the same fashion. Second, the fund was not a
true arbitrage fund at the time of its demise in that the size of its long positions
greatly outweighed its short positions. In effect, the fund was betting that the
worst was over as far as the housing crisis was concerned, which turned out not
to be the case. There is a big difference between a true arbitrage fund, which does
not take outright speculative positions, and a speculative or long fund, which
does.

Anyone doing due diligence on this fund prior to its collapse would have been
well served to ask the following questions:

1. Why have you changed your arbitrage strategy and taken a net long position?

2. How were you able to achieve such a high return in just one year (i.e., how
much risk, such as use of leverage, is being taken to achieve such returns)?

3. What impact will the mortgage-backed securities market becoming less


liquid have on how you invest in your fund?

These three questions would have gone a long way toward seeing the potential
flaws and risks in the Peloton fund. Being highly leveraged meant that as the
value of their investments fell, banks began requiring more collateral. Peloton
had about $10 billion in outstanding positions, but only $2 billion in assets. This
was an unsustainable situation, especially given that there was a move by banks
at this time to tighten margin requirements for hedge funds.

Possible solutions that could have been taken by the fund to avoid this crisis are
fairly straightforward. First, the fund should have continued to do true arbitrage
and not have any net long (or short) positions. The fund was losing money on this
arbitrage, but not to the extent they were on the long position. Also, as illiquidity
increased, the fund managers should have made sure that the amount of leverage
and debt that was being used decreased—this would have meant unwinding some

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of the positions, which would have helped avoid getting squeezed by the fund’s
prime brokers and lenders. Also, the managers should not have become
complacent just because they were coming off of a great year; they should have
remained focused on their strategy and on proper risk management.

Instead of taking responsibility for their actions, Grant and Beller seemed more
inclined to blame others rather than themselves. At the end of February 2008,
they sent a letter out to their clients, which stated, among other things, “…
because of their own well-publicized issues, credit providers have been severely
tightening terms without regard to the creditworthiness or track record of
individual firms, which has compounded our difficulties and made it impossible
to meet margin calls.” In other words, they were in trouble, up to their eyeballs in
debt, and were complaining that the banks would not lend them even more
money. As for a track record, the fund was only started in 2005, so there was no
long-term track record.

According to Janet Tavaloki, a derivative consultant for institutions and


investors, what happened to Peloton could have been avoided. She does not
believe that the company did its homework, and that the managers decided to go
long the mortgage-backed securities based upon historical trends and not
fundamental analysis of what went wrong. If they had done their analysis they
would have found that the assets were still overpriced and overrated. As Tavaloki
points out, “When they were making money, they weren’t clear why they were
making money.” Changing horses midrace ultimately did not work out for
Peloton.

As is often the case, the fund managers picked up and moved on, even if their
investors did not. Both Grant and Beller went on to start new hedge funds.

Summary
Hedge funds are often referred to as absolute return products, since they are not
tied to any bond or stock index for comparison. They tend to have a low
correlation to traditional asset classes, which can make them a good diversifier.
They can have lower reported standard deviation than the overall market, but one

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has to be careful. Publicly traded securities trade whenever the market is open,
and compiling stats on standard deviation is easy. Hedge funds are more
problematic because they tend to not trade as much, since the assets within the
fund itself may have limited marketability and liquidity. This can give the
illusion of risk being lower than it really is.

Chapter 3 Review
1. What are the six key elements that separate hedge funds from mutual funds?
Go to answer.

2. What are some of the typical fees that a potential investor in a hedge fund
should be aware of?
Go to answer.
3. What are some of the major risks to consider when investing in a hedge
fund?
Go to answer.
4. Briefly describe the four main hedge fund strategies.
Go to answer.

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Chapter 4: Private Equity and
Managed Futures

P
rivate equity is a general term that refers to distinct strategies that deal
with nonpublicly traded investments. These strategies include the
following:

 venture capital (VC),

 leveraged buyouts (LBOs),

 mezzanine financing, and

 distressed debt.

Private equity is usually structured as a partnership. To understand private equity,


it is important to understand a few key concepts:

Limited partners. They are institutional or high net worth investors interested in
receiving the income and capital gains. Money that is committed to private equity
funds by limited partners is called committed capital. Typically, committed
capital is not invested immediately. Drawdowns, or capital calls, are issued to
limited partners when an investment opportunity is identified and a portfolio of
the committed capital is needed. Paid-in capital is the cumulative amount of
capital that has been drawn down.

General partners. They are responsible for actively managing the investment
within the private equity fund. Like hedge fund managers, the general partners of
private equity funds earn a management fee and carried interest (a percentage of
the fund’s profits).

Performance. When an investor is considering whether to invest in a private


equity fund, it is important for him or her to know the amount and timing of cash
and stock that has been paid out to limited partners (aka cumulative distribution).

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The remaining market value that the limited partners have in the fund is called
residual value. The investment multiple is calculated as follows:

(Cumulative distributions +Residual value)


Investment multiple =
Paid-in capital

The investment multiple gives a potential investor insights into the fund’s
performance. In addition, the fund’s internal rate of return (IRR) should also give
potential investors an idea of the fund’s performance.

As with hedge funds, private equity historically targets qualified purchasers,


defined as individuals who have $5 million of investments or institutions that
have $25 million. However, private equity funds have been lowering the initial
investments so they can reach out to mass affluent investors. For example, the
Altegris KKR Private Equity Master Fund will accept initial investments of as
little as $10,000, and it targets investors with a net worth exceeding $1 million,
excluding their principal residence. As was the case with hedge funds, as private
equity minimums have come down so have the overall returns.

Venture Capital
Venture capital is probably the most well-known type of private equity investing
in startup companies that the managers feel show great promise. This is a risky
area in that many of the companies are trying unproven ideas, and profitability
may be years away. Negative cash flows are not unusual, and this makes it
difficult for startups to get financing from a bank. This is where the venture
capitalist steps in and provides financing. The goal is to develop a successful
business that can generate sizable profit to attract either public investment capital
(typically via an initial public offering, or IPO) or sell the startup to other
companies. Since three out of four startups fail and don’t return investors’
capital, venture capital investments are considered high-risk investments.
Therefore, the target return for venture capital is quite high, often 30% or more.

Since venture capital sells interests in private, not public, offerings, it is exempt
from SEC registration under the Securities Act of 1933. Venture capital offerings

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typically are restricted to a small number of accredited Reg. D investors. Venture
capital investors include institutional investors (such as pension funds), insurance
companies, endowments, foundations, family offices, and high net worth
individuals. It is not a suitable investment for small investors. The investors who
invest in venture capital funds are limited partners. Venture capitalists, who
manage the fund, are general partners. The general partners have a fiduciary
responsibility to their limited partners. Venture capital can also be structured as
limited liability companies (LLCs), corporate venture funds, and venture capital
funds of funds.

Venture capital has seen its ups and downs over the past couple of decades. In the
first half of the 1990s venture capital commitments ranged from $5 billion to
$7 billion. Starting in 1996 there was exponential growth, and the annual growth
rate between 1995 and 2000 was 82%. In 2000, the amount invested in venture
capital peaked at over $100 billion. There was a rapid decline in venture capital
after the bursting of the technology bubble in 2000, and it began to recover but
was again impacted by the market meltdown in 2008. Since 2008, the stock
market and venture capital funds have been improving. Generally, venture capital
funds do best when the public stock market is doing well. When the stock market
is weak, venture capital funds also tend to be weak.

Cost/Fees
Organizational expenses. Every investor in a venture capital fund pays a pro rata
share of the costs of forming the fund, including costs of marketing/roadshow,
legal services, accounting, and any other expenses relating to the fund’s activities
and investments.

Management fees. Like hedge fund managers, managers who run venture capital
funds charge a management fee and an incentive fee. The management fee is
usually in the 2% to 2.5% range. This fee is charged on the amount of committed
capital, not the amount of raised capital. If the fee was 2% and the amount
committed was $50 million, but only $20 million had been raised so far, the 2%
fee would be assessed on the $50 million. Many funds provide managers the right

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to waive a portion of their management fee in exchange for a special allocation of
profits from the sale of investments.

Carried interest. These are also called incentive fees, which are typically 20%,
but can be as high as 35% of the profits the funds make. As with hedge funds, if
the venture capital manager makes money, he or she will collect the incentive
fee; if he or she loses money, then the incentive fee will not be collected, but
there is no downside to the manager (other than reputation).

Taxation. For venture capital investors, some of their income may be ordinary
interest, which will be taxed as ordinary income, while a large part of portfolio
gains may consist of long-term capital gains and qualified dividends, which will
be taxed at the long-term capital gains rate.

Any venture capital undertaking should have a business plan, and it starts with an
executive summary clearly defining the unique selling point of the startup. The
executive summary should, at minimum, concisely summarize nine areas:

 market of the startup, marketing plan, and competition;

 product or service that will be provided, uniqueness, second generation of


product;

 intellectual property rights of the startup (proprietary technology provides an


advantage);

 management team that will be in place (want the best individuals possible);

 current operations and prior operating history (facilities, labor, regulations,


etc.);

 financial projections (when will the startup reach breakeven?);

 amount of financing (what is the “burn rate,” the rate at which the startup
uses cash?);

 schedule of product development and financing that will be needed; and

 exit opportunities to cash out.

