Asset Classes and Associated Risks
We define an asset class as a set of goods or securities (equity, debt or contracts) which exhibit the same characteristics, behave in the same way on the market and are governed by the same rules. This tutorial explore several Asset Classes with examples.
Furthermore, an asset must be able to be traded on an organized market and generate an income and/or capital gains in the future. The main purpose of acquiring an asset is an investment, i.e., to seek a return.
This section begins with a review of the different asset classes and, more importantly, an analysis of the risks associated with each. Asset price fluctuations depend on whether or not different factors, or more precisely risks, materialize, and these risks are usually specific to each class. After identifying the risks, we will determine whether it is possible to hedge against them and, if so, how. The list of risks will be as comprehensive as possible. At the end of this section, we will classify the asset classes according to their degree of risk using several criteria.
Money Market Investments Definition
Money market instruments include all short-term instruments with a maximum maturity of 12 months.
These are highly liquid, high-quality debt investments that generate a modest yet regular income, such as government debt securities, certificates of deposit, commercial paper or fiduciary deposits. For private management, in terms of the form of investment, fiduciary investments are usually distinguished from money market funds. Although bonds with a maturity of less than one year belong to the money market category, they will not be considered in detail here as they are covered in the next section.
A fiduciary deposit is an investment made in the name of a bank, in the form of a short-term deposit in another bank, but on behalf and at the risk of the investor, who therefore bears the risk of default or bankruptcy of the borrower. Counterparty risk may be mitigated by demanding a minimum rating (AA or AAA for example) or by counterparty diversification.
The interest rate earned is usually lower than the LIBOR (London Inter Bank Offered Rate) on the market for the given maturity. The LIBOR is the interest rate at which banks borrow on the interbank market, while investors who wish to lend money for a given period ask the bank to borrow from them and what interest rate they may obtain.
As the loan is instigated by the lender, a lower interest rate is justified. This is a useful means of financing for banks, allowing them to borrow money at a better rate from their clients. The interest and principal are paid at maturity.
A money market fund invests in short-term debt securities of the highest quality. Income may be distributed or capitalized. Their main advantage over fiduciary investments, which often impose a fixed term, is their high liquidity. However, this type of investment can undergo price fluctuations over time because of the greater variety of investments.
It is interesting to note that during the 2008 liquidity crisis, investors turned massively to money market funds or government debt securities to the detriment of fiduciary investments, seen as overly risky. Fiduciary rates suffered extremely high volatility during this period and sometimes banks even offered a rate higher than the LIBOR to attract investors.
Finally, the choice between these two types of investment rate will be influenced by the rate of income and capital gains tax in the investor's country of residence.
Risks Associated with Money Market Investments
Money market investments are not risk-free. The following risks may all be encountered:
a) Counterparty Risk (Default Risk)
As mentioned above, the quality of the borrower is the essential risk involved in money market investments, as bankruptcy is the ultimate risk borne by investors (default risk). Counterparty risk can be mitigated by careful selection and diversification of borrowers, and a high credit rating requirement. Because of its structure, an investment in a money market fund ensures greater diversification than a fiduciary deposit invested in a single bank.
b) Liquidity Risk
This risk essentially concerns only fixed-term fiduciary investments, as money market funds are very liquid. A fiduciary investment subject to 48 hours' notice is obviously very liquid also. Short maturity instruments limit this risk for investors.
c) Interest Rate Risk
Investors often think that quality money market instruments are risk-free, forgetting that they bear the risk of interest rate fluctuation, which can be significant. Every time a fiduciary deposit is renewed, there is a risk it will be reinvested at a different interest rate, which may be lower than the previous rate. We are referring here to short-term rates, i.e., under 12 months.
When interest rates are rising, short-term fiduciary deposits are preferable as they are quick to take advantage of any new rate rises, unlike money market funds that are slow to adjust to new rates.
Conversely, when rates are falling or expected to fall, it is best to make a longer-term fiduciary deposit, and then to favour money market funds. These are less sensitive to falling interest rates, integrating rate changes more slowly than fiduciary investments. Money market funds are invested in instruments with a longer maturity (though under 12 months), meaning they can benefit from rates that have been fixed for a longer period.
d) Inflation Risk
As previously mentioned, returns offered by money market investments usually only just cover inflation in the long term. Inflation can therefore reduce the future value of the investment. This risk can be reduced by investing in other asset classes, with a view to diversification. The proportion of money market investments will obviously depend on the investor's risk profile. It will be larger for conservative portfolios and very low for more dynamic profiles.
e) Currency Risk
When denominated in currencies other than the reference currency, fiduciary deposits or money market funds represent an additional risk, as the currency risk borne by investors can be significant. Investors often hope to take advantage of a higher interest rate in a foreign currency, but frequently forget that the conversion of these funds into the reference currency can ultimately lead to a capital loss. Exchange rate movements can, in fact, be very violent and affect investments. Therefore, large money market investments in a foreign currency should be avoided.
However, a need for liquidity in several currencies may justify money market investments in different currencies. In other cases, investors can either limit themselves to fiduciary investments in their reference currency, or hedge against the negative effects of exchange rate fluctuations by using forward currency contracts, for example. This will be looked at in more detail later on.
Regarding money market investments, we recommend:
focusing on borrower quality;
taking the direction of short-term interest rates into account; favoring investments in the reference currency.
A bond “represents a fraction of a loan made to a company or a public authority by a large number of investors. This type of security is issued in series, with the same issue price, interest rate, maturity and repayment conditions.” These are debt instruments with maturities of over one year, as short-term bonds (maturity of under 12 months) are regarded as money market instruments.
In principle, investors who buy bonds get a regular return, paid out in the form of interest (coupons), and can also make a capital gain if the initial purchase price was lower than the resale price or redemption value. Bonds bought with the intention of being held until maturity (in which case we speak of yield to maturity) should be distinguished from bonds bought for a shorter period with speculative intent.
A bond's total return can be defined as follows:
a) Types of Bond
Firstly, regular fixed-rate bonds are to be distinguished from zero-coupon bonds which, as their name implies, pay no interest, but make a capital gain when redeemed at maturity. These bonds are bought at a substantial discount to par value, i.e., below 100%, and are redeemed at par (100%).
Floating rate notes pay a coupon that varies over time. The coupon is equal to a reference rate like the LIBOR, plus a spread, i.e., a certain percentage (for example, LIBOR + 2%). In this case, investors are affected by interest rate fluctuations between two coupon dates.
Perpetual bonds have no set maturity and pay fixed coupons for life. Because of their “infinite” maturity, they are very sensitive to interest rate fluctuations and can experience major price fluctuations. Consequently, they should only be considered by investors seeking to earn a fixed income over time, who are unconcerned about the fluctuation of the bond's value.
Perpetual bonds are often “callable”, giving the issuer the right to redeem the loan before maturity at a predetermined date and price. By exercising this option, the issuer can refinance at a lower rate if interest rates have dropped significantly since the initial date of issue. This type of clause reduces the bond's value for investors, as they run the risk of being redeemed before maturity and having to reinvest at a lower rate.
Some bonds are “puttable”, meaning the holder is entitled to request early repayment at a predetermined price. However, they are rarer in practice and, because of this right to early redemption at the holder's request, more expensive.
Inflation-linked bonds provide protection against this threat and help preserve real value over time. Technically, every year, the nominal amount is adjusted to inflation based on the consumer price index. The coupon rate remains the same, but the nominal amount varies over time. However, this type of bond has low liquidity.
Finally, convertible bonds allow the holder to convert the bonded debt to stocks (equity) according to defined conversion procedures, but they are not commonly encountered in practice.
b) Types of Bond Issuer
The first distinction in terms of issuer lies between government, sovereign or supranational bonds and corporate bonds. As we mentioned earlier, government bonds with a maturity of fewer than 12 months, such as American Treasury bills (T-bills) or German “Bubills”, are considered money market instruments because of their maturity, in the same way as commercial paper or certificates of deposit.
Government bonds from developed countries are high-quality debt instruments, but their creditworthiness depends on the country in question and the state of its finances. Greece is a recent example of a developed country with worrying financial health. Bonds from most emerging countries are of a lower quality, due to greater uncertainty about their ability to repay their debts.
By emerging countries, we mean all countries that are not considered advanced. According to the criteria defined by the International Monetary Fund (IMF), the 33 advanced (developed) countries are. However, in the current economic environment, it is important to examine the level of indebtedness of the country in question carefully and to favor those with solid finances. It appears that several countries still do not respect the
Maastricht criteria, which set the upper limits of indebtedness at 60% of GDP for public debt and 3% for the budget deficit. It can also be useful to study the distribution of the debt to find out who the other creditors are. This is particularly true of Europe, a club where everyone “knows everyone else”.
Moving on to corporate bonds, it can be worthwhile to classify these according to company type and, more importantly, industry. In our view, an in-depth examination of the outlook of the industry in which the company operates, as well as the company's fundamentals, is key to determining the quality of the issuer.
The type of issue is also essential, as it determines the level of creditor protection in case of bankruptcy. Subordinated bonds pose an additional risk to creditors, as they are only entitled to have their debt repaid once the other (priority) creditors have been repaid. Bonds with an embedded call option also pose a risk to creditors.
Bonds issued by companies that benefit from a State guarantee or, because of their capital structure, benefit from an implicit State guarantee, also exist. They are generally of a quality equivalent to government bonds but offer lower returns than ordinary corporate bonds of a similar quality.
c) Issuer Quality, Credit Rating Agencies, and Bond Rating
Bondholders seek first and foremost a regular return in the form of coupons. However, interest is not paid if the issuer goes bankrupt or finds itself in default. Consequently, the choice of bonds should be based on the credit quality of the borrower.
Investors can refer to the rating assigned by credit rating agencies to determine the quality of an issue. Standard & Poor's, Moody's and Fitch are the main credit rating agencies. To rate the loan, they carry out a detailed analysis of the company's economic sector and financial state. The interest rate at which the company is able to finance itself on the market directly depends on the rating obtained and therefore determines the cost of financing.
Loans rated AAA are the most creditworthy, and the lower limit for investment grade bonds is BBB (Standard & Poor's), at which creditworthiness remains adequate. Under this threshold, bonds do offer higher returns (they are called high yield bonds) but they carry a higher risk of default.
Bond issues with a BB to B rating are not very creditworthy. Bonds with a CCC to D rating is vulnerable to non-payment and are therefore highly speculative securities. It is important to note that a rating applies to a specific debt issue and not to a company. Subordinated bonds issued by the same borrower will have a lower rating than regular bonds.
As such, it is useful for investors to study the rating of the bond issue before making an investment decision.
Rating agencies can sometimes be slow to change ratings, and the subprime crisis has caused doubt as to their precision and reliability. Moreover, besides the increasing complexity of products requiring analysis, the fact that these agencies are paid by issuers can lead to potential conflicts of interest.
These ratings are a good indication of creditworthiness, but cannot by themselves justify an investment decision. As we suggested earlier, an analysis of the industry and its prospects must also be carried out. In addition, we recommend examining trends in prices for Credit Default Swaps (CDS), which “provide precious information about the perception investors have of debtor risk”.
These instruments will be covered in more detail in the following subsection on risks.
d) Forms of Bond Investment
Investors can decide to invest directly in individual bonds or in bond funds, but management fees and expenditure involved in these funds often affect their performance. Another option is a bond index tracker, i.e., a fund that replicates the performance of such indexes. Passive (or index) management is often favored where bonds are concerned.
e) Taxation of Bonds
Coupons paid are regarded as income and are taxed at various rates depending on the country. Capital gains, however, are treated differently in different countries. For example, capital gains are taxed in France, while in Switzerland there is no capital gains tax on private property.
Risks Associated with Bonds
a) Default Risk Associated with Bonds
This risk relates to the quality of the borrower and its ability to meet its financial commitments, i.e., to pay coupons and/or repay the borrowed amount. The bankruptcy of the borrower results in the loss of all or part of the capital invested. However, the position of creditors is preferable to that of shareholders. Regular bond debt is paid first, followed by “subordinated” debt, and only if there is anything left over will shareholders receive a liquidation dividend.
This risk can be mitigated by investing in high-quality debt, such as government bonds, favoring countries with solid finances. It is also possible to hedge against such a risk by buying CDSs (Credit Default Swaps). For the payment of a premium, this derivative protects the holder against issuer default, such as bankruptcy or moratorium.
The event giving rise to payment must be clearly specified in the contract between the buyer and seller. The amount of the premium depends on the issuer's credit quality and its future development. In this case, the default risk is transferred from the buyer to the seller of the CDS. “Trends in CDS prices are a suitable instrument for measuring the perception of risk on financial markets.”
b) Risk Associated with the Type of Issue and Risk of Early Termination. The type of debt being issued also represents a risk for investors. Senior debt offers better protection than subordinated (junior) debt that may be assimilated to capital.
In case of bankruptcy, creditors of unsubordinated debt have priority over holders of a subordinated bond, who are only entitled to repayment of the debt once the other (priority) creditors have been repaid. Stockholders only have a claim on the company's residual equity. Subordinated bonds, being callable, also carry the risk of early termination. As we have seen, an embedded call option is a reinvestment risk for investors, who could be forced to reinvest at a lower rate. For this reason, the price of these bonds is lower than that of regular bonds.
It is difficult to hedge against these risks, apart from avoiding a certain type of issue and only considering regular, unsubordinated bonds.
c) Liquidity Risk Associated with Bonds
Depending on the size of the loan and the levels of supply and demand, the price of an issue can be particularly sensitive to a lack of liquidity in the secondary market. Therefore, investors may risk not being able to sell their bonds quickly or at a good price if demand is weak or if the spread (gap between the purchase price and the sale price) is significant.
