Risk/Return: Commodities
Commodities offer potential for returns, portfolio diversification, and inflation protection.
Commodity spot prices are a function of supply and demand, the costs of production and storage, value to users, and global economic conditions.
Risk/Return: Timberland and farmland
Timberland and farmland investments have similar risks as other real estate investments in raw land. However, weather is major risk factor for these investments. Bad weather conditions can drastically reduce harvest yields.
Another important risk factor is the international competitive landscape. Unlike other real estate that is mainly impacted by local factors, timberland and farmland produce commodities that are globally traded; therefore, they are impacted by global factors.
Diversification Benefits: Commodities
Commodities are attractive to investors not only for the potential profits but also because:
Diversification benefits: Timberland and farmland
ESG investors looking for responsible and sustainable investing can include timberland and farmland in their portfolios. These investments can help mitigate climate change.
Timberland and farmland have also exhibited low correlation with traditional investments. Thus, they can provide effective diversification benefits.
Instruments: Commodities
Commodity investments are typically made through derivatives as the storage and transportation costs for holding physical commodities are significant. Commodity derivative contracts may trade on exchanges or over the counter. The popular derivatives include futures
, forwards, options, and swaps.
Commodity exposure can also be achieved through:
Instruments: Timberland and Farmland
The primary investment vehicles for timberland and farmland are investment funds. These funds could be offered publicly via REITs or privately via limited partnerships.
Large investors can also consider direct investments in these assets.
Real estate has two major sectors:
The key reasons for investing in real estate are:
Investment characteristics of real estate are as follows:
Real estate investing can be categorized along two dimensions: public/private markets and debt/equity based. Exhibit 27 presents the four quadrants for the basic forms of real estate investments with examples:
Basic forms of real estate investments and examples
| Debt | Equity | |
| Private | • Mortgages
• Construction lending • Mezzanine debt |
• Direct ownership of real estate: ownership through sole ownership, joint ventures, separate accounts, or real estate limited partnerships
• Indirect ownership via real estate funds • Private REITs |
| Public | • MBS (residential and commercial)
• Collateralized mortgage obligations • Mortgage REITs • ETFs that own securitized mortgage debt |
• Shares in real estate operating and development corporations
• Listed REIT shares • Mutual funds • Index funds • ETFs |
Equity-based investments represent ownership of real estate properties. Ownership can be through sole ownership, joint ventures, real estate limited partnerships, etc. A variation of equity-based investments is leveraged ownership: Assume a building costs $10 million, and you put $3 million of your money and borrow $7 million. This is called leveraged ownership. That is, leveraged ownership is where a property is obtained through equity and mortgage financing.
If you are investing in a debt-based real estate investment, it means you are lending money to a purchaser of real estate. A classic example is a mortgage loan. This is considered a real estate investment because the value of the mortgage loan is related to the value of the underlying property.
There can be many variations within the basic forms:
The main advantage of the REIT structure is that it avoids double corporate taxation. Normal corporations pay taxes on income, and then the dividend paid from the after-tax earnings are taxed again at the shareholder’s personal tax rate. REITs can avoid corporate income taxes by distributing 90% – 100% of their rental income as dividends.
The value of the REIT shares is based on the dividend. REIT shares often trade publicly on exchanges. It is a way for individual investors to earn a share of the income from commercial properties (office buildings, warehouses, and shopping malls) without buying them. Risk and return of REITs vary based on the types of properties they invest in. Equity REITs invest primarily in residential and commercial properties.
Residential Property
Commercial Property
REITs
Mortgage-Backed Securities
Real Estate Indexes
There are a number of indexes to measure real estate returns that vary based on the underlying constituents and longevity.
Real Estate Investment Risks
Like any investment, real estate investing has its risks if the outcome does not turn out to be as per expectations.
Many investors prefer real estate for its ability to provide high, steady current income. Real estate also has moderate correlation with other asset classes and thus provides some diversification benefits. However, there are periods when equity REIT correlations with other securities are high, and their correlations are highest during steep market downturns.
The assets underlying infrastructure investments are real, capital intensive, and long-lived. These assets are intended for public use, and they provide essential services e.g., airports, health care facilities, and power plants.