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It is important for the venture capitalist to have an exit plan. Typically, venture
capitalists invest in convertible preferred shares of the startup. Convertible
preferred shares are senior to common stock in terms of dividends, voting rights,
and liquidation preferences. There can be several series of preferred stock
offerings before the startup goes public.

A venture capital fund is typically a long-term investment, with capital locked up


a minimum of 10 years. Venture capital financing can be segmented into
different stages, and different venture capital firms will distinguish themselves by
which stage of financing they invest in. The stages are seed capital, first stage
capital, second stage/expansion capital, and mezzanine financing. A brief
description of each follows.

 Seed capital. This is the first stage where venture capital firms invest. This
stage often occurs after the investment of angel investors, who are family and
friends who initially invested and helped get the venture started to see if there
was a viable business plan that would work. The business plan is presented to
the venture capitalists, who carry out a market analysis and decide whether to
invest or not. At this stage, a prototype is developed and product testing
begins. Free samples are provided to potential customers—what is referred to
as beta testing. The amount raised in this stage is typically $1 million to
$5 million.

 First stage capital. At this stage the company has a viable product that has
been beta tested. The next step is “alpha testing,” which means that a second-
generation prototype is now being sold (rather than given away) to end users.
Revenues are now coming in, and at this stage the hope is that the product
will be something that will be commercially successful. First stage capital
financing is usually more than $2 million.

 Second stage/expansion capital. At this stage the company may begin to


turn profitable and commercial viability has been established. Challenges in
this stage include growing pains, as both sales and receivables are growing,
and there can be cash crunches. Capital is needed for expansion, and the
amount needed is often in the $5 million to $25 million range. This stage of

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financing helps the company get through its initial cash crunch, get on its
feet, and stabilize the receivables and cash flow. The goal is to become self-
sustaining, and oftentimes another round of financing may be needed.

 Mezzanine stage. This is the last stage that the startup will go through prior
to going public or being sold to a buyer. Management is solid, production is
in place, and the company continues to work on its cash flow management.
As with the previous stage, amounts invested are typically in the $5 million
to $25 million range. Mezzanine financing may also be used to buy out
earlier investors in the startup.

Venture capital has become popular again, but it may be a long time before we
see returns such as those obtained in the late 1990s (remember the public stock
market also did exceptionally well at this time too). According to the Chartered
Alternative Investment Analyst Association (CAIA), an investor should expect a
return that is about 400 to 800 basis points higher than what can be achieved in
the public stock market.

Leveraged Buyouts
Leveraged buyouts (LBOs) occur when a publicly traded company is taken
private and puts the company under the control of the current management. The
main candidates for LBOs in the past have been conglomerates. Since
conglomerates are in various industries and do not fit into just one category, they
can be more difficult to follow, and there may be businesses within the
conglomerate that are being overlooked and are undervalued. This provides an
opportunity for a leveraged buyout that can then take advantage of hidden value.

LBOs have suffered a negative connotation to the general public because they are
presented as ruthless and predatory in nature, and are often associated with mass
layoffs. Although this is sometimes the case, LBOs simply use borrowed money
to buy companies. If used properly, LBOs can lead a formerly poor-performing
company to success.

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There are several common LBO scenarios:

 Repackaging plan. This is the process of using loans to make a currently


public company private by buying all outstanding shares with the goal of
repackaging the company and returning it to the market through an initial
public offering (IPO).

 Cut and run. This is assuming the target company is worth more when its
parts of business are valued separately. The LBO will often end up breaking
the company into several parts along business lines and selling parts of the
business to the highest bidder. This process usually involves mass layoffs,
especially in any unprofitable parts of the company, and is probably the
scenario that gives LBOs their predatory reputation.

 Leveraged build-up. A company may use an LBO to acquire one of its


competitors to achieve synergy. It is a risky move, and the company needs to
make sure the return on its investment exceeds its cost to acquire, otherwise
the plan can backfire.

There are advantages for both corporate management and investors with LBOs.
For management, benefits include not having to answer to public shareholders,
the ability to use leverage and deduct the interest, and the potential for the current
management to become significant equity holders in the private company and
benefit from growth in the business. From the shareholders’ perspective, when a
firm goes through an LBO, the price of the common stock shares tends to rise
significantly, as deals often go through at a significant premium to the market
price. Oftentimes, the target of an LBO will be a company with a depressed stock
price.

Leveraged buyouts have less risk than venture capital deals for several reasons:

 The company being taken private is already an established company with


public stock outstanding. LBO companies are often undervalued, mature
companies. Venture capital firms are still young in comparison.

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 LBO companies have a history of earnings, and established products and
services. Venture capital firms typically have had a limited earnings history
and are still working on establishing a firm foothold in the marketplace.

 The management of the LBO company has been in place for a while, knows
the company, and has an established track record. The management of a
venture capital firm may have newer members who are more difficult to
assess, given their limited time with the company.

 Finally, the exit strategy of the IPO is more feasible for the reasons given
above. This past history and track record makes an IPO coming out of a
leveraged buyout easier to do than an IPO for a startup venture.

LBO funds are typically set up in the same way as hedge funds and venture
capital funds—as limited partnerships with the general partners running the fund.
Fees are similar as well. There is an annual management fee, which typically
runs from 1.25% to 3%. This fee is collected once investor funds are received,
even before any investments are made. In addition, just like hedge funds and
venture capital funds, there is an incentive fee of 20% to 30%. There can be a fee
for arranging and taking a company private, or a fee if the deal falls through.
Despite all the fees, private equity firms have grown in popularity and size over
the years, with some funds raising $10 billion or more. The target return for LBO
funds is 20% to 30%.

Mezzanine Debt
Mezzanine debt is another type of private equity, and is a hybrid since it is debt
(and sometimes preferred stock) with an equity component. Oftentimes it is an
intermediate-term note (five to seven years) with embedded stock warrants to
purchase stock. Mezzanine debt gets its name from where it is in the company’s
capital structure—between the floor of equity and the ceiling of senior secured
debt, as illustrated in Figure 2.

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Figure 2: Corporate Capital Structure
Bank Loans (ceiling)

Senior Secured Debt (ceiling)

Senior Subordinated Debt Mezzanine Financing

Convertible Subordinated Debt Mezzanine Financing

Convertible Preferred Stock Mezzanine Financing

Common Equity (floor)

Mezzanine financing is generally geared toward the middle market—companies


that are not large enough to have ready access to the capital markets but are
larger than venture capital firms. The market capitalization of these companies is
usually between $200 million and $2 billion. The size of the mezzanine financing
itself is generally in the range of $20 million to $300 million. Although there
may be some more common ways that mezzanine financing is structured, it is
still very flexible, which is partly why it is popular with both borrowers and
investors. Every deal consists of unique terms and conditions based upon
negotiations between the two parties involved. Typically, investors in mezzanine
financing deals are looking for a return of 15% to 20%, which is lower than the
returns venture capitalists or LBO investors are looking to achieve.

Investors in mezzanine funds include pension funds, endowments, and


foundations. Mezzanine funds tend to have a similar fee structure as venture
capital and LBO funds: a 1% to 2% range for management fees and a 20% profit
sharing fee.

Distressed Debt
Distressed debt is investing in the debt of companies that are in trouble or failing.
These are companies that may have already defaulted on their debt, or may even
be seeking bankruptcy protection. As with the other forms of private equity,
investors have to be willing to be patient and realize that there will be a lack of
liquidity. Both mezzanine debt and distressed debt are tied less to the
performance of the overall market and more to the individual fate and

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circumstances of the company itself. The main risk with investing in distressed
debt is business risk—the risk that the company is not salvageable and will
continue to spiral downward. In many ways, even though distressed debt
investors are investing in debt, they are actually equity investors in that they are
betting on the financial survival of the company and oftentimes have a say in
how a company is restructured.

Since the issuer of the debt is in trouble, there will likely need to be some sort of
workout, corporate reorganization, or bankruptcy solution in order for the bonds
to increase in value. The key is to recognize such an opportunity, and to purchase
the bonds at a significant enough discount in order to be rewarded for taking such
a risk. An example of an opportunity would be a company that is viable but is
experiencing a short-term cash flow problem. Since distressed debt investors are
looking for underperforming companies or companies in trouble, they are often
referred to as vulture investors.

Distressed debt is an inefficient market, meaning there are opportunities for


managers who can analyze what is happening with underperforming companies.
Distressed debt is not publicly traded, and most debt has been issued under Rule
144A of the Securities Act of 1933, meaning these bonds were sold directly to
institutional investors rather than retail investors. Leveraged buyouts can
sometimes lead to distressed debt situations if excessive leverage was used in the
LBO.

Private Equity Summary


Private equity has potential for sophisticated investors and institutions, but with
several caveats. As we have seen, this area requires skill and expertise, so finding
top managers is critical. Also, investing in this arena is not cheap—management
fees run from 1% to 3%, and profit sharing runs from 20% to 30%. A 10% return
with 30% profit sharing and a 3% management fee leaves just 4% for the
investor, which is hardly worth the risk. This means that the manager must
achieve higher returns in order to make the investment worthwhile. Most private
equity fund managers strive to earn absolute returns, meaning they are not tied to

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any benchmark against which to measure their performance. A potential
advantage of private equity is that, historically, it has a low correlation to
traditional assets. A low correlation, however, does not guarantee that it is
necessarily a good investment. Table 6 provides a general summary of the four
types of private equity that we have covered, as well as the return for private real
estate.