Once again, it is difficult for investors to hedge against this risk, but an examination of the size of the issue and of prior market liquidity conditions for the type of bonds in question helps limit this risk. In practice, an issue of over 500 million euros is generally considered to be adequately liquid. The spread also provides a good indication of liquidity.
d) Rating Risk Associated with Bonds
A rating drop will negatively influence the price of bonds, because of the lower debt quality implied by the new rating. Investors can hedge against this risk through careful monitoring of a bond issue's rating. For example, comments made by rating agencies, such as “negative credit watch”, must be taken into account.
Furthermore, it is worth noting that there are often constraints in management contracts that prohibit investments below BBB (investment grade level). Consequently, a credit rating downgrade—from BBB to BB for example—can trigger a rush to sell on the market, further precipitating the downward price movement.
e) Interest Rate Risk (Price Risk and Reinvestment Risk)
Interest rate variations influence both fixed-rate bond prices and the reinvestment rate of coupons, but with opposite effect. When rates drop, coupons are reinvested at a lower rate, whereas the price of the bond itself rises. Conversely, when rates rise, coupons are reinvested at a higher rate, but the price of the bond falls.
Before buying a bond, investors need to find out its yield to maturity, which is a good estimation of the bond's annual return assuming that it is held to maturity and rates do not change. If investors want to sell before maturity, they run the risk of having to sell at a loss if interest rates rise in the future. If they keep it, they have to accept price fluctuations. Therefore, the shorter the maturity, the lower the risk. However, exposure to price risk can be limited in several ways.
i) Approach According to Context
We can distinguish two main situations and determine the appropriate approach for each, taking into account the term structure of interest rates. “Exact” positioning in terms of maturity will depend on the expected evolution of the yield curve (flat, normal or inverted yield curve).
The environment of rising interest rates:
As stated earlier, when interest rates rise, bond prices fall. So, if this scenario is anticipated, it is better to buy short-term bonds which are less sensitive to interest rate variations due to their low duration. This will attenuate the drop in bond prices.
As soon as the rise is over and rates have stabilized, investors should switch to long-term bonds to lock in the higher returns and protect themselves against any future fall in interest rates. Indeed, if rates subsequently drop, the price of these bonds will rise due to the greater appreciation of long-term bonds, which have a higher duration. However, coupons will be reinvested at a lower rate.
The environment of falling interest rates:
We have seen that when interest rates fall, bond prices rise. Long-term bonds are preferable when such a scenario is expected, as their higher duration means they are more sensitive to interest rate variations. This will improve the bond's price appreciation.
As soon as the fall is over and rates have stabilized, investors should switch to short-term bonds so as not to be locked in for too long a period in case of future rates rise. Moreover, a subsequent rise in interest rates will result in a fall in bond prices, but short-term bonds will suffer less from this depreciation due to their lower duration.
ii) Approach According to the Hedge Ratio
Exposure to price risk can be further limited by using what is called a hedge ratio. Using the duration of a hedging instrument for long-term interest rates, it is possible to calculate the amount of the instrument needed to hedge a bond portfolio. A bond futures contract or an interest rate swap can then be used.
The duration of a bond is a weighted average of successive interim maturities and final redemption. In other words, it represents the time it will take investors to recover their initial investment, considering the bond's purchase price, the coupon, its maturity and, finally, interest rates.
A higher time to maturity, a lower coupon rate and a lower yield to maturity all mean a higher duration. Modified duration gives the sensitivity of the bond's price to interest rate movements. The aim of this hedging strategy is to bring the portfolio's overall modified duration to zero, thereby protecting it against the influence of interest rate changes on prices.
For a given bond position with a precise modified duration, it is simply necessary to calculate the number of futures contracts to be sold11 to bring this modified duration to zero. Therefore, if rates were to rise, the overall value of the portfolio would change very little if at all, as the decline in the bond's price would be compensated by the gain made on the sale of the futures contracts.
This strategy is valid in the short term, but in the long term, the hedge must be adjusted according to interest rate movements or the change in modified duration, not to mention the cost of the hedge.
iii) Use of Options as a Hedging Strategy
A strategy adapted to the context of interest rate trends reduces this risk substantially. Investors can also make use of “caps” or “floors”, which allow them to hedge against rates increases or decreases respectively.
When interest rates are expected to rise, investors can buy a “cap” (interest rate call option) to hedge against rates rising above a certain level (strike price). If this threshold is passed, the buyer receives an amount corresponding to the difference between the observed rate and the strike price. This protection is often offered in conjunction with floating mortgage rates, where the borrower benefits from falls in interest rates but risks having to suffer higher interest rates in the future.
Where a decline in interest rates is expected, a “floor” (interest rate put option) may be used, giving protection when interest rates fall below a certain level. The holder of floating-rate debt securities who uses a “floor” will be paid an amount corresponding to the difference between the strike price (precisely defined level) and the observed rate at the moment of coupon payment.
iv) Immunization Strategy
In order to hedge against both price risk and reinvestment risk—“immunizing” against these two opposite effects—a so-called immunization strategy can be adapted to compensate for each.
While a hedging strategy aims to eliminate price sensitivity by selling a certain number of derivatives to bring the duration to zero, immunization aims to immunize the expected return for a given period against interest rate fluctuations. Of course, there is an investment that guarantees a predetermined expected return for a given period: the zero-coupon bond. Most bonds do pay coupons however, meaning that they are exposed to reinvestment risk.
To set up this strategy, a bond should be chosen whose duration corresponds to the investor's time horizon, in order to protect the underlying bond against any fluctuation until the next coupon date. Consequently, the portfolio must be reconfigured just after the coupon date, so that the portfolio duration is kept in line with the residual time horizon. Depending on the case, one effect may outweigh the other slightly.
It is important to note that immunization is based on duration, and relies on the (strong) assumption of the parallel shift in the term structure of interest rates. In other words, this means that short- and long-term rates should develop in parallel, but this is not always the case in practice. It is, therefore, more effective on long-term strategies, as short-term rates are more volatile.
The complex implementation of this strategy is reserved for professionals and, like all hedging strategies, it generates an additional cost for investors.
f) Inflation Risk
This risk is obviously linked to the risk of interest rate fluctuation that we have just discussed, as an interest rate rise to contain inflation has a negative impact on bond prices.
It is possible to hedge against this risk using inflation-indexed bonds. However, investors must be conscious of the reduced liquidity of this type of bond on the market. Furthermore, as with money market investments, returns from debt investments may sometimes only just cover inflation in the long term. This risk can be reduced by considering other asset classes.
g) Currency Risk Associated with Bonds
In the case of investments in a foreign currency, i.e., a currency other than the reference currency, exchange rate fluctuations can have a significant impact on the final return. For a foreign currency investment without foreign exchange risk hedging, the return will be divided into two parts: the gain or loss on the investment itself, and the gain or loss on the exchange rate between the reference currency and the investment currency.
When the currency risk is eliminated, returns will be made up solely of the gain or loss on the investment, minus the cost of the hedge. During some periods, a portfolio hedged against currency risk can outperform one that lets foreign currency fluctuate, but in other periods, the opposite may be true.
As such, is it worth hedging against currency risk, or should exchange rate fluctuations simply be endured?
In general, the answer to this question depends firstly on the weight that the foreign currency position represents in the portfolio. If it is very low (a few percents), it may be justified not to hedge, as the impact on the overall portfolio is negligible. However, if the position is significant (20% or 30%), the question is worth asking.
h) Risks Specific to Emerging Markets
It is difficult for investors to hedge against the various risks involved with emerging markets. Nonetheless, they must be conscious of these risks, and the specific context of a company established there and of the developing country in question must be analyzed in advance.
A government's lack of political experience, or the instability of the political system, leads to an increased risk of rapid and intense political and economic upheaval. This risk is obviously greater in emerging countries.
The economy of an emerging market is more reactive to fluctuations in interest rates and inflation than that of a developed country—it is also more exposed to them. A given event can, therefore, have much stronger repercussions. Furthermore, emerging markets often have a weaker financial base. Finally, their financial markets do not have an adequate structure and monitoring systems. As the assessments are different and ratings non-existent, it is much more difficult to assess credit risks.
Investments in government or corporate debt in emerging markets tend to involve higher risks than in developed countries, because of lesser creditworthiness, high public debt, debt conversions, a lack of market transparency or a lack of information.
The currencies of emerging markets undergo stronger and more unpredictable fluctuations than the currencies of developed countries. Some countries have introduced foreign exchange controls, others are likely to do so at any time, or may abandon their indexation to a reference currency.
For example, many export-focused Asian countries use the US dollar for their transactions. These countries have indexed their currencies on the USD to avoid excess exposure to exchange rate movements. However, countries have an increasing tendency to dismantle this system.
Due to strong price fluctuations and an underdeveloped financial market, the central banks of emerging countries can have difficulty meeting their inflation targets. Inflation may, therefore, fluctuate more than in developed countries.
In emerging countries, monitoring of financial markets is faltering if not inexistent, and so regulation, market transparency, liquidity and efficiency are all lacking. In addition, these markets often display major volatility and significant price differences. Weak regulation accentuates the risk of price manipulation and insider trading.
An asset's liquidity depends on supply and demand. However, the social, economic and political developments, as well as the natural disasters that emerging countries experience, can influence the supply and demand mechanism more quickly and enduringly.
The absence or lack of monitoring of financial markets can result in investors being unable to have their legal rights respected, or only with difficulty. An inexperienced justice system can lead to major legal insecurity. Furthermore, requirements aimed at protecting the rights of shareholders or creditors (disclosure requirements, insider trading prohibition, management obligations, protection of minority interests, etc.) are often insufficient, if they exist at all.
Clearing and settlement systems often vary from one market to another. Often obsolete, they are a source of processing errors, as well as of considerable delays in delivery and execution. Not to mention that some emerging markets do not have these systems.
In regard to bonds, we recommend:
favoring bonds issued by governments with strong finances;
favoring corporate bonds issued by companies with low debt levels and/or solid fundamentals (industry);
ideally choosing unsubordinated loans;
favoring issues that provide adequate liquidity;
considering the direction of interest rates;
hedging large foreign currency positions according to the degree of conviction.
For investing in stocks, we recommend:
combining individual stocks with index funds or futures; diversifying intelligently;
using effective hedging instruments wherever possible (stop losses, puts, futures); examining liquidity and solvency ratios;
carrying out a strategic analysis of the company and its industry; taking into account the political and regulatory framework;
hedging large foreign currency positions according to the degree of conviction.
Real Estate Definition
It is possible to invest directly in real estate by buying a property in one's own name or, in some countries, by holding it through a non-trading real estate investment company, which has the advantage of facilitating the transfer of assets to heirs.
Direct purchase requires a large amount of capital, a long investment horizon, and a comprehensive knowledge of the sector and the location of the property. It implies a certain amount of work on the part of the investor, as the housing stock must be managed in a professional manner. Investors unwilling to get personally involved must pay a property management company at an often considerable cost.
It is also possible to invest in this asset class indirectly, by investing in listed or unlisted real estate funds, or shares in property investment companies or real estate investment trusts (REITs) that provide access to a real estate portfolio.
Indirect purchase requires less capital. In addition, real estate funds and real estate investment companies can reduce risks if they are diversified geographically and by real estate category. Real estate funds are often focused on residential property and are generally more diversified than real estate investment companies, which own mainly commercial offices and warehouses. Consequently, real estate investment companies are more heavily indebted, more sensitive to the economic climate and, most importantly, more closely tied to market trends.
Real estate funds and investment companies are rarely traded at their net asset value and prices include a premium or a discount in relation to this value. For example, in Switzerland, on 31 December 2009, the average premium of listed funds was 21.9%.
Interest rate movements play an important role here—an interest rate rise will push the premium down, while a fall in interest rates will push it up, in this case constituting a premium to pay for access. Investor demand for this type of investment, as well as tax benefits, also maintains the premium at a high level.
Many studies have demonstrated the weak correlation between the direct real estate and stocks/bonds. Consequently, including direct property in a portfolio helps to reduce overall risk and plays a valuable role in diversification strategies. The optimum share is between 15 and 20% of the investor's total wealth.
On the other hand, the indirect property is closely correlated to stocks and bonds, and so is less attractive in terms of diversification. It is generally recommended to allocate about 5% to this asset class, while also taking into account the degree of correlation between the relevant real estate market and the type of assets in the investor's portfolio.
For this analysis, we will only consider the merits of indirect property in a portfolio.
Finally, property investments are often seen as good protection against inflation. When inflation is rising, the value of a mortgage used to finance property declines over time. In other words, the value of the debt will be lower tomorrow than it is today because of inflation, which has a positive effect for borrowers.
Risks Associated with Real Estate
a) Risk Associated with the Physical Nature of the Asset
Land and buildings are physical assets—a fact which makes them unique—for which there is no regulated trading. They are not traded on a centralized stock market. Transaction costs are high, as are maintenance costs.
Investing in real estate funds helps reduce this risk significantly, and delegates the management of real estate.
b) Liquidity Risk
Direct property is far less liquid than the stock market. Selling a property can take several months or even years. Direct investment requires significant capital outlays and generates a liquidity risk, as investors are slow to receive proceeds from the sale of their property. Indirect investment in real estate funds or investment companies helps reduce this risk considerably, as most of these funds offer better liquidity.
c) Risk Associated with the Structure of the Real Estate Market
Real estate markets are often opaque and require detailed knowledge of the local context. It is essential to refer to local experts, which limits access to the market. In addition, information is often asymmetrical and difficult to come by. In other words, this means that some of those active on the market have more information than others.
Consulting experts, carrying out comprehensive analyses of the property market or purchasing real estate funds specialized in this area all help deflect this risk, and funds let investors delegate the management of real estate to professionals.
d) Risk Associated with Supply and Demand
The value of real estate fluctuates according to supply and demand and the economic climate. Tax incentives or attractive credit terms can also stimulate the property market and tend to boost prices.