Infrastructure assets were primarily owned, financed, and operated by the government. Of late, they are financed privately with the intent of selling the newly built assets to the government. The provider of the assets and services has a competitive advantage as the barriers to entry are high due to high costs and regulation.
Investors invest in infrastructure assets
because:
Categories of Infrastructure Investments
Infrastructure investments may be categorized based on: (1) underlying assets, (2) stage of development of the underlying assets, and (3) geographical location of the underlying assets. Let us look at the various sub-categories now.
Infrastructure investments based on underlying assets: They can be classified into economic and social infrastructure assets.
Infrastructure investments based on the stage of development of the underlying assets: They can be classified into brownfield and greenfield investments.
Infrastructure assets may also be categorized based on their geographical location.
Forms of Infrastructure Investments
Investors may invest either directly or indirectly in infrastructure investments. The investment form affects the liquidity and the income and cash flows to the investor.
The advantages of investing directly in infrastructure are that investors have a control over the asset and can capture the full value of the asset. But the downside of a large investment is that it results in concentration and liquidity risks.
Most investors invest indirectly. Some forms of indirect investments include:
Investing in publicly traded infrastructure companies offer the benefit of liquidity. Publicly traded infrastructure securities also have a reasonable fee structure, transparent governance, and provide the benefit of diversification. Master limited partnerships (MLPs) are pass-through entities similar to REITs and are listed on exchanges.
Infrastructure investments with the lowest risk have stable cash flows and higher dividend payout ratios, but they also have lower expected returns and lesser growth opportunities. An example of a low-risk infrastructure investment is toll roads, or a brownfield investment in an asset leased to a government school. An example of a high-risk infrastructure investment is a fund with a greenfield investment.
Some of the risks associated with infrastructure investments include:
Some of the advantages to investors from investing in infrastructure are as follows:
It can be difficult to conducting performance appraisal on alternative investments because these investments have the following characteristics:
Traditional risk and return measures (such as the Sharpe ratio – measure of return per unit of risk) are not always appropriate for alternative investments because:
Apart from the Sharpe ratio other metrics used to review the performance of alternative investments, include:
Private equity and real estate investments often display a J-curve effect – initial decline followed by strong growth over the long term.
The IRR calculation is frequently used to evaluate private equity investments. However, the determination of an IRR involves certain assumptions about a financing rate to use for outgoing cash flows (typically a weighted average cost of capital) and a reinvestment rate assumption to make on incoming cash flows (which must be assumed and may or may not actually be earned).
To overcome this complexity, the multiple of invested capital (MOIC), or money multiple is frequently used. It simply measures the total value of all distributions and residual asset values relative to an initial total investment.
The cap rate is often used to evaluate real estate investments. It is calculated as the annual rent actually being earned divided by the price originally paid for the property.
Leverage
Hedge funds often use leverage to enhance returns. To lever their portfolio hedge funds use derivatives or borrow capital from prime brokers. Hedge funds have to deposit cash or other collateral into a margin account with the prime broker and the prime broker lends securities to the hedge fund. If the margin account falls below a certain level, a margin call is initiated and the hedge fund has to put up more collateral. This can magnify the losses of a hedge fund because it may have to liquidate the losing position to meet the margin call.
Illiquidity and Potential Redemption Pressures
Hedge funds are valued on a daily, weekly, monthly, and/or quarterly basis. The value of a hedge fund depends on the value of underlying positions.
The price used for valuation depends on whether market prices are available and if the underlying position is liquid. When market prices are available, the fund decides what price to use. Common practice is to quote at . A conservative approach is to use bid prices for long and ask prices for short.
GAAP accounting rules categorize hedge fund investments into three buckets:
Level 3 assets values require additional scrutiny from investors. The models used should be appropriate and consistent. The values obtained may not reflect true liquidation values. Also, the returns may be smoothed and the volatility understated.
Another factor that can magnify losses for hedge funds is redemption pressure. Redemptions usually occur when the hedge fund is performing poorly. Redemptions can force hedge fund managers to liquidate positions at disadvantageous prices.