Table 6: Types of Private Equity

Tied to Market
Investment Target Return Performance? Level of Risk
Venture capital 30%–50% yes very high

Leveraged buyouts 20%–30% yes high

Distressed debt 15%–25% no high

Mezzanine debt 15%–20% no medium to high

Private real estate 9%–15%+ somewhat medium

Private equity investments face many risks similar to hedge funds: illiquid
investments, lack of transparency in pricing and valuation, overly dependent on
key managers, headline/reputation risks, etc.

A fairly recent trend in private equity is that several large private equity firms
went public. These publicly traded private equity firms do not require a large
capital commitment to buy their exchange-traded shares, and their shares are
more liquid and offer more transparency, thus giving ordinary investors who
want some exposure to the private equity funds an opportunity. Still, investors
should understand most private equity funds invest in risky businesses and
investors should not put any money into any publicly traded private equity firm if
they cannot afford to lose their investment.

Advisers should ask the following questions before recommending any private
equity investments to a client:

 What is the private equity strategy?

 Is this the time to be in that strategy, or may it be peaking?

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 Who is the manager? What is his or her track record?

 How much are the fees?

 Should private equity be in the client’s portfolio? How does it impact their
overall asset allocation?

 Does the client understand the lack of liquidity and long-term time horizon?

 As an adviser, do I thoroughly understand how this particular strategy works,


and understand both the upside and downside to the investment (taking fees
into account)?

 Have I educated the client on all risks and characteristics of the investment?

Private equity obviously has a place in the financial markets; the question the
adviser has to answer is which strategies, if any, are appropriate for their client.

Managed Futures
Until the early 1970s, the managed futures industry was essentially unregulated.
This led to Congress passing the Commodity Futures Trading Commission Act
of 1974, which created the Commodity Futures Trading Commission (CFTC).
Under this act, Congress defined the terms “commodity pool operator” and
“commodity trading advisor,” who both have to register with the CFTC (unless
they meet certain exemption requirements). The National Futures Association
(NFA) is the designated self-regulatory organization for the managed futures
industry. A Commodity Trading Advisor (CTA) is required to register with the
CFTC and is also required to go through an FBI deep background check, as well
as provide rigorous disclosure documents.

New futures contracts are being added all the time. For example, environmental
contracts are now traded on greenhouse gases, nitrogen oxide, and sulfur dioxide.
There are now futures contracts for the change in total nonfarm payrolls, and for
the S&P/Case-Shiller home price index, in addition to numerous contracts on
various commodities, currencies, and indexes. Futures based on the weather, such

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as temperature changes, hurricanes, rainfall, snowfall, and frost are also
available. One can now speculate on the weather, not just talk about it! And if
one’s livelihood depends upon the weather, there are now ways to hedge against
it. Trading individual futures contracts requires specialized knowledge, so
investors will often turn to managed futures as a way to include this asset class in
their portfolios.

Managed futures are considered by some to be an important part of an overall


balanced approach to asset allocation. Historically, they have had a low
correlation with stocks and bonds, and can perform well when stocks and bonds
do not. As with any trading program, advisers and investors should exercise due
care and thoroughly research any potential managed fund they are considering,
and have a clear understanding of the risks and weaknesses involved. There are
several kinds of trading strategies and approaches that a CTA could take, and just
because an investment has a low correlation with other assets in the portfolio
doesn’t necessarily mean that it is a good investment. Generally, only a small
portion, such as 5% to 10%, of the overall portfolio should be considered for
managed futures.

In 2005, Ibbotson Associates released a paper, “Managed Futures and Asset


Allocation,” written by Peng Chen, Ph.D., CFA, Christopher O’Neill, Ph.D.,
CFA, CFP, and Kevin Zhu, Ph.D. In their conclusions they state:

The results suggest that the managed futures funds offer distinct risk and
return characteristics to investors that are not easily replicated through
investing in traditional stocks and bonds. Including managed futures
improves the risk-return tradeoff of the long-term asset allocation portfolios,
thus benefiting long-term investors. Our scenario analysis results show that
managed futures exhibit superior performance while most other asset classes
underperform. Overall, the results demonstrate that the managed futures
funds benefit long-term investors, especially in rising interest rate
environments.

The assets in managed futures funds have grown to about $337 billion, or 8% of
the total $2.8 trillion of assets in hedge funds. In recent years, managed futures

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have struggled with poor performance. On average, they lost 2.51% in 2012 and
0.87% in 2013. This poor performance resulted in a cash net outflow reaching
nearly $6 billion in the first six months of 2014.

Minimum Investment
Minimum account investments in CTAs have a wide range, from as low as
$25,000 to as high as $5 million. Morgan Stanley’s Spectrum Technical Fund
accepted minimum investments of $2,000 for retirement accounts. Before
investing in any CTA, investors should request disclosure documents from the
CTA. The disclosure documents should include type of trading program operated
by the CTA, the maximum peak-to-valley drawdown, the annualized rate of
return, and risk-adjusted return.

Costs
An area of concern for investors in managed futures funds is the fees. Bloomberg
compiled data that was filed by the $337 billion managed futures market with the
U.S. Securities and Exchange Commission (SEC) and found that 89% of the
$11.51 billion of gains in 63 managed futures funds went to fees, commissions,
and expenses during the decade from January 1, 2003, to December 31, 2012.
Prospectuses show that brokers can have a strong incentive to keep clients in
these funds, as they receive commissions of up to 4% annually, based upon the
amount of assets invested. Investors also paid as much as 9% in total fees each
year, including charges by general partners and fund managers. The article
containing this information appeared in November 2013, and in December 2013
the CFTC opened an investigation to probe into the high fees that are being
charged.

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Benefits and Risks
Benefits

Low correlations with traditional stocks and bonds is a major benefit of managed
futures. This includes the ability to provide positive returns when stocks and
bond returns are negative. Managed futures may be an effective diversifier for
some portfolios.

Risks

Lack of transparency. Investors have little information on pricing and trading


strategies because most managed futures funds do not disclose their investment
and trading strategies. In addition, many trading strategies are executed
automatically by computers programmed with trading algorithms. Some
managers don’t even notice when the strategy changes.

High costs. High fees charged by some managed futures funds can wipe out any
profits they earn. One example of this is the Spectrum Technical Fund, which
earned $490.3 million in trading profits and interest income over 10 years ending
December 31, 2012. During the same time period, investors paid $498.7 million
in commissions, fees, and expenses. In the end investors lost $8.3 million over
the decade. Even though the fund had a low correlation with the stock market and
was successful, after fees, investors suffered a loss. Unfortunately, what
happened to investors of the Spectrum Technical Fund isn’t uncommon in the
managed futures funds industry.

Conflicts of interests. The Bloomberg Markets article “Fleeced by Fees” reported


that Grant Park Futures Fund LP allowed its president, David Kavanagh, to place
undisclosed personal bets ahead of, and sometimes opposite to, the fund’s trade.
Grant Park banned that practice in 2013. Grant Park reported a net investor loss of
$68.6 million in the decade ending on December 31, 2013, after subtracting fees
and commissions of $427.7 million. Fund investors lost an additional $46.9 million
in the first nine months of 2013 after fees and commissions of $27.2 million.

In addition to the risks mentioned above, managed futures funds have similar
risks to those of hedge funds.

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Chapter 4 Review
1. Provide a brief description of each of the four major distinct strategies
available to private equity investors.
Go to answer.

2. What is the potential benefit of adding managed futures to a portfolio?


Go to answer.

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Chapter 5: Addressing the Impact
of Behavioral Finance
Reading this chapter will allow you to:

3–3 Explain the impact of behavioral finance and other factors that have
been shown to influence investor results.

I
nvestor behavior is one of the key elements to the long-term success of any
investment program. One of the assumptions inherent in modern portfolio
theory is that investors behave rationally within the market, and will not pay
too much for a security nor sell a security for too little. But if investors do behave
rationally, how do you explain extremes such as the market crash on October 19,
1987? Or the run-up in real estate prices in many areas of the country from 2000
through 2006? Or the panic selling and volatility we experienced in the market in
2008? Can we so readily discount the impact of human emotions in the
marketplace? What impact does fear and greed have on human behavior, and
subsequently the markets?

The study of investor behavior is known as behavioral finance, and it has been
gaining in momentum and importance. In fact, in 2002 a Nobel Memorial Prize
in Economic Sciences was awarded to Daniel Kahneman, whose work involved
integrating both economics and psychology. More practitioners are becoming
aware of its value in helping their clients avoid some of the common self-
destructive money “traps.” Behavioral finance looks at the emotions, irrational
decision-making, and biases that can come into play when individuals invest and
handle money.

Following are some common behavioral emotions and mistakes that investors
can make, as well as suggestions to help clients overcome their behavioral biases.