Only a thorough analysis of the macroeconomic variables and of the relevant property market will reduce this risk. Investors must, therefore, determine the attractiveness of this asset class and the future prospects of the market in question (country, residential or commercial property, etc.) in order to make a decision.
e) Interest Rate Risk
Real estate is affected by interest rate movements. When interest rates are low, mortgages are cheap and it is easy to make higher than average returns. Conversely, high-interest rates mean dwindling returns. As such, it is interesting to note that when rates are low and inflation is expected to rise, the value of debt will be lower in the future, thereby favoring borrowers.
It is possible to use OTC (over the counter) interest rate products to hedge against the risk of fluctuation. When a decline in interest rates is expected, a “floor” (interest rate put option) may be used, giving protection when interest rates fall below a certain level. The holder of a “floor” will be paid an amount corresponding to the difference between the strike rate and the observed rate at a set maturity date.
Conversely, when interest rates are expected to rise, investors can buy a “cap” (interest rate call option) to hedge against rates rising above a certain level (strike rate). This protection is often offered as part of floating mortgage rates, where the borrower benefits from rates fall but risks having to suffer higher interest rates in the future.
Finally, a “collar”, which is a combination of a floor and a cap, makes it possible to set a minimum and maximum level of interest rate fluctuation. As with all insurance, this type of protection comes at a cost that must be evaluated in relation to the expected risk of interest rate movement and its consequences for the investment.
f) Currency Risk
When investing in a foreign currency, investors are also exposed to foreign exchange risk in relation to their reference currency. As previously discussed, it is possible to hedge against this risk.
For (indirect) real estate investment, we recommend:
favoring listed and very liquid funds;
consulting experts and carrying out detailed analyses before selecting specialized real estate funds;
deciding on the geographic exposure and the type of property preferred (residential and/or commercial);
taking into account the level of interest rates and their expected movement; hedging large foreign currency positions according to the degree of conviction.
Commodities and Metals Definition
By commodities, we mean physical goods produced by agriculture or the mining industry, for example, and standardized in order to be used as underlying assets in a trade. Commodities (energy, precious and other metals, agricultural products) are usually traded on futures markets. Under contractual agreements, investors can buy or sell futures contracts related to the price movement of a given commodity.
The price of these different commodities fluctuates according to supply and demand on each of these markets, but this asset class provides attractive future prospects. High demand due to world population growth, finite reserves, the development of renewable energy, and the appearance of a middle class in some emerging countries are all increasing the attractiveness of commodities.
It is worth noting that meat consumption is related to GDP growth and that several kilos of grain and hundreds of liters of water are required to produce a kilo of meat. From a social and ethical perspective, however, it is debatable whether investors “should” invest, or speculate, on price rises for basic foodstuffs. In our view, this speculation, which can contribute to world hunger, should be excluded from any investment decision, and only the energy and precious or industrial metals sectors should be considered.
At this stage, it is also important to mention the development of socially responsible, ethical and environmentally respectful investments with various themes and involving various industries. For example, “responsible” investors who share this approach to investment can favor clean energy or alternative energy equity funds, which invest in the development of renewable energy or alternatives to highly-polluting traditional energy sources.
Commodities are organized into three broad categories: energy, agricultural products, and precious and industrial metals.
Prices in the energy sector essentially depend on supply and demand in the market, influenced in particular by geopolitical factors, which also cause a risk premium to be included in pricing. Natural gas is perhaps destined eventually to replace or supplement the oil supply. There is also significant growth in demand for electricity, requiring modifications in terms of supply and capacity.
As for oil, price increases for black gold seem inevitable in the long term. Demand, linked to the economic climate, as well as the level of US oil stocks, are essential factors in price setting.
However, oil resources are not infinite and will eventually be exhausted. This rarity helps sustain price rises. Moreover, demand from rapidly developing countries such as China and India is constantly increasing. The risk of dollar depreciation, future inflation, and risks related to equity and property markets have also prompted investors to buy oil as a safe investment in the same way as gold.
In addition, oil extraction, which takes place in increasingly difficult conditions and at greater and greater depths, is increasingly expensive for companies. Finally, speculation on the oil futures market helps sustain high prices. In a recent study, the International Monetary Fund (IMF) even admitted that soaring prices in 2007–2008 could largely be explained by speculation. In general, renewable energy only becomes profitable once the price of oil rises above 60 dollars per barrel.
b) Agricultural Products
Agricultural products are reputed to be volatile, difficult to access and depend above all on the structural conditions governing the market in question (assessment of the planting or operational area relative to demand). For example, producers earn two times less by planting cotton than soya beans.
A smaller production surface and the appeal of natural products can, therefore, help sustain cotton prices. As for timber, prices have fallen sharply due to problems triggered by the real estate crisis. The recession in the construction industry has pushed prices down, offering new investment opportunities.
It would be overambitious to review each of these markets here. We will simply note that overall, economic and climate conditions influence levels of supply and demand and therefore, ultimately, prices. Furthermore, speculators often abound on these markets. For these reasons, a detailed analysis is essential before making any investment.
c) Precious Metals
For centuries, gold has been coveted for its rarity, beauty and near inalterability. Central banks hold gold stockpiles as reserves of wealth. Gold is mainly used for jewelry, electronics, coins, dentistry and decoration (art). India is the biggest consumer of gold, followed by China and the United States.
Malkiel considers that gold plays a limited role in a portfolio, in that it does not generate income and can undergo severe fluctuations. Nonetheless, gold is a highly appreciated investment and is usually present in portfolios, especially those of conservative clients. The financial crisis and fears of banks going bankrupt have boosted demand for physical gold, which has seen its price rise above 1000 dollars—recently up to almost 2000 dollars—an ounce. It is truly considered to be a safe investment by investors and probably seen as an alternative to weak currencies such as US dollar.
Silver is the best conductor of heat and electricity. It is used for antibacterial purposes, electricity, jewelry, silverware, and photography. Unlike gold, silver is not really regarded as a safe investment, and its price fluctuates in a more cyclical manner due to its industrial use. Palladium is used mainly for catalytic converters, electronics, jewelry, dentistry, and chemistry. Finally, platinum is used for catalytic converters, jewelry, chemicals, electronics, glass, and oil.
d) Industrial Metals
The prices of industrial metals change in a more cyclical manner due to their link with industry and the economic climate.
Aluminum and its alloys are included in the composition of many industrial and commercial products for uses ranging from soft drink cans to airplanes, aluminum foil, and power lines. Copper has many household, industrial and technological applications. It is both ductile and resistant to corrosion and is a good conductor of heat and electricity. Its main uses are electricity, coins, water pipes, microprocessors, and construction.
About 70% of nickel is used to produce austenitic stainless steel, 10% for superalloys (aerospace) and 20% for alloy steels, rechargeable batteries, catalysts, chemicals, and coins. Zinc is mainly used as corrosion protection for iron and steel. It is also an essential micronutrient for human, animal and plant health. It is mainly used for galvanization, pharmaceuticals, casting, construction, and brass.
Tin is mainly used as a protective layer or alloyed with other metals. It is found in containers, receptacles, electronics, and transport.
Lead is a dense, malleable, corrosion-resistant metal used in construction, electrical systems, batteries, and radiation-proof screens.
Risks Associated with Commodities and Metals
Commodities and metals are exposed to the following risks.
a) Risk of Price Fluctuation Related to Supply and Demand
As we have already noted, the price of commodities depends on fluctuations in supply and demand over time, which vary according to the economic climate and economic cycles. The presence of speculators also puts pressure on prices. In our opinion, demand generally has a greater stimulating effect on prices than supply, as to a certain extent supply has to adapt itself to demand.
The price of oil, for instance, is influenced more strongly by demand than supply; however, it is also worth following OPEC (Organisation of the Petroleum Exporting Countries) meetings, which set production quotas—and therefore supply—specifically according to demand. Member countries may decide, as was the case at their meeting on 10 March 2010, to maintain quotas when supply is sufficient to satisfy demand.
In terms of precious metals and gold, in particular, the influence of central banks must be reiterated, as they buy and sell gold according to their desired level of reserves. It is difficult for investors to hedge against this risk, but it can be limited by undertaking a comprehensive analysis of the market being considered in order only to invest at opportune (favorable) moments and avoid investing when conditions are difficult.
b) Climate Risk and Natural Disasters
The climate and natural disasters also have an influence on prices. However, weather conditions mainly affect supply. A good (abundant) harvest has the effect of lowering prices, whereas a bad harvest pushes prices up to compensate for the small quantities produced. This risk is less significant for precious metals.
Producers usually protect themselves against this type of event by using insurance or futures contracts. It is difficult for investors to hedge against this risk, but it can be mitigated by a comprehensive analysis of the relevant market, which takes into account prevailing weather conditions that will affect the market.
c) Risk Associated with Government Intervention, Embargoes and Trade Barriers
When conditions of supply or demand become exaggerated, governments reserve the right to intervene in these markets in order to rebalance them by setting quotas or restrictions. The objective is to maintain or return to a fair equilibrium price. This risk exists mainly for commodities.
Recall, for example, the intervention of the Cambodian, Pakistani and Indian governments, which temporarily prohibited rice exports during the period of excessive demand in 2008. This was to curb rising prices, favor the domestic market and avoid local uprisings caused by famine. More recently (May 2010), India decided to ban cotton exports to force producers to favor the domestic textile market. This measure penalized neighboring countries that import cotton, such as Pakistan, Bangladesh, and China.
Once again, it is difficult for investors to hedge against this type of risk, which should really be considered as characteristic of the commodities market (essentially for agricultural products) and constantly borne in mind.
d) Risk Associated with Fluctuations in Interest Rates and Other Variables
The price of commodity futures changes mainly according to interest rate movements, but it also depends on variations in storage costs and in the convenience yield, which is linked to stock levels and their seasonal fluctuations. Depending on the case, holding the commodities themselves (i.e., immediate availability) does confer advantages that holders of futures contracts do not have.
For example, in the case of heating oil in winter, the spot holder (who buys today for immediate delivery) has an immediate advantage over futures holders, implying, in this case, a high convenience yield that creates a situation of backwardation. This convenience yield is lower in summer.
e) Risk Associated with Exchange Rate Fluctuations
As with any investment in a currency other than the reference currency, investors are exposed to currency risk.
Commodities are often listed in dollars, the movement of which can have various different consequences.
“A rising U.S. dollar normally has a depressing effect on most commodity prices. In other words, a rising dollar is normally considered to be noninflationary. One of the commodities most affected by the dollar is the gold market […], the prices of gold and the U.S. dollar usually trend in opposite directions.” Nonetheless, there are observable instances of gold and the dollar both rising in tandem, perhaps indicating that this relation is waning.
“Commodity prices are considered to be leading indicators of inflationary trends. As a result, commodity prices usually trend in the opposite direction of bond prices.” So the dollar influences commodities, which in turn influence bonds, which finally influence stocks.
f) Risk Associated with Futures Market Cycles
In a situation of normal backwardation, futures prices are lower than the spot price (cash price), and they decrease over time. In this case, the market demands a premium, so to speak, for short-term availability.
Conversely, in a so-called contango situation, futures prices are higher than the spot price, and they are therefore rising over time. In 2009, the structure of the oil futures price curve clearly showed a contango situation (upward sloping).
As we said to begin with, futures contracts are the main instrument for investing in this asset class. Depending on the economic situation and on supply and demand levels, one or other of these two situations may present itself and it is very important for investors to position themselves correctly. Poor positioning is an investment risk.
During backwardation, it is better to buy futures contracts, while during contango, buying at spot is preferable to buying futures. But this is not always possible in practice, especially for consumable commodities where the use of futures contracts is necessary.
Therefore, with futures contracts, “rollover gains are made when a forward curve is in backwardation, as the expired contract can be replaced by a more advantageous contract. On the other hand, when a commodity market is in contango, rollover losses are inevitable.” Indeed, in the first case, again is made because a new, cheaper contract can be bought, whereas in the second case, a new contract must be bought at a higher price than the futures contract that has just been sold, thus generating a loss
When investing in energy and precious or industrial metals, we recommend:
studying supply and demand levels according to the economic climate and cycle; taking weather conditions and natural disasters into account; keeping a close eye on state intervention;
taking into account interest rate levels and, more importantly, the situation of backwardation or contango;
monitoring the US dollar;
hedging large foreign currency positions according to the degree of conviction.
Private Equity Definition
Private equity is a form of venture capital financing for companies that are not publicly traded on a stock exchange or, exceptionally, who wish to delist. These investments usually occur at the early stages of a company's development, when future prospects are uncertain and risks are higher.
Private equity investments made in young companies or start-ups with high growth potential are often referred to as venture capital. But private equity can also take the form of capital made available to a young company just before its initial public offering, or IPO, for example (mezzanine financing).
Generally, this form of financing is structured so that the proceeds from the IPO are sufficient to repay the company's shareholders all or part of their participation. When used to finance a change of owner, in the case of a delisting for example, this is more often called a buyout.
This type of investment may be made directly, or indirectly through a private equity fund. However, in this case, there is no guarantee that the fund manager will be able to acquire the shares and make the capital gains expected of this type of investment. The manager's skills are decisive for the success of an indirect investment.
Risks Associated with Private Equity
a) Liquidity Risk
A private equity investment usually has very low liquidity due mainly to the existence of lock-up periods, which prevent investors from exiting before a certain date. This risk cannot be avoided. In fact, lack of liquidity is more a characteristic of this type of investment than a risk.
b) Risk Associated with Unlisted Investments
As private equity is not publicly traded, valuation of the investment over time is difficult. Investment in listed private equity funds helps limit exposure to this risk, but as in practice there are very few of these, we tend to consider this risk as one of the characteristics of this investment.
c) Risk Associated with Limited Regulation and a Lack of Transparency
The absence of an organized, regulated market specifically allows this type of investment to be conducted within a less regulated framework, which is also less stringent in terms of transparency. Investors can reduce this risk by requiring that the manager invest where there are stronger regulations, which depend on the country, and that they provide greater transparency about their investments.
d) Major Insolvency and Bankruptcy Risk
When investing in venture capital, future prospects are uncertain and the ultimate risk of bankruptcy is obviously more pronounced. Investors can lose practically everything.