To discourage redemptions:
Example: Incentive Fees Relative to Waterfall Types
A PE fund invests $10 million in Portfolio company A and $12 million in portfolio company B. Company A generates a $6 million profit, but Company B generates a $7 million loss. The time period for the gain and loss are the same. The manager’s carried interest incentive fee is 20% of profits. Calculate the incentive fee under:
Solution to 1:
Overall, the fund lost money (+$6 million – $7 million = -$1 million) so under a European-style whole-of-fund waterfall, the manger will not receive any incentive fee
Solution to 2:
Under an American-style waterfall, the GP could still earn 20% x $6 million = $1.2 million as incentive fees on the profitable Company A deal.
Hedge funds commonly use a “2 and 20” fee structure and fund of funds commonly use the “1 and 10” fee structure. However, many variations of the fee structure exist.
Analysts should be aware of any custom fee arrangements in place that will affect the calculation of fees and performance. These can include such arrangements such as:
Example: Fee and return calculations
Consider a hedge fund with an initial investment of 200 million; the fee structure is 2 and 20 and is based on year-end valuation. In year 1, the return is 30%.
Solution:
Profit = $60 million.
Management fee: 0.02 x 260 = $5.2 million.
Incentive fee which is 20% of profit = 20% x 60 = $12 million.
Total fee = $5.2 million + $12 million = $17.2 million.
Investor’s return = [(260-17.2)/200] -1 = 21.4%
Total fee = 5.2 + 10.96 = $16.16 million.
Investor’s return = [(260-16.16)/200] – 1 = 21.92%.
As you can see the return is better than Part 1 because incentive fee paid is relatively less here.
Incentive fee = 0.2 x (260 – 200 – 5.2 – 10) = 8.96.
Total fee = 5.20 + 8.96 = $14.16 million.
Incentive fee is further reduced and the investor’s return is enhanced.
Investor’s return = [(260-14.16)/200] – 1 = 22.92%.
Investor’s return = [(220-4.4)/242.8] – 1 = -11.2%
Investor’s net return = [(256- 7.76)/215.6] – 1 = 15.14%.
Example: Hedge fund versus fund of funds
An investor is contemplating investing £200 million in either the Hedge Fund (HF) or the Fund of Funds (FOF). FOF has a “1 and 10” fee structure and invests 10% of its assets under management in HF. HF has a standard “2 and 20” fee structure with no hurdle rate. Management fees are calculated on an annual basis on assets under management at the beginning of the year. Management fees and incentive fees are calculated independently. HF has a 25% return for the year before management and incentive fees.
Solution to 1:
HF has a profit before fees on a £200 million investment of £50 million (= 200 million × 25%). The management fee is £4 million (= 200 million × 2%) and the incentive fee is £10 million (= 50 million × 20%). The return to investor is 18% (= (50 – 4 – 10) / 200).
Solution to 2:
FOF earns an 18% return or £36 million profit after fees on £200 million invested with hedge funds. FOF charges the investor a management fee of £2 million (= 200 million × 1%) and an incentive fee of £3.6 million (= 36 million × 10%). The return to the investor is 15.2% (= (36 – 2 -3.6) / 200).
Hedge fund index returns can be overstated due to survivorship, and backfill biases.
Example:
A PE fund makes two investments for $5 million each in Company A and Company B. One year later Company A returns a $8 million profit. But two years later Company B turns out to be a complete bust and is worth zero.
The GP’s carried interest is 20% of aggregate profits and there is a clawback provision. How much carried interest will the GP receive in year 1 and year 2.
Solution:
In year 1, the GP will receive a carried interest of 20% of $8 million = $1.6 million. This amount would typically be held in an escrow account for the benefit of the GP but not actually paid.
In year 2, the GP loses $5 million of the initial $8 million gain, so the aggregate profit is only $3 million. The carried interest payable is 20% x $3 million = $0.6 million. The GP has to return $1 million of the previously accrued incentive fee to the LPs because of the clawback provision.
Example
The hedge fund had an initial investment of $60 million. At the end of the first year, the value was 70 million after fees. At the end of the second year, the value was 80 million before fees. The fund has a 2 and 20 fee structure and incentive fees are calculated using a high water mark and a soft hurdle rate of 5%. Calculate the total fee paid for year 2.
Solution:
Management fee = 80 x .02 = 1.6 million
Incentive fee = (80 – 70) x .2 = 2 million
Total fee = 1.6 + 2 = 3.6 million
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