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Loss Aversion
Investors hate to take losses, and people generally prefer to avoid losses than to
achieve gains. The degree to which investors are averse to taking losses was
illuminated in a 1979 study by Kahneman and Tversky, in which they
summarized their findings in the Fourfold Pattern. They found that a loss has
about 2.5 times the impact of a gain of the same magnitude. Loss aversion, which
is related to fear of regret, explains why many investors will not sell anything at a
loss. Instead, if required to sell something, they sell those securities in which they
have a profit, the opposite of the “cut your losses and let profits run” strategy
recommended by many savvy investors. (The tendency to keep losing
investments and sell profitable investments is called the disposition effect.)

Table 7: Fourfold Pattern

Gains Losses
High Probability

 Prospect Theory example: 95% chance to win 95% chance to lose


$10,000 $10,000
 Emotion the prospect
evokes: Fear of disappointment Hope to avoid loss

 Behavior: Risk Averse Risk Seeking

 Expected attitudes: Accept unfavorable terms Reject favorable terms

This fear of Most surprised the


disappointment researchers that
causes individuals to individuals would
pass up opportunities. take on undue risk to
avoid a loss.

Low Probability

 Prospect Theory example: 5% chance to win 5% chance to lose


$10,000 $10,000
 Emotion the prospect
evokes: Hope of large gain Fear of large loss

 Behavior: Risk Seeking Risk Averse

 Expected attitudes: Reject favorable term Accept unfavorable terms

Example: Lottery Example: Insurance

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Selling at a loss not only admits a mistake, but also ends any hope of at least
getting back to breakeven. Investment professionals often hear from clients who
state that rather than selling at a loss, they will sell when the stock gets back to
the price at which they bought it. This “get-even-itis” attitude can be very
harmful to investment results because some stocks never will get back to the
price at which an investor bought them or, even if the price does increase, it may
take a very long time. In the meantime, better investments are passed by while
waiting for the stock to rebound. In this case, what an investor does not do can be
as harmful as what he or she does. Overcoming loss aversion involves taking a
disciplined approach to security selection and valuation. Having valuation targets
in place for both entry points and exit points for a given security will take the
emotion out of the process. That doesn’t necessarily eliminate the pain of a loss,
but it will help to keep the portfolio management process on track. A high net
worth client is likely to not have as pronounced loss aversion as the mass
affluent.

Fear of Regret
A great quote from Mark Twain is “Twenty years from now you will be more
disappointed by the things you didn’t do than by the ones you did do.” Regret is a
strong human emotion, and it can come into play with investments, and how one
invests. Fear of regret may drive someone to buy the latest “hot stock” because of
the fear of missing an opportunity. It may also keep an investor from entering the
market after it has generated a series of losses, which leads to a tendency to buy
high and sell low. An adviser can ask the client if they would buy a house, sell it
when it goes down in price, and then buy it again when it increases in price!

Regret is more than experiencing the pain of a loss. Regret involves the pain of
feeling responsible for the loss. Investors can avoid not only the loss but the
feeling of regret if they can hold on to a poorly performing stock until it gets
back to where he or she bought it. Of course, this may not be the best investment
decision because some stocks never come back. Usually, there is more regret
associated with taking an action that turns out poorly (known as an error of
commission) than with not taking an action that would have benefited the

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investor (known as an error of omission). This is why an individual may put off
making any decision at all because of the fear that any decisive action may prove
to be less than optimal or an outright mistake. For example, regret may be
experienced when a stock takes off and the investor either did not buy it or sold it
before the price increase. The consequences may include the client becoming too
conservative to meet their long-term goals by shying away from riskier
investments, or possibly jumping on the bandwagon at the wrong time because
that is what everyone else is doing (following the herd).

Educate your clients to accept that losses happen for everyone at some point,
while also being sure to maintain the appropriate level of overall risk in the
portfolio based upon the client’s goals. Again, a high net worth client is likely to
have exhibited more risky behavior, including less regret than the mass affluent.

Overconfidence (or Optimism Bias)


One study of stock analysts revealed the following: If analysts forecast that a
stock will increase in value with 80% confidence, they are right about 40% of the
time. Ask anyone if they are an above-average or below-average driver and most
(more than 50%) will say they are above-average. The Small Business
Association reports that 50% of businesses fail in the first year and 66% in the
first two years. Some individuals have a great ideas for businesses, but clearly
overestimate the chances of success for those businesses. Humans are not
naturally adept at probabilities, often exposing a tendency toward
overconfidence. You may find this tendency especially in high net worth
individuals, as those individuals likely took a chance and succeeded, thus
reinforcing their confidence.

With investor behavior, this overconfidence can lead to illusions of control that
can lead to biased judgments, investing too much in investments about which
investors know too little, taking undue risks, and failure to realize they are at an
informational disadvantage to institutional investors. During strong bull markets,
it is easy for investors to credit themselves for their strong performance and
ignore the contribution of the bull market itself to that strong performance.

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Successful investing decisions can become a source of pride and ego
gratification, and the modern-day equivalent of a successful hunter during the
caveman days. A consequence of this can be not meeting financial goals. If
investors are overconfident about the returns they expect to get, they may save
and invest less than they otherwise would. Then if those expected returns are not
realized, they could very well come up short of achieving those goals. This is
particularly relevant as baby boomers are approaching retirement. The latest A
Retirement Confidence Survey, conducted by the Employee Benefit Research
Institute (2016), noted that workers have the same amount of resources in 2015
as reported in 2014 for retirement (and 26% have less than $1,000 saved), but
workers have grown in confidence from 2014 to 2015 that they will have a
comfortable retirement. This is an example of overconfidence.

Overconfidence can also mask errors investors make. So instead of learning from
their errors, investors attribute poor investment results not to their own mistakes,
but to some other cause over which they have no control. For example, with the
meltdown of technology stocks in the 2000–2002 period, some investors blamed
their losses on poor recommendations from brokerage firms or a “bad market”
rather than their buying stocks of companies with poor business plans and P/Es
approaching 100, or even companies with no earnings and price-to-sales ratios of
40 to 50. These grossly inflated valuations were reason enough for investors to
avoid such stocks.

Another aspect of overconfidence is “optimism bias,” which is the tendency for an


investor to be convinced that he or she will do better than other investors.
However, investing is a zero sum game in that for every seller there is a buyer, so if
one made the correct decision the other did not.

Overconfidence is often manifested in overtrading by investors, and especially by


male investors. A 1998 study by Brad Barber and Terrance Odean, which
analyzed the trading histories of 60,000 investors over a six-year period ending in
1996, revealed that the individuals beat the value-weighted market index by 60
basis points (1% = 100 basis points), gross of trading costs. However, trading
costs were 240 basis points, resulting in underperformance compared to the

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index. Furthermore, individuals who traded the most had the worst performance,
underperforming the index by 500 basis points.

In general, there is no correlation between confidence and better performance.


This was clearly demonstrated between 1999 and 2001 when investors
generally—and day traders particularly—were exceedingly confident in 1999 and
early 2000, only to encounter significant losses by the first quarter of 2001 and,
in the case of numerous technology stocks, huge losses. Even many professional
money managers become overconfident and end up underperforming the market,
as was seen with the performance of many mutual funds during this time period.

Investors must remain objective in order to overcome the overconfidence bias,


which you can facilitate in your role working with the client. The CFA Institute
curriculum describes a process of performing post-investment analysis that
separates the successful investment decisions from the poor investment decisions,
and then looking for patterns that might lead one to establish rules or reminders
to avoid the unprofitable trades in the future.

Representativeness
Representativeness involves making judgments based on the biases of our quick-
thinking selves (as researched by Kahneman and Tversky). It is a method the
brain uses to classify rapidly in order to get us through a lot of information, and
thereby creates shortcuts (we also have slower, more analytical thinking that we
use to solve complex problems). You can see a classic example of our “quick-
thinking self” in politics. If you have two individuals, one from the right and
another from the left, and have them watch the same political program, they will
have different opinions of the objectivity and fairness of the program.

As applied to investments, representativeness appears when investors become


overly negative about investments that have done poorly in the past and overly
positive about investments that have done well in the past. From this, stocks, in
particular, can become undervalued and overvalued respectively. With mutual
funds, the SEC tries to help mutual fund investors avoid representativeness with
its prospectus statement that “past performance is no guarantee of future results.”

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Yet the tracking of new cash flow into mutual funds almost always shows
investor money chasing those funds with high rates of return during the last one,
three, or five years. This tendency often results in investors buying after the
funds have had their best performance. Investors form a bias and believe that a
fund manager who performed well in a prior period of time has a good chance of
continuing to perform well in the future. Representativeness, then, can be a
misleading guide to future investment performance.

In addition, individuals place too much value on what they know based on their
experiences—this familiarity can be confused with knowledge. This explains
why investors who have not invested in international securities are reluctant to do
so. Another example is employees allocating too much of their company’s
retirement plan to company stock. Obviously they are familiar with the company
so they are comfortable investing in it. While the idea of “investing in what you
know” makes sense, the danger is in the difference between an investor’s actual
knowledge versus what one thinks he or she knows. Many employees
unfortunately found out this difference when so many internet and
telecommunication companies went bankrupt between 2000 and 2003.