It is difficult for investors to hedge against this type of risk, even when using financial instruments such as puts or futures. In our view, the best possible hedge for investors who can't manage this risk is simply to avoid this type of investment altogether.
e) Risk Associated with the Lack of Diversification
Private equity typically implies a large concentration of investments in order to allocate considerable initial resources to projects in the development stage, when financing needs are high. Although it is a characteristic of this type of investment, this approach does, therefore, suffer from a lack of diversification. Diversification into other asset classes, and investing in private equity to a limited extent (a small exposure in the portfolio), will help limit this risk.
f) Leverage Risk
The use of debt is one of the characteristics of private equity and exposes investors to additional financial risk due to leverage, i.e., using debt to increase the investment's profitability. The borrowed capital must, therefore, generate an additional profit relative to the risk taken. If the risk pays off, gains will be multiplied but, conversely, the same goes for losses. In our view, it is difficult for investors to hedge against this risk.
g) Currency Risk
As with any investment in a currency other than the reference currency, investors are exposed to currency risk. Please refer to the previous discussion on this point.
h) Risk Associated with the Human Factor
Finally, in young companies where the personalities of executives in key positions play an essential role, any change in the team can have extremely negative repercussions on private equity investments. Private equity is, therefore, a highly speculative investment, and should be considered the riskiest asset class. It may only be suggested to a limited number of investors.
In conclusion, although private equity can be considered an asset class, the activity of venture capital is highly specific and should only be included in a portfolio with the utmost caution. The frequent lack of listing, the high degree of risk, and the lack of transparency are all issues which must be of paramount concern to investors.
If investors wish to include private equity in their assets, we recommend deciding on the amount to invest, then delegating management to professionals.
Such an investment is somewhat similar to the activity of a business angel or venture capitalist keen to invest actively, i.e., with significant participation in both capital and decision-making. Indirect investment is an alternative, but the choice of fund and manager is paramount.
Other Asset Classes
Aside from currencies, which are often regarded as an asset class, we might consider including other assets such as aircraft or boats, as income is generated by their rental or commercial exploitation.
However, given the depreciation over time of these assets, maintenance and exploitation costs, and the limited number of individuals who own private jets or boats intended for hire, they should instead be regarded as the “non-investment, for personal use” part of an individual's fortune.
The same reasoning applies to cars, with the exception of vintage cars whose value can grow significantly over time. This type of investment can, therefore, prove very profitable. The same is true of all collectors' items or artworks whose value can appreciate with time to be sold for more than their purchase price. Finally, we might consider wine and bottles of future “grand crus” that are also likely to grow in value over time.
In our view, however, all the goods we have just listed depend on one essential factor: passion. Individuals have personal interests and particular pastimes and hobbies they are willing to spend money on. So although these assets to become part of an individual's fortune, they are acquired not as an investment but rather as the realization of a dream or pursuit of a passion. These decisions are based on deep personal motivation and less on the profit motive.
A sailing or car enthusiast will buy a yacht or a vintage car. A modern art lover will buy a work by his or her favorite artist for the pleasure of owning it and being able to contemplate it at home. In the event that the work should be sold, this art enthusiast would probably use the proceeds of the sale to buy another one. As for wine, a “grand cru” is intended above all to be enjoyed on a grand occasion or at a special event, and the pleasure it gives to the palate is the main objective sought by wine lovers.
Obviously, some of these goods may be bought with a view to speculation, i.e., quick resale in order to make again on the capital invested. However, the market for this type of goods is often illiquid and valuation includes a significant level of subjectivity. Furthermore, the value is often related to the uniqueness of the item and its history. Finally, the term speculation often refers to short-term objectives, while the holding period of this type of asset is usually long and is not a factor that is appreciated objectively by an enthusiast.
For all these reasons, we do not consider these goods as “normal” investment assets as far as this analysis is concerned, although we recognize that they can be regarded as such, marginally, for some investors.
Particular Forms of Investment within Asset Classes
Hedge Funds Definition
By definition, hedge funds have an absolute return objective, allowing managers to take long and short positions on the market, rewarding them with performance-related commissions and allowing them a great deal of flexibility in terms of investment style and approach. Managers adopt a more active management style and seek to profit from the market's various inefficiencies.
“A hedge fund is a private investment association that uses a large range of financial instruments such as short selling of stocks, derivatives, leverage or arbitrage, all in different markets. Usually, the managers of these funds invest part of their own resources and are paid according to their performance. Hedge funds often require high minimum investments and access to them is limited. They are intended mainly for wealthy clients, whether private or institutional.”
Therefore, hedge funds should not be regarded as an asset class, but rather a particular investment strategy. Furthermore, because of the diversity of strategies used and the fact that returns are derived from the return made on other traditional asset classes, it cannot be maintained that hedge funds have the specific characteristics necessary to be regarded as a separate asset class.
In Switzerland, FINMA recognizes that “hedge funds are a special form of collective capital investment […] subject to more lenient legal requirements than other forms of investment and therefore have greater freedom of investment”.
It is possible to invest directly in individual hedge funds, or indirectly in funds of hedge funds, which provide diversified exposure to several different funds and management strategies. Selecting the best fund of hedge funds, adapted to market cycles represent the added value essential in the management of this type of product.
Although hedge funds will not be studied comprehensively as part of our analysis, we will address the importance of the strategy used by the fund manager. It is particularly worth mentioning the following strategies, which clearly argue in favor of inefficient markets and are useful in demonstrating a flexible approach to investment.
Funds using this strategy identity, on the one hand, undervalued stocks (long or buy positions) and, on the other hand, overvalued stocks (short or sell positions) in certain regions or market segments. They bet on the fact that sooner or later the liquidation of these positions will generate capital gains.
In the Equity Long-Short strategy, there is no ongoing search for beta neutrality in terms of market risk. However, for so-called Equity Market Neutral strategies, managers seek a beta neutral position (long side beta = short side beta), i.e., the sums of the betas for the long and short positions are equal.
Arbitrage strategies aim to exploit price differences in markets for identical or similar investments. These strategies include fixed income arbitrage, convertible bond arbitrage or mortgage-backed securities arbitrage.
Managers who apply these strategies aim to exploit certain events, such as coming changes in companies (mergers, acquisitions, restructurings, remediation, etc.). Merger arbitrage, distressed securities, and special situations strategies also belong to this category.
Hedge funds that pursue these strategies attempt to identify macroeconomic developments early (changes in interest rates and exchange rates in particular), and profit from them. Growth funds and emerging market funds are both parts of this category.
In this category of hedge fund, futures contracts are traded on financial instruments, currencies, and commodities. As we mentioned previously, flexibility is an essential factor and it will form the basis of the approach to portfolio construction suggested later. If hedge funds manage to generate attractive returns with less historical volatility, this is due in part to the flexibility of their investment policy.
Furthermore, relatively illiquid markets offer bigger investment opportunities, specifically because they are less efficient. As Swensen points out, “The most lucrative investments tend to be located in shady areas, rather than under […] Wall Street's spotlight.”
Before briefly presenting the risks associated with this type of investment, it is interesting to note6 that some studies indicate that hedge fund returns cannot be adequately approximated by commonly used statistical distributions such as normal distribution. This is consistent with our earlier conclusion about risky assets.
Risks Associated with Hedge Funds
This type of strategy does include a set of market-related risks, particularly liquidity risk and leverage risk. In fact, quarterly or semi-annual liquidity periods strongly affect entry and exit points for this type of investment, unlike stock or bond investments that offer virtually immediate liquidity.
In times of crisis, liquidity is particularly sought after and there is no doubt that many hedge funds were unable to fully meet exit requests following the massive demand for redemptions at the end of 2008. They found themselves having to stagger redemptions, or sometimes even separate their illiquid investments from their more liquid assets into distinct classes (creating “side pockets”).
Recently, some funds have modified their structure or created a new, more liquid investment class so that they can offer investors better liquidity, usually weekly, and sometimes even daily. Article 34 of the EU Directive on the Undertakings for Collective Investment in Transferable Securities (UCITS) imposes a minimum of fortnightly or monthly liquidity periods, which has the advantage for investors of reducing the terms of redemption.
This structure is particularly suitable for “long-short” strategies, which invest in more liquid assets than other types of strategy. It is still too early to get an adequate performance history for these new, more liquid classes, but the performance targets announced by managers are clearly set lower than those of traditional, less liquid classes. There is a price to pay for reasonable liquidity with this type of investment.
Leverage certainly helps multiply gains by borrowing from banks several times the amounts managed, but it can also multiply losses. The existence of this leverage, however, confers considerable power to lenders, who can request redemption of all or part of the funds according to market conditions and the value of assets used as collateral for loans. In the event of margin calls or demands for redemption, some hedge funds may be forced to sell assets or even to close the fund, as was, unfortunately, the case in 2008 with the Carlyle Capital and Peloton ABS funds, among others.
Using derivatives can also lead to a risk of significant losses on the fund's investments.
The lack of transparency linked with hedge funds can also represent a risk for investors, who are not always correctly informed about the strategies being used. This is often an opaque environment, and as Bing Liang of the University of Massachusetts showed in her study, “unfortunately, 35% of hedge funds produce misleading and unaudited data. […]
If these small deviations from reality were taken into account, the average annual performance of hedge funds would no longer be 10.7% for the last few years (before 2004), but 6.4%. A figure which pales in comparison to a performance of 6.9% for the stock market and 7.5% for bonds.” Moreover, dead hedge funds and those which choose not to reveal their performance are not included in hedge fund indexes, which are therefore biased.
In terms of performance, some studies show that compared to other financial assets (stocks, bonds, and real estate), this type of strategy may be less profitable over a longer period. For example, “from August 2003 to late 2008, the SPI index of Swiss stocks rose by 26.16%, or 4.38% per year.
For this period, the CS Tremont Investable index shows a negative performance of −14.74%, or −2.90% per year for hedge funds.” Nonetheless, this type of strategy resisted far better to the 2008 bear market, an exceptional year in every respect, where the magnitude of the correction that occurred in the markets was simply unforeseeable.
It is useful to note that hedge funds target positive performance above all, independently of any benchmark. This absolute return objective is certainly an interesting alternative to the traditional relative return approach. Furthermore, it would obviously be a mistake to put all hedge funds in the same basket. There are excellent fund managers who are professional and competent, and who deliver satisfying performances independently of market movements.
We will leave it to each investor's discretion to decide whether or not they want to include hedge funds in their portfolio. However, it is essential to understand what we are investing in, how performance is delivered and the risks associated with the strategy concerned. Unfortunately, the Madoff affair illustrated the lack of due diligence on behalf of certain banks and investment companies worldwide, who did not adequately question the way such a performance had been achieved over such a long period.
There are inherent risks in each particular strategy for hedge fund management, but these aspects do not fall within the scope of our analysis and we invite the reader to refer to specialized works in this area.
Malkiel recommends avoiding hedge funds, as in his view they were responsible for promoting the Internet bubble from 1998 to 2000 and for having played a destabilizing role in the oil market in 2005 and 2006. He believes that the doubling in price cannot be explained simply by changes in supply and demand and it would seem that speculative activities, driven mainly by hedge funds, contributed to this rise.
In our opinion, it is more appropriate to consider this type of strategy as complementary to a particular asset class, while bearing in mind their illiquidity. For example, a long/short hedge fund should be considered in a portfolio's equity exposure because the fund's underlying assets are really just stocks. A hedge fund using futures contracts on commodities should supplement exposure to commodities as they have the same underlying; only the type of strategy is different. The percentage invested depends on the investor and the share of funds that can be less liquid.
If investors decide to include hedge funds in their portfolio as an alternative strategy to a particular asset class, we recommend:
favoring liquid funds, and accepting to pay the price for this liquidity;
favoring funds that do not use much leverage;
making sure they fully understand how the performance is achieved; selecting the strategies best adapted to the market context.
Structured Products Definition
By structured product, we mean “the combination of derivatives and traditional assets, such as stocks or bonds. The combination of these components results in a financial instrument in the form of a security.” Structured products are usually divided into three categories:
1. Participation products, such as certificates, which accurately reflect the movement of the underlying asset.
2. Yield enhancement products, such as maximum-return products, that allow investors to forego the potential upside exposure to an underlying asset above a given threshold in exchange for compensation, in the form of either a discount or, as with a “reverse convertible”, an enhanced coupon. These combine a bond with a short put option and at maturity either pay a high coupon, or the holder receives the securities according to the movement in the underlying.
3. Capital guaranteed products, which limit the risk of losses in the event of falling prices, while making it possible to participate in a rise in the underlying. Structured products can behave both like stocks and like interest-generating investments. Furthermore, the nature of the product can change dynamically over its entire lifetime.
Thus, investors keen to gain exposure to a specific market can do so in different ways. They can buy a few individual securities of companies listed on this market, buy an index fund for the market in question or buy into an investment fund. Finally, they can buy a structured product linked to the price movement of this underlying, depending on their views and price or return objectives.
Consequently, structured products are not really an asset class, but rather a particular form of investment in one of the asset classes according to the relevant underlying asset, investment theme or industry. Their inclusion must depend on the terms of the issue of these products at the time they are being examined, and therefore on their attractiveness for investors.
Nonetheless, it is important to be conscious of the risks associated with investing in this type of product.
Risks Associated with Structured Products
The main risk associated with the issue of structured products is counterparty risk, which depends specifically on the creditworthiness of the issuer. The other risks are related to the components of the structured product and to the movement of the underlying assets.
The bank Wegelin & Cie offers an interesting approach: to decompose the structured product, by separating “the complicated financial instruments and reducing them to a few basic components”. This approach also has the advantage of separating the so-called “nominal” part from the real part, which constitutes the real exposure to the underlying asset.