There are two primary types of representativeness: base-rate neglect and sample-
size neglect:

 Base-rate neglect refers to investors attempting to determine the potential


success of a new investment by comparing it to an already understood
category or previously held investment. Essentially, the investor relies on
stereotypes.

 Sample-size neglect refers to an investor failing to accurately consider the


sample size of the data used to make a judgment. The investor makes an
assumption that a small sample size is representative of the larger body of
data.

As mentioned with earlier behavioral biases, applying an asset allocation strategy


with high net worth clients, and sticking with it, will help to counteract the
effects of representativeness bias. The periodic table of returns that both Callan

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Associates and J.P. Morgan Asset Management produce on a regular basis are
great illustrative tools to help clients understand the cyclical nature of the
markets and asset classes. Chasing hot performance is detrimental to the client’s
long term performance and their ability to meet their financial goals.

Framing
Framing is the notion that it matters how a concept is presented to an individual.
For example, assume a meal at a restaurant normally is priced at $10. The
restaurant might offer an “early bird special” where that price is $8 before 6 p.m.,
and thereby get more business if people think they are getting a discount. Now
assume, instead, the price of the meal is $8 but after 6 p.m. there is a $2
surcharge. Of course, the restaurant will be perceived in a more favorable fashion
by offering a discount rather than a surcharge even though the pricing structure is
identical. In like manner, how an investor views a situation can have a significant
impact on the investor’s decision. Investors often choose a guaranteed positive
outcome (while avoiding a chance of greater gain that also carries the possibility
of no gain at all), but they will take a chance to avoid a negative outcome (rather
than taking a certain smaller loss). Another aspect of this is when an investor
frames a situation based on their invested assets. This is illustrated by the
following examples:

1. Scenario 1. You have been given $1,000, and have the following choices:

 You can receive another $500 for sure.

 You can flip a coin, and if it comes up heads you get another $1,000, but
if it comes up tails you get nothing.

2. Scenario 2. You have been given $2,000, and have the following choices:

 You can lose $500 for sure.

 You can flip a coin, and if it comes up heads you lose $1,000, but if it
comes up tails you lose nothing.

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What were your choices for the two scenarios? Was your choice “a” in the first
scenario and “b” in the second? If so, you are guilty of just focusing on gains and
losses, and not looking at the overall big picture and the effect on your wealth.
About 85% of people choose option “a” in the first scenario, and about 70% of
people choose option “b” in the second scenario.

If you take a close look at both scenarios you will see that they are actually
identical. For both scenarios you will end up with $1,500 for sure if you pick
option “a,” or else have a 50/50 chance of either ending up with $1,000 or $2,000
if you pick option “b.” So you should pick the same option under either scenario.
Which option you prefer is up to you, but if you pick “a” in the first scenario you
should also pick “a” in the second, or if you pick “b” in one scenario you should
pick it in the other. People pick different answers because of how the questions
are asked—in other words how they are “framed.”

As researched by Richard Thaler in his book, Nudge, the reality is that every
decision is framed, so an adviser should, when acting ethically, present the best
investment options in a good light. As long as an adviser is following their
fiduciary duty to always act in the clients’ best interest, this framing is helpful
and not manipulative.

There is a worthwhile Ted Talk delivered by Shlomo Benartzi, who works with
Richard Thaler and is himself a big name in behavioral economics. In the
beginning of the video, the concepts of opt-in and opt-out are analyzed, with, of
course, much better results with having to opt-out (as some companies presently
use with their 401(k) plans). Toward the end of the video, Benartzi recounts how
they were tasked in getting a group of union members to save (the workers
perceived it as a loss). Benartzi and Thaler suggested that the workers planned to
save when they got their yearly raise. Half of the raise would go to spending and
half would go to saving. This worked; the workers felt no loss this way.

Generally, investors are better off framing a decision in broad terms based on
overall wealth and meeting long-term goals, rather than in narrower terms based
on gains and losses for a particular investment. Remain objective and open-
minded when analyzing investments.

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Rationalization or Confirmation Bias
This bias suggests that investors search for and rely on information that supports
their decisions. The tendency to give too much importance to information that
confirms one’s impressions or preferences is called confirmation bias. “Bad
news” and facts that might challenge one’s opinions tend to be ignored. In
research circles, this can be referred to as data mining (reporting only evidence
that supports your case). In investment circles, rationalization often occurs when
one analyst gives a buy signal while another gives a sell signal; both cannot be
right. But both will point to convincing evidence—sometimes even the same
evidence with a different spin—to support their positions.

Confirmation bias can be overcome in a couple of ways. First, by consciously


seeking out the information that opposes one’s point of view. Processing this
negative information along with what the investor believes to be supporting
information can lead to a better informed investment decision. The second
approach is to seek out corroborating information through company, industry,
and sector information. Both of these involve educating a high net worth client
about this investing bias.

Hindsight Bias
This is the characteristic of investors, when looking back, seeing events that took
place in the past as having been more predictable than they seemed before they
happened. Likewise, things that didn’t happen seem, in hindsight, much less
likely to have happened than they did beforehand. In other words, there is a
reconciliation of a person’s beliefs based on the outcome of events. For example,
if a financial professional recommends an investment that does well, a client
tends to think of that recommendation as one he or she liked from the start, even
if that was not the case. With recommendations that do not turn out well,
however, the client may think that he or she had doubts to begin with about the
recommendation, even when, in fact, that was not true. This thinking results in a
client giving less credit to the investment professional for good recommendations
and more blame for recommendations that do not work out.

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The stock market sell-off in 2008 can be seen as a classic example of hindsight
bias. Looking back, one might think they should have been able to tell that the
market was going to correct dramatically because of the subprime market and
decline in real estate prices. But how was one to know the extent of the sell-off
and how long it would last? How could one have predicted the credit crunch and
subsequent government bailouts? Everything is always clearer in the rearview
mirror.

You have probably noticed by now that a common element to dealing with
behavioral biases is to be honest with oneself and carefully examine both good
and bad investment decisions, and that it is also important to educate clients on
the cyclical nature of the markets and asset classes. Recognizing and coming to
terms with investment mistakes can help in avoiding future mistakes.
Specifically, with hindsight bias, keeping up an investment policy statement and
any notes from client meetings creates a written record of goals, especially the
efficacy of staying the course for successfully reaching those stated long-term
goals.

Anchoring
Anchoring refers to the tendency to hold to certain beliefs even when faced with
new information that should alter those beliefs, thereby creating, in effect, tunnel
vision. In other words, investors start at an initial mental reference point based on
past experience. This might lead to overweighting irrelevant data or slowly
adjusting to a correct answer or decision as they receive additional information.
Imagine an auction in which a bidder will have an amount in mind, and then often
bid way over that amount when the bidding goes higher, creating the new
“normal.”

As applied to the announcement of a company’s earnings, anchoring results in


security analysts underreacting to unexpected earnings announcements. This does
not mean there is not a reaction, because such announcements typically move the
stock quickly and, in some cases, significantly. It does mean that security analysts
do not revise their earnings estimates enough to reflect this new information. As a

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result, positive or negative earnings surprises tend to be followed by more positive
or negative earnings surprises; again, the new “normal.”

Individual investors, of course, also experience anchoring. Their investment


experiences create beliefs that they subsequently rely on, and then they
underreact to new information. One of the most vivid examples of this can be
seen by examining investor conduct with technology stocks in the late 1990s. It
appeared that investors could do no wrong by buying technology stocks and, no
matter what prices were paid, technology stock prices would be higher in the
future. However, even though valuations went to extremes and it became evident
that the prospect of any earnings for many of these companies was well in the
future, if ever, many investors did not react to this information. By the end of
2002, the cost of anchoring to these stocks’ prices was obvious.

Overcoming anchoring bias involves questioning the rationale being used to


value a security. Do the data and the economic environment still support the
original decision, or does the valuation or forecast need to be adjusted for new
information? Charts can be used to illustrate long-term investment positions in
relation to any changes. Objectivity is once again the key to success.

Recency (or Availability Bias)


This is the problem of putting too much weight on current events or data and not
enough weight on past, historic trends. Many investors expect the market to
continue rising in a current bull market; likewise, these same investors often
expect a current bear market to get worse. Recency is shown in momentum
investing when investors buy “hot” stocks simply on the basis of their recent
strong performance. One difference between recency and representativeness is
that recency involves a shorter, more recent time frame than representativeness.

A market-wide example of recency occurred in the 1990s bull market. At that


time there were many individuals projecting annual returns of 20% or greater in
their retirement accounts based on the recent performance of the stock market,
even though historical returns were half that amount. Another good example of
recency is the market sell-off in 2008. With the overall market down over 40%

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for the year, going into the presidential elections many investors were either
selling stocks or no longer investing in stocks in their retirement accounts.
Recent events had impacted their outlook, and the concern was that the market
was going to continue going down indefinitely. Living through the recession in
their early investing lives is one of the likely reasons that millennials generally
avoid equities, exhibiting recency bias. What happened in 2008 is the opposite of
what occurred in the 1990s. In the 1990s we had extreme optimism and
unrealistically high long-term expectations, whereas in 2008 we experienced
extreme pessimism and unrealistically low long-term expectations.

Recency bias can be overcome by, you guessed it, careful research and adhering
to an appropriately developed investment strategy. By doing so, knee-jerk
reactions to the most recent events (whether good or bad) will be avoided and the
long-term financial goals of the client will be the driver of any portfolio actions.

Mental Accounting
Mental accounting involves treating one dollar different from another depending
on where it comes from, where it is kept, and how it is spent. This can lead to
being too quick to spend, too slow to save, and too conservative or aggressive
with investing. For example, receiving a gift from a grandparent might seem
more valuable than the same dollar amount earned from a job. So that gift might
be invested more conservatively than money earned because losing “Grandma’s”
money would be more traumatic than losing one’s own money. Mental
accounting can also be affected by the amount of money involved. For example,
most people would go to greater lengths to save $25 on a $100 purchase than
they would to save $25 on a $1,000 purchase—the $25 seems to have more value
with the $100 purchase.

Example. Your client, Esther, has a long-term goal of buying a house in 10


years, with a forecasted gain of 5% on her investments each year. When the
economy proved stronger than expected and Esther actually gained 8% on her
investments, she wants to reallocate the extra 3% gain into extremely high-risk
stocks, viewing that as “bonus money” through mental accounting. As Esther’s

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financial adviser, you should gently remind Esther that the 5% forecasted gain
represents ups and downs in the investment returns: Higher returns than
forecasted are used to safeguard downturns or create an earlier date to achieve
the goal.

Compartmentalization of funds not only distracts from considering the total


portfolio, but also gets the investor to thinking of his or her investments in terms
of individual winners and losers rather than in their entirety.

One approach to dealing with mental accounting is to point out to the client the
drawbacks to such an approach, such as higher than desired asset correlation
across the various pockets or buckets. An adviser must be able to develop and
present a holistic view of the entire portfolio and then relate that portfolio and the
associated performance to the client’s financial plan. The focus should be on total
portfolio returns, and not on which bucket has higher or lower income returns or
higher or lower capital appreciation returns.

Money Illusion
Money illusion is the misunderstanding people have in relating nominal rates or
prices with real (inflation-adjusted) rates or prices. For example, if an investor is
given the choice of a 7% gain when inflation is 8% or a 4% gain when inflation is
2%, most investors would select the 7% gain. In real terms, however, the investor
would be better in the 2% inflation scenario. This example also relates to the fact
that people can more easily dismiss small numbers without putting them into the
correct financial perspective. This misunderstanding can lead to incorrect financial
decisions or cloud their financial judgment.

Example. Richard retired in 2011 and realized that his recent one- and two-
year CDs, saved for retirement, had only garnered 2% interest. He remembered
his father, who retired in 1981, talking about getting a 12% return on his short-
term investments! Ah, the good old days. However, taking account of inflation
(true buying power), Richard has done better than his father. Between 2009
and 2011, inflation averaged 1.61%, while inflation from 1979 through 1981
averaged 12.69%.

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This is another area where an adviser can add value by helping clients understand
that returns stated in nominal terms can be misleading, and the impact of inflation
should be accounted for. Another example of money illusion may be investing in
higher yielding corporate bonds without exploring municipal bonds, which will
have a lower coupon but may have a higher taxable equivalent yield.

Status Quo Bias


People faced with a selection of choices tend to choose whatever option ratifies,
confirms, or continues the existing situation (i.e., the status quo). As in the realm
of physics, people can become subject to inertia. Inertia may be significant, but
status quo bias suggests a more intense anchoring effect. In other words, “we’ve
always done it this way” or “it’s always been this way.” This can blind investors
to changing situations, and perhaps lead them to not make adjustments that they
should.

Here is an example: Prior to 1958, the dividend yield of the S&P 500 index was
always greater than the yield on 10-year U.S. Treasury notes. This was
considered logical since stocks were riskier than Treasury bonds, so the yield
should be higher. When the Treasury note started yielding more than the S&P
500 index it was considered an anomaly by many, and these investors were going
to wait until the relationship returned to “normal” before buying stocks. Well, if
they waited they were out of the market for 50 years, since the dividend yield on
the S&P 500 did not rise above the interest rate on the 10-year Treasury note
again until 2008!

A link exists between status quo bias and loss aversion bias, and this can result in
investors holding inappropriate assets for their situation and level of risk
tolerance. Status quo bias may also prevent an investor from exploring other
investments. The CFA Institute cautions that status quo bias may be
exceptionally strong and hard to overcome, and advisers should be educating
clients on the benefits of diversification and proper asset allocation.

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Illusion of Control Bias
The illusion of control bias is the tendency to believe that one can control or
influence outcomes, when this is not possible. Investors do not have any control
on the direction of interest rates or a stock price. Choice, familiarity, competition,
and active involvement can all increase confidence unrealistically. This bias is
somewhat more prevalent with high net worth investors, who may have an
unrealistic picture of the amount of control they have, thereby setting themselves
up for major frustration when things don’t go as they “planned.” The
consequences to illusion of control bias include excessive trading and
inadequately diversified portfolios, exemplified by a high net worth business
owner (large percentage of portfolio in the business) or corporate executive
(large percentage of portfolio in corporate stock and options).

Overcoming the illusion of control bias involves educating clients on the sheer
scope of the global investment environment, which should help point out that no
one individual can possibly exert the level of control that this bias assumes. The
real force at work is the probabilistic nature of investment outcomes. Other
avenues to help clients include seeking contrary viewpoints that might refute
one’s illusion of control, and also maintaining good records for the rationale for a
trade.

Endowment Bias
Endowment bias is when individuals value an owned asset more than those that
are not owned. One result is a tendency to demand a higher price to sell an
owned asset, along with requiring a lower price to purchase an unowned asset. In
essence, ownership “endows” a given asset with added value. An example of this
often happens when people sell their home—they generally have a higher
opinion of their home, and the expectation of a higher price. The buyer, on the
other hand, is looking for a good value, and wants to pay less.

One interesting recent finding about endowment bias is in a study by John List
from the University of Maryland, which showed that individuals who are

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educated about an asset are not as likely to experience endowment bias—
confirming the value of client education. In the study, List offered sports card
dealers a lucrative trade, and only some traders took the deal. Looking deeper,
List found that novice sports card sellers did not take the good trade, while
experienced ones did. The experienced dealers could better see the true value of
their own card and that of the one being offered, while those less experienced
thought their own card was of greater value than it really was (endowment bias).

As with status quo bias, the endowment bias can lead to holding inappropriate
assets for one’s situation and risk tolerance. The endowment bias tends to be
strong with inherited assets, and an adviser should not hesitate to explore the
reasons for the client to continue holding the “endowed” assets. Such a
conversation could involve the adviser asking the client what they would have
done if they had inherited a like amount of cash versus the assets that they did
receive.

Summary
Behavioral finance continues to evolve and will become more important for
financial planners in the years to come. By having a good understanding of the
basics of behavioral finance, advisers can not only become better investors
themselves, but they can also help their clients become better investors. Advisers
who spot these behaviors in their clients can educate them on what is happening
and why; then their clients can become more successful long-term investors.
Unlike the efficient market hypothesis that assumes all investors are rational,
behavioral finance takes into account that we are all human and prone to our
emotions, and that we do not necessarily always act in our own best interests.

Behavioral finance is gaining wider acceptance in the financial planning field,


especially in light of the recent credit crisis. Everything cannot be quantified and
reduced to formulas and numbers—the markets are created and used by humans,
who are not perfect. We all have various emotions, and we do not always behave
rationally. As we saw with modern portfolio theory, a basic assumption is that
investors behave rationally, always doing what is in their best interest. This is not
necessarily the case.

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A good understanding of behavioral finance will hopefully enable advisers to
help their clients avoid common behavioral traps. Our behavior as investors,
whether rational or not, has an impact on the market. The same applies to
institutional investors—if they all head for the exit at the same time, which
essentially happened in the credit crisis in 2008, then the markets will no longer
behave the way that the formulas and numbers say they should! Numbers can
perhaps give us an idea of probabilities, but even an event with an extremely low
probability can still happen. An awareness of both the quantitative and qualitative
sides of the market is important— investing is not pure science, it is both a
science and an art.

Two books that provide interesting reading dealing more deeply with behavioral
finance are Facilitating Financial Health, Tools for Financial Planners,
Coaches, and Therapists by Klontz, Kahler, and Klontz; and Behavioral Finance
and Wealth Management by Michael Pompian.

Chapter 5 Review
1. List several examples of common investor mistakes relating to behavioral
finance.
Go to answer.

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Summary

I
vestment strategy is a necessary component to a successful investment
program. You should remember that strategy is dependent upon the
following three key elements: an identifiable goal, a method to attain that
goal, and the competencies and resources to sustain the strategy.

Real estate investing can be accomplished in a variety of ways and the ability to
diversify into real estate has never been easier for investors at all levels of
wealth. High net worth investors oftentimes are able to make significant direct
investment into real estate that provides the high net worth investor with
opportunities for substantial wealth enhancement while also providing taxation
benefits.

There has been an increasing amount of investor interest in both hedge funds and
private equity. These are generally complex investments with various structures
and strategies. There are various fees and unique risks associated with both hedge
funds and private equity, and investors and advisers both need to their homework
and understand these potential investments and their unique risks and potential
benefits prior to making any investment decision.