For example, by decomposing a capital guaranteed product, we arrive at two components: the bond part (zero-coupon) that provides a capital guarantee at maturity and the options part that makes it possible to profit from a rising market.
Besides counterparty risk, investors are exposed to the risks associated with investing in a zero-coupon bond (essentially default risk) and the risks associated with the movement of the underlying asset, with losses being limited at maturity, however, thanks to the particular construction of this product.
Even so, as part of this capital guaranteed product, if the underlying undergoes a strong decline compared to the initial strike price, the option is likely to become almost worthless, and its delta will fall. In the event of a market recovery, the extent of the rise will not match the market rebound due to the option's low delta. Moreover, the method used to calculate returns (quarterly, over the last six months, etc.) may also affect the product's final performance.
So using options has its own particularities. The exercise price, the interest rate level and the volatility of the underlying will all affect the price movement of the option and, consequently, that of the product. The reader should refer to the Swiss Derivative Guide 2010,16 which covers structured products and the use of options in great detail.
For structured products, some of which can be very attractive, we particularly recommend:
favoring quality issuers in order to minimize counterparty risk;
closely examining the product's terms of issue (protection, participation, a method of calculating returns, etc.). They must be attractive enough to justify allocating capital; favoring short-term products. At this stage, it will be useful to spend a moment looking at how options work.
Options are derivatives whose value is derived from the value of an underlying asset, which may be the price of a stock, an interest rate or the price of a commodity. Consequently, they should not be regarded as an asset class, but rather as a particular form of investment, or more precisely as hedging or speculation instruments.
Holding a call option gives the right (not the obligation) to purchase the underlying at a predetermined price (strike price) at a set expiration date or up until a certain expiration date. This option makes it possible to hedge against higher prices if a price increase is expected. It can also be used to speculate on price rises.
Conversely, holding a put option gives the right (not the obligation) to sell the underlying at a predetermined price (strike price) at a set expiration date or until a certain expiration date. It allows its holder to hedge against an expected decrease in prices. It can also be used to speculate on price decreases, or even to purchase the underlying at the desired price.
It should also be clear that holding an option (long call or long put) only confers a right, whereas the sale of options (short call or short put) implies the obligation to deliver the underlying or to pay for it if the option is exercised by its holder.
A “European” option may only be exercised at the expiration date, whereas an “American” option may be exercised at any moment up until the expiration date. Options are usually evaluated using the Black-Scholes formula. However, as we shall see in the following sections, it is not really suitable as it makes very strong and quite unrealistic basic assumptions, like for example the assumption of constant volatility over time.
The option's price will change over time depending on the development of certain factors such as price variations in the underlying (sensitivity measured by the option's delta), the passage of time (sensitivity measured by theta), variations in volatility (sensitivity measured by Kappa), variations in the interest rate (sensitivity measured by rho) and even the variation of the option's delta compared to the movement of the underlying asset's price (sensitivity measured by gamma).
This price, called the “premium”, comprises the intrinsic value and the time value. It fluctuates until the expiration date according to the variables cited above, reaching a time value of zero at expiration. So investors are buying time, and the more time they buy, the more they have to pay. Their option, as with any insurance, has a far from the negligible price if they hope to hedge the entire position invested in stocks.
Some investors, such as Peter Lynch or Warren Buffett, avoid options entirely, the latter even considering that “derivatives are financial weapons of mass destruction”. Nonetheless, they are a part of the financial landscape and without wanting to go into detail, buying and selling options poses many risks.
Risks Associated with Options
a) Long Call Option (Buying a Call)
With a long call option position, where a price rise is expected, losses are limited to the premium paid to acquire the option. In this case, the potential gain is theoretically unlimited and depends on a price rise in the underlying asset.
Take, for example, a call worth 1 EUR on a stock trading today at 20 EUR with a strike price set at 22 EUR; the buyer here is anticipating a price increase in the security. He or she will start making money once the price rises above 23 EUR, as first he or she must absorb the premium (22 EUR + 1 EUR). Any loss is limited to the 1 EUR spent and the gain will be equal to the difference between the stock price at expiration and the strike plus the premium. So, if the expectation was correct, and the stock is worth 40 EUR, the call buyer will have made the sum of 17 EUR per option (40 − (22 + 1)).
b) Short Call Option (Selling a Call)
In a short call option strategy, the investor expects prices to remain stable or to decrease slightly and wants to make a premium. The gain is therefore limited to the premium earned.
However, the risk of loss is theoretically unlimited, as if the buyer exercises the option, the seller will have to deliver the underlying security. If he or she does not own it, he or she will first have to buy it on the market at a price that may be far higher than the strike. Many banks limit this risk by only authorizing short “covered” calls, where the investor already owns the underlying security in his or her portfolio.
It should be noted that selling covered calls is only appropriate if investors have a neutral or slightly bearish/bullish view of prices. In the event of a sharp decline, the premium received will not cover the loss in value of the position, and it is better to sell the stock if a major correction is anticipated.
Conversely, to take the example of a call sold for 1 EUR on the stock currently trading at 20 EUR with a strike also set at 20 EUR, here the seller is anticipating a slight decline in the security. The premium earned represents the gain on the position. If the expectation was correct and the price drops slightly to 18 EUR, the call holder will not exercise the option as he or she can buy the security more cheaply on the market (18 EUR instead of 20 EUR, not counting the premium of 1 EUR). The seller of the call, therefore, wins in this scenario.
However, if the security rises to 25 EUR, the option will be exercised and the seller will have to deliver the security in exchange for 20 EUR, which represents a loss of 4 EUR ((20 + 1) − 25).
c) Long Put Option (Buying a Put)
In a long put position, a downward price movement is expected and losses are limited to the premium paid to acquire the option. In this case, the potential gain is also limited. For example, by buying a put at 1 EUR on a stock worth 20 EUR with a strike price of 20 EUR, the buyer is seeking to hedge against an expected decline in prices.
The loss is limited to the premium, and he or she will start making money when the price drops below the threshold of 19 EUR (20 − 1). The gain will be equal to the difference between 19 EUR and the price at expiration. If the expectation was correct and the security goes down to 10 EUR, the put holder will have made 9 EUR ((20 − 1) − 10).
d) Short Put Option (Selling a Put)
In a short put position, prices are expected to remain stable or to rise slightly. Selling the option earns a premium. It also makes it possible to acquire an underlying security at a certain price (strike).
However, unlike selling a call, here the risk of loss is limited, except in the event that the company goes bankrupt where the risk of loss becomes unlimited, as if the option is exercised, the put seller has to buy the security at the strike price. So he or she must pay but receives the underlying in exchange, which may still be of some value. Blocking certain positions or liquidities can mitigate this risk for banks.
Conversely, to take the example of a put sold for 1 EUR on the stock currently trading at 20 EUR with a strike set at 21 EUR, the seller is anticipating here a slight increase in the security. The premium earned represents the gain on the operation.
If the expectation was correct and the price rises slightly to 22 EUR, the put holder will not exercise the option as he or she can sell the security for more on the market (22 EUR instead of 21 EUR, not counting the premium of 1 EUR). The seller of the put, therefore, wins in this scenario. However, if the security falls to 18 EUR, the option will be exercised and the put seller will have to buy the security at 21 EUR although it is only worth 18, representing a loss of 2 EUR ((18 + 1) − 21).
Buying a call and a put at the same strike price and the same expiration date simultaneously is called a “long straddle”. A gain is made if the underlying security moves outside the interval [strike—premium paid; strike + premium paid]. Conversely, selling a call and a put at the same strike price and the same expiration date simultaneously is called a “short straddle”. A gain is made if the underlying security stays inside the interval [strike—premium received; strike + premium received].
In the case of a long straddle with a strike price of 20 EUR on a security, the loss is limited to the premiums paid for the call and the put, or 1 EUR each (2 EUR in total). A gain starts being made when the price goes above 21 EUR (20 + 1) or drops below 19 EUR (20 − 1). Here, an increase or decrease greater than these two limits is expected.
Simultaneously buying a call and a put with different strike prices is called a “long strangle”. A gain is made if the underlying security moves outside the interval [strike of the put—premium paid; strike of the call + premium paid].
Conversely, simultaneously selling a call and a put with different strike prices is called a “short strangle”. A gain is made if the underlying security stays inside the interval [strike of the put—premium received; strike of the call + premium received].
In the case of a long strangle with a put strike price of 15 EUR on the security and a call strike price of 18 EUR, the loss is again limited to the premiums paid for the call and the put, or 1 EUR each (2 EUR in total). However, a gain starts being made either when the price goes above 19 EUR (18 + 1) or drops below 14 EUR (15 − 1). Here, an increase or decrease greater than these two broader limits is expected.
We believe that options should essentially be regarded as hedging instruments or components of a structured product, with, nonetheless, a considerable speculative aspect. Furthermore, setting the strike price and choosing the expiration date are far from easy in practice, and it is common for investors to be right, but too early, or to hedge too late.
Classification of Asset Classes According to their Degree of Risk
It is now time to classify these different asset classes according to their degree of risk. We need to consider money market investments, bonds, stocks, commodities, real estate, and private equity, with sub-sections within some asset classes. In our opinion, private equity is at this stage the riskiest asset class (absence of a listed market, lack of liquidity, very high bankruptcy or default risk). So here are the assets to be classified:
money market funds;
high yield bonds;
stocks from developed countries;
stocks from emerging countries;
precious and industrial metals;
real estate (indirect);
Selected Criteria for Classification of Asset Classes
It has already been stated that volatility (or standard deviation), beta and VaR are not appropriate measures of risk. So, one or more common criteria must be found, other than price variation, which allows a hierarchy of these asset classes to be established according to the risks associated with each.
As we mentioned to begin with, investors are seeking a return that can take the form of regular income, capital gains or a combination of both. A regular income is preferable in that it is determined in advance and therefore more certain for investors than a potential income.
future cash flows.
In the case of government or other high-quality bonds, the future cash flow is known (all the coupons have to be paid); therefore, this market seems efficient. Moreover, it allows very little room for active management. On the other hand, if we look at stocks, where cash flows are conditional, or commodities, where cash flows may even be non-existent, these markets are far less efficient and allow more room for active management.
So asset classes have differing degrees of efficiency, with differences within each class.
However, is it possible to exploit these inefficiencies by trying to forecast and anticipate prices? Is the modeling of market movements feasible? We will attempt to answer these questions firstly by focusing on fundamental analysis, which seeks to determine the true value of an asset in order to compare it with the market price. We will then look at the technical analysis, which concentrates solely on the market price and its movements, and aims to take advantage of past information.
Both these approaches aim to exploit pockets of market inefficiency so that investors can determine an asset's “real” price compared to that established by the market, which is not really the “fair” price. On the basis of these analyses, they can increase their chances of achieving their objective—capital preservation and growth—while reducing the risk of losses.
Fundamental analysis is based solely on market data and companies' financial results. It studies the various events within a company, its sector and the economic environment that are likely to cause its share price to rise or fall.
It principally examines the balance sheet to find out assets and liabilities, the income statement to assess revenues, expenses, and hence profits, and finally the cash flow statement. This important document reflects the company's ability to generate cash, an essential factor sought by any investor. Furthermore, unlike other documents, cash flows are difficult for accountants to manipulate. Obviously, it is better to have financial statements audited by recognized firms.
In any case, it is useful to stress the importance of footnotes in corporate financial reports, which often provide a wealth of information to anyone patient enough to read them.
As indicated above, we can first determine the company's intrinsic value, which will then be compared to its market value in order to decide whether to make the investment. However, the company can also be assessed using relative measures or, more precisely, certain ratios that we will describe below. Here we will focus on stocks.
Financial databases provide this type of information about companies. Access to the Bloomberg and Reuters financial information services for professionals must be paid for, but a great deal of information can be obtained at www.reuters.com/
Discounted Cash Flow
One method of stock picking involves determining the value of a stock by discounting its future cash flows. Indeed, “a stock's value depends on the issuing company's ability to make profits in the future. The art of the financial analyst is, therefore, to try and predict this profit outlook and compare it to the price at which the stock is traded. This analysis helps determine if the stock is too expensive compared to its profit potential or, on the contrary, too cheap.”
If this estimated value is higher than the market price, it is worth considering buying the stock. Conversely, if this value is lower than the market price, a short position or simply the decision not to buy the security may be envisaged.
The dividend discount model suggested by J.B. Williams or Gordon-Shapiro can be used to calculate this intrinsic value. However, it is based on the assumption that cash flows generated by a stock are the dividends paid out and that these grow over time either at a constant or a variable rate. Discounted free cash flows are used in practice to evaluate a company that pays no dividends and is not publicly traded, but we will not go into further detail on this point.
Gordon-Shapiro's formula is often used to determine this value by introducing the following parameters:
P0 = the price sought at time 0
EPS1 = estimated earnings per share in year 1
Payout ratio = amount of earnings paid out in dividends to shareholders
Cost of capital expressed as a rate
ROE = return on equity
However, the result obtained is very sensitive to the choice of parameters and of forecasts made about the expected growth rate of dividends. Companies often try to pay a steady dividend over time, which may imply accounting manipulations. It is also difficult to estimate the cost of capital.
Furthermore, unlike bonds, income generated by stocks is not fixed and can fluctuate over time. Finally, the time horizon considered to evaluate stocks using this formula is infinite, while the evaluation period is fixed for bonds (except for perpetual). Consequently, it is difficult to get a precise, reliable result using estimations and such a long time horizon.
In our opinion, this formula presents a number of disadvantages and should be rejected, at least from this analysis. We might consider that investors should pay no more than the intrinsic value calculated, or by companies whose expected growth rates are above average over the next five years.
Independently of whether or not to use this formula, the idea of intrinsic value has been decisive for one of the greatest and richest investors of our time: Warren Buffett. He is very much a follower of value investing, but this approach is rarely included in the programme of major business schools.
It is also interesting to examine the following ratios.
Price to Earnings Ratio (P/E)
The Price to Earnings Ratio represents the stock price divided by the earnings per share:
In other words, it indicates to investors how much they have to pay per unit of earnings when buying this stock. So the higher the P/E, the more they have to pay. However, it is important to compare this ratio to the P/E of the industry the company operates in.
While it is very easy to use, the P/E ratio changes over time and can fall quickly when earnings or stock prices decline; it depends on corporate profits that fluctuate with economic conditions. So a low P/E is not necessarily attractive if the industry is in a downturn. Moreover, growth can differ from one company to another within the same industry, and this ratio ignores any such differentials.
It is also sensitive to the financial structure of the company and depends on accounting data that can be manipulated.
We advise caution in using the P/E ratio. It should not be used as the sole criteria for making an investment choice.
Price to Book
This ratio is a more useful indicator for determining the value of a company and its future growth. In other words, it indicates how many times investors must pay the value of equity on the market. It should be compared to the P/B of the sector or industry. Too high a figure may suggest the risk of a bubble and, therefore, of correction. Generally, between 1 and 2 is regarded as a reasonable level.
Although easy to calculate, the P/B also depends on accounting data and can pose problems when evaluating companies with a large number of intangible assets. For that type of company, it is better to use the Price to Cash Flow ratio, which has the advantage of being independent of accounting methods.
On the matter of accounting, this anecdote from a company director who wanted to hire a new accountant is revealing. The first candidate enters and the company director asks him what he knows. The candidate replies that he knows all the rules of accounting extremely well, especially the American rules used by large multinationals.
Unconvinced by this reply, our company director asks the second candidate the same thing. He gets the same type of reply, so he asks the third candidate to enter. This time, the candidate retorts: “Allow me to answer with a question of my own: what would you like to appear in your balance sheet?”, to which the company director replies: “You're hired.”
We also recommend that investors do not use the Price to Book ratio as the sole criterion when making an investment decision, and to favor securities with a P/B of between 1 and 2.
A more in-depth analysis of the company and its environment must be carried out, in line with the value investing approach advocated by Buffett and Lynch that we will cover in detail later. Firstly, it is necessary to understand the company's business model (how does it make money?) and its competitive advantages.
The Business Model
The aim here is to find out how the company makes money in practice. “The business model is the approach that the company has chosen to generate its income. In other words, it is the mechanism that will enable the company to make money.”
Generally, the final product or service is made up of many stages or, more precisely, many intermediary products or services. A company can either focus on the whole range of activities that make up the final service or product, or choose to concentrate on some in particular. It may concentrate only on design, production or distribution, or on a combination of two or even three activities. From an economic point of view, it will have to determine whether the income generated by the chosen strategy is higher than the expenses this choice entails.
A company's value is usually made up of intangible assets, otherwise known as intellectual property. These intangible assets can be used in various ways. “They can be sold, licensed, used as collateral or to guarantee a loan, as security to borrow money from friends, family, private investors, and even banks.”
As part of the strategic analysis, assuming that knowledge is protected by intellectual property rights (patents, brands, etc.), the company must also decide how to exploit it commercially.
Thanks to this legal protection, a company's competitors will not be able to commercially exploit its own intangible assets, which therefore constitute its competitive advantage. However, this protection is of limited duration, and beyond a defined period competitors will, in turn, be able to exploit these intangible assets commercially.
A company cannot hold a monopoly over an indefinite period. Furthermore, the protection only applies to the country in which the patent is used and registered. International procedures have to be undertaken, either in the countries concerned or via a system of international patents, in order to extend legal protection to other countries.
However, instead of exploiting its invention itself and “going to war” with its competitors, the company may decide to sell the exploitation rights and become, in some respects, the supplier of its competitors. Indeed, “when the product requires an overly large distribution network or logistics […], assigning a license to a strategic partner rather than owning production may be the best strategic option”.
A company may also “consider receiving royalties by licensing [the] patented inventions to other companies that are able to market them”.7 “Dolby” is a perfect example. Ray Dolby, after having designed and protected his system to improve sound recording, preferred to sell the exploitation rights for his invention to other companies, thus becoming a respected supplier rather than a hated competitor.
The reasoning is identical to the protection provided by a brand. Protection excludes the possibility of other companies using the brand, but once again for a limited period of time. It is important to distinguish the name of a company, which enjoys exclusive and unlimited protection, from the brand, which is always linked to the products or services of the company and is protected for a limited period of time.
However, the sale of rights to use a brand—franchising for example—is rarely possible in the early stages of a company, as it must first acquire experience, a reputation and, above all, brand awareness for the products or services offered. Furthermore, the sale of rights to use a brand usually contributes to the company's activities by playing an advertising role and increasing brand awareness and, therefore, the company's profile.
Here we can give the example of “Caterpillar”, which granted rights to use its brand to clothing manufacturer companies, in particular, the famous Caterpillar shoes. These, in fact, are only manufactured under license. Instead of producing shoes itself, the company preferred to sell exploitation rights to other companies with better knowledge of the manufacture of such items. Similarly, the “Délifrance” bakeries usually only hold the rights to use the brand.
Determining how the company makes money in practice is essential, but it is almost equally important to assess the quality of the management. This is a difficult factor to estimate for a private investor, but for a fund manager who wants to invest several million, meetings can be arranged with the company's management. Therefore, investors can delegate this assessment to a fund manager and decide to invest some of their money. They leave it to the manager to conduct the stock analysis and selection.
At this stage, we might wonder if it is really possible to exert any influence whatsoever by investing in a company. Indeed, investors put their trust in the management, whose interests are often at odds with those of shareholders. Managers are often there for a short time only and have objectives of maximizing short-term profit, while investors have a long-term approach and objectives. It can be taken as a very positive factor if managers are also shareholders in the company, ideally in the majority group. The ideal situation is when the founder is still in charge of managing the company.
However, we do suggest that investors undertake this analysis so they can atleast be familiar with what they are buying, and how their stock will be able to grow over time. The next step is to undertake a more thorough strategic analysis,8 like the one developed by Snopek and Tripiana to be used in the start-up process and that we would like to outline below.
Companies offering similar products or services can generate different turnovers and, more especially, profits. A company's profitability will mainly depend on its chosen strategy, but also on market imperfections.
Firstly, what is called an external analysis should be undertaken, examining the structure of the relevant market segments, such as the existence of barriers to entry or exit, the intensity of competitive forces and the potential market and its growth. Critical success factors must also be considered.
a) Barriers to Entry
As we mentioned above, profitability will essentially depend on the barriers to entry to the correspondent sub-industry.
By barrier to entry, we mean any factor that makes the expected profitability of a new entrant to a market lower than that of already established companies. Expected profitability is therefore directly related to barriers to entry; the business will only be profitable if it is difficult for new competitors to enter the sector, as each new entrant threatens to cause a drop in prices and, consequently, margins.
We will now present the main barriers to entry, whether induced by differences in costs or by differentiation.
First to be considered are economies of scale, which can be defined as lower costs per unit achieved once a certain volume of production is reached. However, beyond a certain volume, the unit cost per product stops decreasing, a phenomenon referred to as diseconomies of scale.
Large purchases are entitled to certain discounts, which can also be described as economies of scale. These are essentially related to the technology used to manufacture the product and to experience but depend heavily on the industry. So in some cases, it is unnecessary to be too large and the size may even be a disadvantage.
Market size is another barrier to entry, in that it determines the possible number of competitors within a market. If the development of a new product is very expensive and the market is small, few products will be able to be sold and it will be hard to make a return on investment. Such is the case, for example, for the market for very large aircraft; the development of a Boeing 747 is very expensive (about $10 billion) and the market is very small with a very limited number of units sold. Consequently, the number of competitors in this market is very small.
As such, the maximum number of competitors can be easily calculated by dividing the total market size by the minimum size for efficiency. Total market size corresponds to the total number of units sold per year, while the minimum size for efficiency refers to the minimum size a company must be to benefit from economies of scale.
For example, considering that about 12 million vehicles are sold on the European automotive market and that the minimum size for the efficiency of a manufacturer is 3 million cars, this market can support a maximum of only four competitors. Above this point, the market becomes saturated and concentration will be necessary, as was the case in the audit industry with the “Big Five” becoming the “Big Four”. Furthermore, if the market is saturated, a new arrival will have to force out a competitor, who will not necessarily give in easily.
Privileged access to raw materials and a consequent reduction in transport costs is another type of barrier. Special production processes, such as the existence of patents protecting product manufacturing methods, also help protect the industry. Furthermore, certain company-specific particularities or ways of working are “private” processes that can be difficult to copy, and as such constitute another type of barrier.
Costs are also barriers to entry, especially when the prices charged by the market leader correspond to the costs of potential competitors, as the prices set are such that business is unattractive for the latter companies (this is called the “Entry Deterring Price”). The possibility of sharing costs between different products (cost sharing) also belongs to this category.
The money required to be able to enter a market and operate a business is not, in principle, a barrier to entry, as if the project is interesting, feasible and promising, investors can be found relatively easily. However, in some cases, financial resources can be difficult to muster, especially if the level of investment necessary is very high.
The product provides certain values sought by clients, who accept to pay a given margin for the value and quality that it brings them. Thus, the branding, quality, and reputation of the product or company are other types of barrier to entry. As we indicated earlier, consumers or buyers are willing to pay a certain margin for a quality product. As such, the market leader can set a price which, without this margin, corresponds to the costs of potential competitors, thereby discouraging them from entering the market.
Similarly, the company's prestige, reputation, know-how or experience are all barriers to entry, which can prove very strong in some industries. Finally, government interventions aiming to create monopolies can also be barriers, as they limit the entry of other competitors. Subsidies granted to certain companies, agreements with the government or specific legislation can also be protective factors in a particular industry.
To conclude, it is important to understand that the higher the barriers to entry, the better the industry is protected, and therefore the greater expected profitability.
b) Barriers to Exit
By barrier to exit, we mean anything that stops companies from exiting the market easily when business is bad. The main obstacles are sunk costs (large investments that are hard to recover), the difficulty of converting factories, or a lack of flexibility due to contracts. Furthermore, switching costs, i.e., the costs of switching suppliers, may also be a barrier to exit but are considered here instead as barriers to mobility (preventing the free “movement” of the company).
It should be noted that if these barriers are strong, it may create unhealthy competition, as the “bad” companies cannot exit, spoil the market and prevent others from developing properly. Occasionally, some believe that a sector is “strategic”, to the point that they are willing to lose money just so they can be present.
To conclude, it is worth bearing in mind that the greater the barriers to exit, the harder it will be to exit the industry if the business is going badly.
c) Competitive Forces
Barriers to entry are certainly necessary to guarantee good profitability, but they are not enough on their own. There are other factors in play, particularly competition within an industry. So profitability will also depend on the degree of rivalry between competitors.
There are five competitive forces that influence both the profitability of a particular industry and the business strategy to follow.
i) Competitive Rivalry within an Industry
The term “competition” is difficult to define, as too broad a definition leads to too high a number of competitors, some of which are not worth “attacking”. Yet if the definition is too narrow, it reduces the company's “battlefield” excessively.
We can use the notion of the need to help define competition. Two companies are competitors, in our view, if they meet the same demand, i.e., the same specific need. For example, on the Paris-Geneva line, the TGV is in competition with Air France-KLM, which itself is in competition with other airlines.
Consequently, competition “includes anything—person, organization or group —that is likely to take money from your clientele. Thus, cinemas are now in competition with DVD hire and cable television companies […]. Today, competition must be seen as all the different ways the customer has of getting what he wants, not as a precise list of companies working in your industrial field who try to beat you by lowering their prices or improving their performances.”
The rivalry between current competitors depends first of all on the number of competitors. If there are few competitors, the rivalry will be weak, while a large number of competitors means strong rivalry. Product differentiation also plays a role in terms of rivalry, as highly differentiated products entail the creation of small monopolies with a little rivalry, where competition is only involved for the first customer.
Switching costs, i.e., the costs for the customer of switching suppliers, and therefore companies, can make the customer resist trying the competition. Again, if these costs are very high, we may see the creation of monopolies, where competition is only apparent for the first customer. Here we can give the example of Johnson & Johnson, which managed to increase switching costs by using a different terminology and different diameters from its competitors, making it more difficult to change suppliers.
In addition, fixed costs can also influence competition within an industry, as if costs are essentially fixed and demand fluctuates, a price war will occur. Conversely, if costs are predominantly variable, prices will usually be fixed. Industry growth also influences rivalry. When growth is strong, there is little competition between companies as ultimately they all make money. If growth is weak on the other hand, competition will be fierce, everyone having to fight for their “bread”.
Finally, in industries where the additional capacity offered is far higher than demand, the size of increases in companies' supply can also be a competitive factor. For example, the construction of a factory may provide an enormous production capacity compared to the increase in demand, making the factories too large for the market.
Similarly, the creation of a new connecting flight significantly increases the supply of seats that they have to be filled, and this does not always correspond to the increase in demand. As we mentioned earlier, barriers to exit can also influence competition within an industry.
ii) Potential Competitors
Still, it pays to be wary of potential competitors who may come looking for their slice of the cake and constitute a threat for the companies already present. The existence of strong barriers to entry or low growth provides effective protection.
iii) The Threat of Substitute Products
By substitute products, we mean all kinds of products and services “similar” to those of the company. These must also be taken into consideration. They enter into direct competition with your products because they meet the same need. Sugar and artificial sweeteners are a perfect example.