There is continued research into the behavioral aspects of investor decisions, but
what has been uncovered so far shows us that the potential negative implications
are very real for both institutional and individual investors. All advisers can
benefit from an understanding of the sometimes destructive thought processes
that researchers have identified in investors.

Having read the material in this module, you should be able to:

3–1 Explain the importance of strategy in achieving investment goals.

3–2 Explain terminology, characteristics, risks, concepts, and strategies


for the use and valuation of various types of alternative investments.

3–3 Explain the impact of behavioral finance and other factors that have
been shown to influence investor results.

Summary  109
© 2010–2018, College for Financial Planning, all rights reserved.
Chapter Review Answers
Chapter 1
3–1 Explain the importance of strategy in achieving investment goals.

1. List three key elements of an investment strategy.


a. an identifiable goal
b. a method to attain that goal
c. the competencies and resources to sustain the strategy
Return to question.

2. List benefits of the buy-and-hold strategy.


returns at least as good as strategies based on technical analysis, low
transaction costs, the deferral of capital gains taxes on profits, not
missing the best days of the market
Return to question.

3. For each of the following economic stages, list the industries that are
expected to do well.
a. expansion: early stage
consumer credit, transportation, energy, and consumer cyclicals
Return to question.
b. expansion: middle stage
basic materials
Return to question.
c. expansion: late stage
capital goods
Return to question.
d. recession
consumer staples and utilities
Return to question.

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4. Describe the following technical indicators used by contrarians.
a. short selling
Increasing short selling in a stock indicates a growing herd
consensus that the market will decline; the contrarian should
consider an opposite move.
Return to question.
b. specialists’ sentiment
Considered to be the “smart money,” increased bullishness by
specialists in a stock makes contrarians bullish as well, and vice
versa.
Return to question.
c. mutual fund cash positions
Mutual fund managers are considered to be herd animals; when
mutual funds have low and decreasing cash positions, contrarians
take this as a sell signal; the reverse is true as well.
Return to question.
d. investment advisory opinions
This theory suggests that the aggregate opinion of investment
advisers is often wrong. That is, when the majority of investment
advisers are bullish (bearish), a contrarian should sell (buy)
securities.
Return to question.
e. put-call ratio
High and increasing put-call ratios suggest buying opportunities to
the contrarian, and low or decreasing put-call ratios suggest the
opposite.
Return to question.

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Chapter 2
3–2 Explain terminology, characteristics, risks, concepts, and strategies
for the use and valuation of various types of alternative investments.

1. What are some of the major disadvantages of investing directly in real estate?
Disadvantages of directly investing in real estate include the inherent
illiquidity, the required property management, the large minimum
investment, the high transaction costs, the immobility of the asset,
fixity (the high cost of changing the use of a structure), the difficulty of
predicting future risks and returns, and the likelihood of changes in the
tax treatment of real estate investment.
Return to question.
2. Identify factors that affect the cash flow projections and the valuation of a
real estate investment.
A cash flow projection (for an income-producing property) takes into
consideration the cost of the investment, inflows (e.g., rents),
depreciation, maintenance and other costs, principal repayment and
interest, taxes, and reinvestment of positive annual cash flows. Most
of the revenues and expenses are subject to change. In addition, the
appreciation of an investment in real estate can vary from what is
expected. Noneconomic factors affect real estate, as do local
circumstances. The cost of capital, financing fees, and other
acquisition costs also must be factored into the valuation process.
Return to question.
3. The following information pertains to Spacious and Gracious Apartments.

Gross rental receipts $750,000


Other income (laundry, parking, etc.) $22,000
Average vacancy rate 6% of PGI
Operating expenses $210,000
Mortgage loan payments $362,000
Depreciation expense $131,000
Cap rate 12%

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a. Calculate the property’s net operating income based on this information.

$750,000 Gross rents (GRR)


+ 22,000 Other income
= $772,000 Potential gross income
(PGI)
− 46,320 (6% of PGI)
= $725,680 Effective gross income
− 210,000 Operating expenses
= $515,680 Net operating income
(NOI)
Return to question.
b. Calculate the property’s value.
The property’s value can be computed using the following formula.

NOI $515,680
V= = = $4,297,333
Cap rate .12
Return to question.

4. What are some of the risks and regulatory concerns regarding nontraded and
private REITs, and private real estate funds?

Risks include illiquidity, pricing, transparency, redemption, distribution,


and over-leveraging. Regulators are concerned that these risks be
adequately considered and disclosed to potential investors. Private
REITs are not subject to the same disclosure requirements as publicly
traded or nontraded REITs. Regulators are concerned that the lack of
disclosure documents makes it extremely difficult for investors to
make an informed decision. FINRA has provided guidance that these
are long-term investments and investors must understand and be
willing to bear the risks of illiquidity. Fees are also a concern, and
advisers should consider any costs and compare a potential real
estate investment to other investments available that would have a
similar holding period.
Go to answer.

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© 2010–2018, College for Financial Planning, all rights reserved.
Chapter 3
3–2 Explain terminology, characteristics, risks, concepts, and strategies
for the use and valuation of various types of alternative investments.

1. What are the six key elements that separate hedge funds from mutual funds?
1. Hedge funds are private investment vehicles for sophisticated
investors.
2. Hedge funds tend to be more heavily concentrated and
specialized than mutual funds.
3. Hedge funds generally use derivatives to a much larger degree
than mutual funds.
4. Hedge funds go both long and short, many mutual funds are long-
only.
5. Hedge funds often invest in illiquid and nonpublic securities.
6. Hedge funds often use leverage, and oftentimes the amount of
leverage can be substantial.
Return to question.

2. What are some of the typical fees that a potential investor in a hedge fund
should be aware of?
An annual management fee of is charged, typically in the area of 2%.
Most hedge funds also have an incentive (performance) fee between
10% and 20% of the fund’s profits. The term “2 and 20” would refer to
a 2% management fee and 20% of profits going to the hedge fund
manager. There can be a hurdle rate that the fund manager must
surpass in order to earn a performance fee. There can also be a
surrender fee with the fund is sold.
Return to question.

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3. What are some of the major risks to consider when investing in a hedge
fund?
Hedge funds are generally illiquid, which is an advantage for the
hedge fund manager since he or she does not need to worry about
redemptions for a given period of time and can be patient with the
strategy that is being implemented. However, this lack of liquidity is a
disadvantage for the investor, and investors should only commit funds
that they can definitely tie up for a period of time. Other risks include
manager risk, investment strategy risk, headline/regulatory risk, and
the risk that there may be adverse tax consequences.
Return to question.

4. Briefly describe the four main hedge fund strategies.


1. Market directional—includes equity long/short, short-selling, and
activist.
2. Corporate restructuring—includes distressed securities, merger
arbitrage, event driven, and Regulation D offerings.
3. Convergence trading—includes fixed-income arbitrage,
convertible bond arbitrage, equity market-neutral, and relative
value arbitrage.
4. Opportunistic trading—includes global macro funds (run by
managers such as George Soros) and fund of funds.
Return to question.

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Chapter 4
3–2 Explain terminology, characteristics, risks, concepts, and strategies
for the use and valuation of various types of alternative investments.

1. Provide a brief description of each of the four major distinct strategies


available to private equity investors.
 Venture capital—Venture capital is the most well-known type of
private equity, and venture capital investors are seeking a high
rate of return, but also taking on a very high level of risk. Venture
capital returns are tied to market performance, meaning venture
capital performs best when the public stock markets are also
doing well.
 Leveraged buyouts (LBOs)—LBOs occur when a publicly traded
company (which is typically undervalued) is taken private. A
common LBO scenario is to take the company private in order to
repackage and restructure the company, and then return the
company to the public market at a higher price through an IPO.
Another LBO approach would be to break up the company into
several parts and sell off the different parts of the business to
different bidders. This process is referred to as “cut and run” and
can result in mass layoffs, especially for the unprofitable parts of
the company. An advantage to corporate management and
investors with LBOs is that they do not have to answer to public
shareholders. Since established and more mature companies are
a typical LBO candidate, there is less risk with LBOs than with
venture capital.
 Mezzanine financing—Mezzanine financing is essentially debt
with an equity component. For example, it could be an
intermediate term note with embedded stock warrants. Mezzanine
debt gets its name from the fact that it is between common equity
(the floor) and bank loans and senior debt (the ceiling). Mezzanine
financing is often found in the middle market—companies that are

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not yet large enough to have ready access to the capital markets
but are larger than venture capital firms.

 Distressed debt—Distressed debt is investing in the debt of


companies that are in trouble or failing. As with mezzanine debt,
distressed debt is tied less to the performance of the overall
market and more toward the individual circumstances of the
company itself. The main risk with distressed debt is business risk,
namely that the company could go out of business completely. In
many ways distressed debt investors are actually equity investors
in that they are betting on the financial survival of the company,
and they will most likely have a say in how the company is
restructured. This restructuring could include converting debt into
equity ownership for the distressed debt holders.
Return to question.

2. What is the potential benefit of adding managed futures to a portfolio?


Research has shown that including managed futures as part of an
overall asset allocation strategy can enhance long-term returns while
lowering overall risk. Managed futures have often had a low
correlation with traditional stocks and bonds, making it a good
diversifier. In order to be an effective addition to a portfolio though,
fees must be reasonable and kept under control.
Return to question.