Accordingly, products that can serve the same purpose for the customer with an advantageous cost-benefit ratio must be closely monitored. We advise paying particular attention to the characteristics of these products, their price, and especially their development, in order to avoid seeing your customers move towards the competition.
iv) The Bargaining Power of Customers
It is also important to be aware that, in some cases, customers have strong bargaining power, which may influence the profitability of a given industry. If customers are concentrated, if their purchases represent a large number of the company's sales, if their supply options are many, if their switching costs are low and, especially, if the product is standard or undifferentiated (customers are only sensitive to price), then customers have strong bargaining power.
v) The Bargaining Power of Suppliers
As with customers, suppliers may also have bargaining power.
When there is a limited number of suppliers, few substitutes for the product or service, when the cost of switching supplier is high and, especially, the product is unique or differentiated, suppliers have strong bargaining power. Ultimately, it must not be forgotten that anyone can have a good idea and that therefore competitors will always exist and, more importantly, act.
d) The Potential Market and its Growth
The current and potential market size is relatively difficult to estimate, in that it is based primarily on quantitative data, such as sales or market shares.
However, it is possible to find information related to the growth of a given industry in newspapers, specialized journals and especially on the Internet, which is a considerable source of information. By using search engines and surfing company websites, the websites of marketing firms or any sites dedicated to a particular subject or field, a great deal of information about the potential or current market can be found.
It will be important to find out whether the market is growing, shrinking, or even stagnant. Industry growth provides an invaluable indication, but also useful is the idea of a product lifecycle, which usually includes four stages.
In the introduction stage, the product starts to be distributed on the market, which is usually characterized by slow growth. Earnings are often negative during this period, in large part because of high development costs.
In the growth stage, sales volume increases swiftly, demand grows and profits are generated. In the maturity stage, the demand for the product begins to stagnate and the market stops growing. Profits reach their maximum level and begin to drop slightly due to the expense of marketing to maintain demand.
In the decline stage, sales fall sharply, as do profits, and the market begins to shrink or decline. Innovation resulting in a new product is essential at this stage so that a transition may occur. Bear in mind that the duration of each of these stages depends on the product. Some products have very short life cycles and others very long ones. For example, fashion items and IT products have very short life cycles.
Determining which stage the market is in is essential. Some companies wait until the product leaves the introduction stage, to avoid losses due to product development and launch and enter directly into a period where it is possible to make a profit. It doesn't necessarily pay to be a pioneer.
Finally, particular attention must be paid here to the size of supply increases or, more precisely, to the risk of providing additional capacity higher than demand, especially during the decline stage.
e) The Political/Economic/Legal/Social/Technological Environment
It is also important to analyze the general environment, political stability, and the social or legal context. The influence of political forces or labor unions on an industry and, therefore, on a company must be taken into consideration, as must the legal framework within which the company will operate.
Legal standards define many duties and obligations, both for individuals and for companies, and these standards change over time. The company must be aware of any new regulations, constraints, and even opportunities that may appear.
The economic context is obviously to be considered, without forgetting that economic health varies from one industry to another, making generalizations about the overall economy unrealistic. The social context or, more precisely, public opinion must also be taken into account, as it is important that customers see the company's activities as “socially” and “ethically” acceptable according to current moral and social values.
Finally, the technological environment is extremely important for two reasons. Firstly, it tells the company which technologies it can or will be able to use as part of its business activities. In addition, the company should also look at “general” technological developments that are not necessarily directly related to their products or services, but which may, however, influence their very existence.
f) Critical Success Factors
Critical success factors are the elements necessary for a company's success in a given industry for a certain period.
At this stage, it is worth emphasizing that these critical success factors not only vary according to sub-industry but also change over time. So, it is necessary to identify the “rules of the game” that will ensure success, according to the demands of customers and the business in question.
It should be noted that it is entirely possible to modify the rules of the game if the current success factors are unsuitable and a change will obviously be required at some stage in the future. Consequently, a company may well decide to alter the competitive playing field, based on the development of its distinctive skills.
As critical success factors depend on each sector, it is practically impossible to compile an exhaustive list. Nonetheless, a few examples will help provide a clearer idea of the concept.
In the agri-food industry, brand marketing, reputation, diversity of supply, and the distribution network are all critical success factors. The efficiency of industrial facilities and an efficient distribution network are two of the critical success factors for automotive manufacturing. In retail distribution, it is important to have sufficient purchase volume to ensure bargaining power vis-à-vis suppliers. For other sectors, price, product quality, reputation and customer loyalty may constitute other critical success factors.
It is therefore important to ascertain which resources and skills are required to run the business and, more importantly, to examine whether the company has skills which make it stand out from its competitors. This is precisely the purpose of internal analysis.
After the external analysis, it is necessary to reflect on what, on an internal level —i.e., given their different resources and skills—could give a long-term competitive advantage to a company aiming to succeed better than others and to be as profitable as possible.
Resources are generally separated into five categories, and to run the business in question the value and adequacy of each of these must be appreciated.
Physical resources include all the tangible elements available, such as premises or equipment.
Financial resources are made up of equity or debt as well as borrowing capacity and cash flow.
By human resources, we mean the “individuals available”, including their education and training, their skills, experience and especially their motivation.
Intangible resources are essentially the technologies mastered and patented by the company, as well as their supply and distribution networks. Finally, in terms of organizational resources, particular attention must be paid to the company's structure and the style of leadership and human resource management.
It will be essential to determine the strengths and weaknesses of each of these resource categories so that the necessary measures can be taken if certain resources have to be sought externally. Thus, by combining these resources, the company will be able to develop specific capabilities. Over time and through a process of improvement and development, these will become core competencies that distinguish the company from its competitors.
b) Core Competencies
Core competencies are the competencies specific to a company that it sees as having a strategic value.
These competencies generate value for the customer, as they contribute strongly to creating the benefit the customer seeks in the product. Moreover, these core competencies must be rare; current or potential competitors must not have them. They also have to be difficult and costly to imitate for other companies. Finally, there must be no strategic equivalents for these competencies, i.e., it must be impossible to substitute them with other competencies.
In light of these distinctive capabilities, the company may determine which competitive advantage to focus on, in line with the critical success factors of the industry.
c) Competitive Advantage
We will see that ultimately, profitability depends on uniqueness, to the extent that a company with a strong competitive advantage, and a unique product or service that is difficult to copy, will clearly have a profitable business. Competitive advantage can be defined as a characteristic of a company that differentiates it from other companies and can give it an advantage in both the medium and the long term.
A company can develop a competitive advantage through the differentiation of its products or by exploiting cost differences with its competitors. For example, strong branding, an excellent reputation, low production costs or the use of cutting-edge technology are various characteristics that distinguish one company from the rest.
A company can gain a competitive advantage either by exploiting market imperfections or by improving the operations of its value chain, its efficiency (low production costs with perfect quality), its flexibility (extremely short cycles), research and development (continuous innovation) or through cooperative arrangements or strategic networks.
However, in some industries, differentiation no longer depends on the products or the technology used, as they can ultimately be used by competitors, but on the quality of customer relations. Indeed, it is essential for a company to understand thoroughly the characteristics and requirements of demand, in order to be able to satisfy it in the best and fastest possible way.
So for a company, competitive advantage means being as closely aligned as possible to the market on which it has decided to position itself. As stated by Arie de Geus of Royal Dutch Shell, “the ability to learn faster than your competitors may be the only sustainable competitive advantage”.
d) Industry Profitability
Here we will turn to an essential factor for strategic analysis: profitability ratios. These make it possible to ascertain the profitability of a given industry.
Return on investment (ROI) measures the amount of capital that must be invested to make a profit. It is divided into two parts: the net profit margin (NPM), which represents the amount earned on each dollar value of revenue, and the total asset turnover (TAT), which is an indicator of the volume of business done by the company for one year. It, therefore, reflects the level of capital intensity.
The NPM is calculated by dividing the company's net profit (revenue minus total costs) by its revenue. Meanwhile, the TAT is calculated by dividing total revenue by the company's assets, including needs for working capital. In a growth environment, the net margin on products will increase, as your revenue, and therefore net profit will increase (assuming that charges are identical). However, in a period of recession, the challenge is to achieve the same revenue with fewer available resources and especially with fewer sales.
Therefore, particular attention should be paid to this ratio.
It is also important to examine the second ratio, the TAT, as it gives an indication of the speed at which assets are circulated (see below).
Thus, the examination of an industry consists primarily in determining its profitability using the two ratios we have just presented. The rates of these ratios will provide a diagnosis of the sector in question, but it should be noted here that these two ratios are always opposed. By examining the financial statements of other companies operating in the chosen industry, it is possible to get an idea of the value of the rates of these two ratios. However, these are specific to a particular company and cannot be extended over an entire sector.
If the NPM is high and the TAT is low, this means that (attractive) margins on products or services can be achieved and that these are specialized or differentiated markets. Competitive pressure is normally quite low. However, fixed assets are significant and the movement of assets within the company is not very fast. In this sector, a differentiation and positioning strategy are entirely suitable.
On the other hand, if the NPM is low and the TAT is high, this means that margins are fairly low and the environment is very competitive. Furthermore, this also implies that assets, particularly cash, must circulate quickly within the company. In this sector, such as supermarket retailing, for example, a cost leadership strategy is ideal.
The SWOT Table (Strengths, Weaknesses, Opportunities, and Threats)
The results obtained should be summarised on a SWOT table (Strengths— Weaknesses—Opportunities—Threats).
Relevant aspects that emerged from the external analysis must be entered either in the “Threats” column if they indeed pose a threat or risk to the company, or in the “Opportunities” column if the company can take advantage of certain possibilities or a favorable context for doing business.
Then, in the light of factors gleaned from the internal analysis, the company's advantages and strengths should be placed in the “Strengths” column and any negative aspects, shortcomings and weaknesses in the “Weaknesses” column. The table is presented like this:
THREATS OPPORTUNITIES STRENGTHS WEAKNESSES
This simple table helps the company steer its business over the long term as, using the table, it can determine whether it should engage in a given activity or abandon it. Another advantage is that it presents the positive and, more importantly, negative points of the company; it indicates which aspects leave room for improvement and which competencies should be sought externally.
Above all, the table will help investors decide whether or not they should invest money in the company.
Criticism of Fundamental Analysis
“In the real world, causes are usually obscure. Key information is very often unknown or unattainable, as with the 1998 Russian financial crisis. It can be hidden or misrepresented, as with the bursting of the dotcom bubble or the Enron and Parmalat group scandals. It can also be misinterpreted: the precise mechanism that links news to prices, or causes to effect, is mysterious and apparently incoherent.
For example, for the same piece of news, two opposite effects might occur. The threat of war: the dollar falls. The threat of war: the dollar rises. Which of these will actually happen? In hindsight, it seems obvious; in retrospect, fundamental analysis can be reconstructed, and always appears brilliant.”
Moreover, conflict of interest can be a real concern, pushing analysts employed by a bank to issue recommendations on securities simply to generate commissions for their employer or to “favor” important clients. The possibility of forecasting expected price movements is also subject to debate and criticism. “In a study comparing them with weather forecasters, Tadeusz Tyszka and Piotr Zielonka document that the analysts are worse at predicting while having a greater faith in their own skills.”
Warren Buffett recommends that investors ignore analysts, brokers, and experts, and instead make their own investment decisions based on their knowledge of management and financial markets. He advises reading as much as possible to get a maximum amount of information on which to base an investment decision, and never to decide whether or not to invest simply because of the encouragement of others.
“Ben Graham observed in The Intelligent Investor—Buffett's favourite investment book—that ‘we have seen much more money made and kept by “ordinary people” who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock market lore’.”
In our view, it is not the analysts' skill that should be doubted, but rather the conceptual framework within which the analyses are conducted. As we noted, to begin with, risk measures and some of the criteria used are perhaps not entirely suitable. Furthermore, the under- or overestimation of certain factors or events that can affect the price of securities, as well as the existence of behavioral biases—excess confidence, optimism or pessimism, for example—should be better taken into account.
The Financial Times' famous monkey, who picks stock by randomly throwing darts at a list, can sometimes make higher returns than those obtained using complex mathematical models. These models are usually very sensitive to the choice of parameters, which are very difficult to estimate. As stated earlier, it is difficult to get a precise, reliable result using estimations. In addition, these models are often based on fragile hypotheses that consequently limit their usefulness.
It may be time to consider that the luck factor can play an important part in investment decisions and that other factors should be taken into account.
Above all, investors must keep in mind that an analysis has to be undertaken before making an investment decision, having collected as much information as possible. Besides the strategic analysis we have suggested, particular attention should be paid to a company's:
financial health (liquidity, level of indebtedness, rating);
profits, dividends and associated ratios (P/E, P/B, etc.);
free cash flow;
specific risks (political, regulatory, boycott, etc.).
Technical analysis is the study of price charts and various indicators derived from them, with the aim of predicting price movements. It is based on three principles that we will now examine.
The Three Fundamental Principles of Technical Analysis
Prices Reflect All Available Information
This assertion is the essential foundation of technical analysis, which claims that “anything that can possibly affect the price—fundamentally, politically, psychologically, or otherwise—is actually reflected in the price of that market”,without worrying about why prices rise or fall. To begin with, these assertions show a certain simplification of how markets work and reduce the study of markets to the study of charts, which only formally reflect what has happened.
Moreover, prices may certainly incorporate all available market information, but can purely private information, particularly when it can be exploited before being made public (insider trading), really be regarded as available information? As we stated earlier, markets are not perfectly efficient; consequently, prices do not perfectly reflect all market information.
Finally, as we will see in more detail below, the market does not always incorporate all available information immediately because of the under- and overreaction of investors to information.
An interesting study on the under- and overreaction of financial analysts in post-crash periods highlights the following aspects. “The analysis of reactions to news mainly reveals a sharp decline in underreaction to the extremely negative news. Overreaction to extremely positive news, more hesitant before the crash, also abates.” Therefore, this analysis indicates the existence of underreaction to extremely negative news and overreaction to extremely positive news in the pre-crash period.