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Chapter 5
3–3 Explain the impact of behavioral finance and other factors that have
been shown to influence investor results.

1. List several examples of common investor mistakes relating to behavioral


finance.
a. Loss aversion. Loss aversion explains why many investors will not
sell anything at a loss. Doing so not only admits a mistake but also
ends any hope of at least getting back even. Investment
professionals often hear from clients who state that rather than
selling at a loss, they will sell when the stock gets back to the
price at which they bought it.
b. Fear of regret. Regret involves the pain of feeling responsible for a
loss. Investors can avoid not only the loss but the feeling of regret
if they can hold on to a poorly performing stock until it gets back to
where he or she bought it.
c. Overconfidence. With investor behavior, overconfidence can lead
to illusions of control that can lead to biased judgments and failure
to realize they are at an informational disadvantage to institutional
investors. Overconfidence can also mask errors investors make.
d. Representativeness. Representativeness involves making
judgments based on stereotypes. As applied to investments,
representativeness appears when investors become overly
negative about investments that have done poorly in the past, and
overly positive about investments that have done well in the past.
From this, stocks, in particular, can become undervalued and
overvalued, respectively.
e. Framing the problem. Framing is the notion that it matters how a
concept is presented to an individual. How an investor views a
situation can have a significant impact on his or her decision.
Investors often choose a guaranteed positive outcome (while

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avoiding a chance of greater gain that also carries the possibility
of no gain at all), but they will take a chance to avoid a negative
outcome (rather than taking a certain smaller loss).
f. Rationalization. This problem suggests that investors search for
and rely on information that supports their decisions, and avoid or
dismiss information that does not support their decisions. The
tendency to give too much importance to information that confirms
one’s impressions or preferences is called “confirmation bias.”
“Bad news” and facts that might challenge one’s opinions tend to
be ignored.
g. Hindsight bias. This is the characteristic of investors, when looking
back, to see events that took place in the past as having been
more predictable than they seemed before they happened.
Likewise, things that didn’t happen seem, in hindsight, much less
likely to have happened than they did beforehand. In other words,
there is a reconciliation of a person’s beliefs based on the
outcome of events.
h. Anchoring. Anchoring refers to the tendency to hold to certain
beliefs even when faced with new information that should alter
those beliefs, thereby creating, in effect, tunnel vision. In other
words, investors start at an initial mental reference point and
slowly adjust to a correct answer or decision as they receive
additional information. Their investment experiences create beliefs
that they subsequently rely on, and then they underreact to new
information.
i. Recency. This is the problem of putting too much weight on
current events and not enough weight on past, historic trends.
Many investors expect the market to continue rising in a current
bull market; likewise, these same investors often expect a current
bear market to get worse. Recency is shown in momentum
investing when investors buy “hot” stocks simply on the basis of
their recent strong performance. One difference between recency

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© 2010–2018, College for Financial Planning, all rights reserved.
and representativeness is that recency involves a shorter, more
recent time frame than representativeness.
j. Mental accounting. Mental accounting involves treating one dollar
different than another depending on where it comes from, where it
is kept, and how it is spent. Mental accounting divides an
investor’s assets into different pockets, thereby taking away from
the investor thinking of his or her overall portfolio as a total
portfolio. A common example of this is the “house money effect,”
where an investor thinks of the initial investment as his money and
any profits as not really being his, which leads to the profits being
invested in more risky assets.
k. Status quo bias. This bias, as the name suggests, is the
preference for things to remain the same, or at least change very
little. This bias results in individuals reluctant to change their
investments or their prior investment decisions.
l. Illusion of control. The illusion of control bias is the tendency to
believe that one can control or influence outcomes when this is
not possible. The consequences to illusion of control bias include
excessive trading and inadequately diversified portfolios.
Employees will also take on too much exposure to their
employer’s stock in some case.
m. Endowment effect. The endowment effect refers to the fact that a
person puts a higher value on something she owns than she
would be willing to pay to acquire it, or others would be willing to
pay for it. In essence, ownership “endows” a given asset with
added value.
Return to question.

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References
Anson, M. J. CAIA Level 1: An Introduction to Core Topics in Alternative
Investments. Hoboken: John Wiley & Sons. (2009).

BlackRock. “Using the Versatility of Hedge Funds.” Retrieved from BlackRock:


http://www.blackrock.com/investing/resources/education/alternative-
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Bloomberg.com. www.bloomberg.com. (December 2012).

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The Economist. “To have and to hold.”


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Index Fund Advisors. “Index Funds: The 12-Step Recovery Program for Active
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Index Arbitrage. www.indexarb.com. (December 2009).

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Nicholas, J. G. Investing in Hedge Funds. Princeton: Bloomberg Press. (1999).

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NYSE Euronext. www.nyse.com. (December 2012).

Numa Financial Systems Ltd. www.numa.com. (December 2009).

O’Brien, R. J. www.rjobrien.com/Docs/margins.pdf. (February 2008).

Peng Chen, P. C. “Managed Futures and Asset Allocation.” Retrieved from


Ibbotson Associates: http://corporate.morningstar.com/US/documents/
MethodologyDocuments/IBBAssociates/ManagedFutures.pdf. (July 7, 2014).

SEC. “Federal Register Registration under the Advisers Act of Certain Hedge
Fund Advisers; Final Rule.” Retrieved from the SEC: http://www.sec.gov/
rules/final/ia-2333.pdf. (June 2, 2014).

Standard & Poor’s. www.standardandpoors.com/indices/sp-500/en/us/


?indexId=spusa-500-usduf--p-us-l--. (January 2011).

Thaler, R., and Sunstein, C. Nudge. New York: Penguin Press. (2009).

122  Advanced Investment Products and Strategies


© 2010–2018, College for Financial Planning, all rights reserved.
About the Authors
Craig Kinnunen, MS, CFP® is an associate professor at the
College for Financial Planning. Prior to joining the
College, Craig enjoyed a long and successful career in
personal financial planning and wealth management.
Craig’s enthusiasm for financial planning extends beyond
the classroom, as he also spends time providing pro bono
financial education and individual financial counseling to
members of the Colorado National Guard. Craig earned a
bachelor of science degree in accounting from Northern
Michigan University and followed that up with a master of science degree in
finance from the University of Colorado in Denver. You can contact Craig at
craig.kinnunen@cffp.edu.

Cindy Shnaider, MSF is an associate professor at the College


for Financial Planning. After earning her master’s degree
from the College, Cindy began developing and teaching
finance and financial planning courses in the College’s
graduate degree program, and has continued to do so for over
five years. Some of those courses include advanced corporate
finance, behavioral finance, and portfolio management.
Cindy is also the lead professor for the Foundations in Financial Planning course,
leading to the RP designation. You can contact Cindy at
cindy.shnaider@cffp.edu.

About the Authors  123


© 2010–2018, College for Financial Planning, all rights reserved.
Index
A master index covering all modules of this course can be found on eCampus.

Behavioral finance market directional, 66


anchoring, 101 opportunistic trading, 70
confirmation bias, 100 regulations, 60
endowment bias, 106 strategies, 66
fear of regret, 93 Income property valuation
framing the problem, 98 gross income multiplier, 42
hindsight bias, 100 net operating income (NOI)
capitalization, 40
illusion of control bias, 106
Investing with economic cycles, 7
loss aversion, 92
Hedge funds, 59
mental accounting, 103
Leveraged buyouts, 80
money illusion, 104
Managed futures funds, 87
optimism bias, 94
benefits and risks, 89
overconfidence, 94
costs, 88
rationalization, 100
minimum investment, 88
recency, 102
Market directional strategies, 66
representativeness, 96
Mezzanine debt, 82
status quo bias, 105
Net operating income (NOI)
Buy-and-hold strategy, 4
capitalization, 40
Contrarian strategy, 12
Nontraded REITs, 48
Distressed debt, 83
benefits, 49
Enemies of effective strategy, 21
costs/taxation, 48
Gross income multiplier (GIM), 42
minimum investment, 48
Hedge funds, 58
regulatory concerns, 51
convergence trading, 68
risks, 49
corporate restructuring, 67
suitability, 51
costs and fees, 62
definition, 58

124  Advanced Investment Products and Strategies


© 2010–2018, College for Financial Planning, all rights reserved.
Private equity Real estate investments, 27
distressed debt, 83 advantages, 28
LBOs, 80 corporation, 32
mezzanine debt, 82 disadvantages, 29
partners, 75 forms of, 30
venture capital, 76 general partnership/joint venture, 31
Private real estate funds outright ownership, 30
core properties, 52 REITs, 33
costs/taxation, 54 RELPs, 31
opportunistic properties, 53 types of, 27
regulatory issues, 54 types of REITs, 34
risks/suitability, 56 Small stock investing, 15
value-added properties, 53 Strategy, importance of, 3
Real estate investment trusts (REITs) Venture capital, 76
factors to consider, 36 costs/fees, 77
nontraded REITs, 48 funding, 79
private REITs, 52

Index  125
© 2010–2018, College for Financial Planning, all rights reserved.