Investors may also react to a lack of information, be tempted to react to rumors, or simply tell themselves stories to invent reasons to act. Evidently, the assertion that prices immediately reflect all available information is not always corroborated by the reality of the financial markets.
Prices Move in Trends
According to the second concept, prices move in trends and “a trend is more likely to continue than reverse […] or a trend in motion will continue in the same direction until it reverses”.5 Therefore, it is advisable to surf the trend for as long as possible before its reversal.
Price movements are certainly a succession of increases and decreases, but do prices follow a random path or can their movements be predicted? We will try to answer this question in the next section, but let's stay for a moment with this idea of trends, as in our view it is an important concept.
A series of higher highs (closing prices for example) coupled with higher lows indicates a bullish movement. The market reaches new heights and the lower levels are gradually rising. Conversely, a series of lower lows and lower highs indicate a bearish movement. When movement is lateral or without any defined direction, it is referred to as “sideways”.
Analysts usually define a long-term trend over a period of more than a year, an intermediate trend over a one to three-month period, and a short-term trend over a period of less than one month.
Alternations between bullish and bearish trends are called market cycles and are generally classified according to their duration. Long-term or primary cycles last for two years or more. The seasonal cycle lasts one year. The intermediate or secondary cycle lasts for nine to 26 weeks. Finally, the four-week trading cycle is separated into two shorter cycles, alpha, and beta, which last an average of two weeks each.
The Kondratieff cycle lasts about 54 years, during which the economy undergoes phases of growth and correction. There are four periods (seasons): spring, summer, autumn and winter and, according to some analysts, the winter that should have started sometime around the year 2000 may have begun after the last peak in 2007. This winter cycle will last about fifty years.
Generally speaking, the primary and seasonal cycles determine the major trend of a market. Following the three most significant high points and the three most significant low points, it is possible to draw the upper and lower lines of a channel, which can be used to identify trend reversals. However, once a trend reversal is noticed, this means that we have already entered the new trend.
Other tools which help determine trends or trend reversals include chart patterns, such as the “head and shoulders”, “cup and handle”, “double or triple tops and bottoms” or “triangles”, as well as several indicators such as the MACD, Bollinger bands, RSI or the stochastic oscillator.
A former trader who taught technical analysis for more than 10 years and became a major expert on Elliott waves said one day that, in his opinion, all these indicators should be forgotten in order to focus on what he believed was the essential aspect: trends. This concept, which we also see as essential, will be covered in more detail in the following sections.
As for Elliott waves, he said he would sometimes wake in the middle of the night, panicking, not knowing if we were in the 2nd or 3rd wave. The fact his wife thought he was going crazy combined with the difficulty of applying this theory finally led him to abandon the approach. However, at this stage, it will be interesting to spend a moment looking into this theory.
Elliott Wave Theory
Elliot Wave Theory, formulated by Ralph Nelson Elliott, describes the movement of financial markets. The starting point of the theory is that markets move in a series of successive waves, regardless of the scale of observation (from the minute to the very long term), in what can be termed a fractal process.
This methodology is largely inspired by the famous Dow Theory. It is built on a basic principle that is both simple and obvious: markets move according to trends (bullish or bearish), within which corrective phases (of varying lengths and significance) are interposed.
These trends and corrections are charted according to the following pattern: the trend in five waves and the correction (decline) in three. Around this basic principle are grafted precise rules governing the length and graphic patterns that these waves make. This fairly comprehensive theory incorporates all the chartist patterns and rules and the famous Fibonacci ratios, based on the golden ratio.
A market moves in eight successive waves. Waves 1, 3 and 5 are ascending waves, while waves 2 and 4 go against the bullish trend and are called corrective waves because they correct waves 1 and 3. Once the rise in 5 waves is over, a correction in 3 waves (a, b and c) begins.
The influence of Charles Dow's theory is decisive here. Elliott was inspired by it, completing it to define the personality of the waves, especially the corrective wave. Prechter takes things even further, justifying the existence of these waves by the psychology of the different types of people involved in the market (buyers, sellers, traders, etc.). Each wave, therefore, has its own signature, which reflects the psychology of the moment.
Some assert that the Elliott wave model provides an indication of when to enter a particular market and when to exit, independently of the notion of profit or profitability.
However, as Murphy notes, “it is important to keep in mind that wave theory was originally meant to be applied to the stock market averages. It doesn't work as well in individual common stocks. It's quite possible that it doesn't work that well in some of the more thinly traded futures markets as well because mass psychology is one of the important foundations on which the theory rests.”8 It is most effective in the commodities markets, which are widely followed.
By applying Elliott Wave Theory to the stock market, some analysts believe that the major decline (wave A) took place after the peak of 2000, that the increase which followed until 2007 represented the ascending wave B, and that the new large decline (wave C) has just started and could last several decades. Thus, markets supposedly do not move randomly, even if we allow for some degree of “freedom”. By recognizing the movements, investors can, therefore, position themselves appropriately and profit from the movement they have anticipated.
Events and news do not create the trend. On the contrary, everything is written in the collective unconscious. Whatever the time horizon or country, human psychology is immutable. It reproduces the same configurations in a recurring and fractal way.
This approach is very interesting, but the difficulty of determining the movement of the waves, and of the current wave, makes it somewhat difficult to use, with an overriding subjective factor in the analysis. As we have pointed out, investors seek a rather simpler method than this, and another model should be envisaged.
This concept asserts that “the key to understanding the future lies in a study of the past, or that the future is just a repetition of the past”. Thus, the same errors are always repeated (formation of speculative bubbles and crashes) by individuals who have not learned the lessons of the past.
By adopting this clearly optimistic approach, we might believe that a time will come when the numerous errors committed in the past will be assimilated and we will have learned to act differently, more intelligently. Man evolves, sometimes against his will, but he evolves. Yet this can take time and asserting that history repeats itself constantly seems to us a somewhat exaggerated claim.
It was indicated earlier and has been shown by many studies, that it is not possible to take advantage of past movements to predict future movements. Consequently, all these techniques, however tremendous they may seem, will not make it possible to generate excessive profits, and luck is an important explicative factor for those who would claim the contrary.
The problem lies essentially in the fact that human nature likes order and structure. It wants to see specific patterns in disordered price movements and formats the brain to detect them.
Moreover, even if a trading technique appears to work or give good results, its use will lead market players to increasingly anticipate the subsequent movement. It is somehow anticipated and known, as it is based on the trading technique already proven. Market players will, therefore, anticipate it more and more, leading to a kind of self-destruction of the technique over time.
As with a trading technique that had supposedly been found, everyone realizes that history repeats, and will, therefore, predict the same movement that occurred last time that error was committed in the past. However, we might imagine that there exists a secret trading technique that works, but is only used by a limited number of people. However, when we look at the list of the wealthiest individuals in the world, there is unfortunately not a single chartist, at least not for the moment.
Criticism of Technical Analysis
Some believe that technical analysis works because the majority of traders believe in it. They, therefore, create the trends that they foresee. One criticism often directed at technical analysts is indeed that it is a self-fulfilling prophecy. Murphy, the great technical analysis expert, answers this criticism by stating that “it might be more appropriate to label it as a compliment. After all, for any forecasting technique to become so popular that it begins to influence events, it would have to be pretty good.”
However, it is not because a lot of people believe and use something that it is necessarily right. Before Australia was discovered, for example, everyone believed that swans were only ever white because they had never seen any other colors, and white was, therefore, the norm. The discovery of a black swan invalidated this general belief derived from a very large number of observations of white swans.
Conclusion on Technical Analysis
All three basic concepts of technical analysis are truly debatable. This technique is essentially used by traders or speculators with a short-term view and a goal of speculation rather than an investment objective.
Many academic or empirical studies have shown that this approach, net of transaction costs, does no better than a “buy and hold strategy”, i.e., holding assets over the long term with little portfolio rotation. The strategy of simply holding an index fund generates more money. Various tests have been done with different technical indicators, and it has also been shown that these are of no use for investors.
Again, as Malkiel notes, human nature likes order and the idea of chance is hard to accept. Taleb also adds that “our minds are wonderful explanation machines, capable of making sense out of almost anything, capable of mounting explanations for all manner of phenomena, and generally incapable of accepting the idea of unpredictability”.
So, people seek models and patterns in random movements. Joël de Rosnay said that “the best way to foresee the future is to invent it”, and that is perhaps what people do. By developing models, they seek to predict and perhaps invent, a kind of future, but the reality is sometimes not the one that was expected. The Chinese, known for being more gamblers than investors, may have the right idea in considering the stock market as a giant casino and luck as a decisive factor for the return on their investment.
Since information on companies appears randomly, prices must follow a random movement. This aspect will be looked at in more depth in the following blogs. Finally, we will reiterate that charts only provide information on the past and, as noted by Warren Buffett, “if history revealed the path to riches, librarians would be rich”.
Nonetheless, supports and resistances can indicate important levels, and breakouts from these thresholds can indeed provide valuable clues about future price movements. When a stock price moves within an interval without it being possible to meaningfully predict the next movement, investors should wait for more clarity. It is better to make a moderate but sure profit than to speculate on a profit that may indeed be higher but is hypothetical.
In our view, the fact that a certain number of market participants use technical analysis to make their investment decisions should be taken into account.
Accordingly, technical analysis can be useful for determining trends and support and resistance levels.
It should not, however, be used as the sole decision-making tool for investment. It is also useful for setting limit orders, which usually should not be placed on levels of support or resistance, but around these values. Supports are previous low levels and resistances are previous peaks. Depending on price movements, these thresholds may be reversed.
Investment Approach Based on “Psychological Principles”
Instead of wasting time and energy calculating the intrinsic values of an asset or to examine past price movements, another approach (the so-called Keynes approach) may be adopted, which involves analyzing investor behavior and their optimism and pessimism. This approach, based on psychological principles, is similar to behavioral finance.
As Malkiel notes, the aim of the game is to buy securities before the crowd, whose conduct will cause a rise in securities prices, based on psychological principles. Initially, an investment is worth a certain price for the buyer, who expects to sell it to someone else at a higher price. In turn, the new buyer anticipates that other prospective buyers will assign it a higher value, and so on. The infatuation of the Internet years and the speculative bubble it created can in part be explained by this type of behavior.
A speculative bubble is formed by the sharp upturn in a group of securities or a sector, driven by the media and sustained by new investors entering the market. This is usually accompanied by the proliferation of publications on the investment theme in newspapers and magazines.
However, according to Malkiel, the key factor for investing is not a company's social effect or technological impact, but its capacity to generate income and, especially, to make a profit. Thus, the market always ends up self-correcting to reveal the true market value of a company, which is the expected value in the Warren Buffett approach.
This approach may seem risky to the extent that the market is governed by irrational behavior. It is consequently very difficult to foresee behavior and to determine when it will change.
Valuation of Money Market Investments
The value of a money market investment is fairly easy to evaluate as it essentially depends on the level of short-term interest rates and on the quality of the borrower.
The returns of a government bond with a fixed (short) maturity, or the LIBOR rate for the period considered, constitute reference values for money market returns, with necessary adjustments depending on the rating. As we initially indicated, the LIBOR is the rate at which banks can borrow money on the interbank market. It is the rate offered to a bank that wants to borrow funds on this market.
The fiduciary rate is the rate at which investors can lend money to banks. In this case, investors ask to lend a given amount for a certain period. This is, therefore, a rate “requested” by the investor. The fiduciary rate will usually be lower than the LIBOR rate, and the size of the difference between the two rates will depend on the quality of the borrower as well as the need for a given currency at a certain maturity.
However, if the bank is in great need of cash and is in a difficult financial situation, the fiduciary rate may be higher than the LIBOR, as was the case for Irish banks in 2009. Fiduciary investments are also a means of short-term financing for banks, to meet their cash flow needs. As rates are fixed by the banks, investors can simply compare them for a given currency and maturity. They will invest with whichever bank satisfies their requirements in terms of credit quality (rating) and offers the best compensation.
They cannot compare a theoretical rate with a market rate, meaning that, in our opinion, investors should simply examine and compare the returns offered for this type of investment without any theoretical valuations.
The choice between the different types of money market investment (fiduciary deposit, money market fund, short-term bonds) is, therefore, the most important factor, without forgetting the need for proper diversification. Indeed, we indicated earlier that depending on the context, a fiduciary investment may prove more suitable than a money market fund or a short-term bond.
Investors should finally compare the return offered by money market investments to that of other asset classes and, depending on the outlook for interest rates and the attractiveness of other assets, they will have to determine whether they should diversify their investments or focus on one or two asset classes.
For money market investments, we believe that the degree of efficiency is high due to the very high level of certainty about future cash flows (interest). Indeed, the information available and reflected is comprehensive. The short-term rates are given by the market, and investors cannot really compare them to theoretical rates. They must, therefore, make a comparison between different borrowers. A fiduciary investment is made by the bank in its own name, but on behalf and at the risk of the client.
Valuation of Bonds
By buying a bond, the holder will receive, in principle, a fixed and regular income (coupon) and if all goes as planned at maturity, obtain their final redemption. These elements can be regarded as financial flows. To value a bond on a theoretical level, the most logical method is to calculate the present value of future cash flows using suitable rates, i.e., rates suited to the borrower's credit risk and to its term to maturity.
However, in practice, these rates are hard to estimate and, as with any estimation, are subject to a subjective analysis. For a known coupon and redemption amount, investors must make estimates about the movement of the different rates in order to determine an estimated theoretical price, which can then be compared with the market price. So the investment decision would have to rely on this basis.
It is easier to examine the market price and to study the yield to maturity in order to decide whether or not to invest in a bond, while obviously also considering the quality of the issuer. Expectations about future inflation and, above all, interest rates are far more important than calculating a theoretical price.
For example, what is the point of buying a long-term bond at a fair price, or even at lower than the theoretical price, when interest rates have started to rise? Investors, in addition to seeing the price of their security fall, would be locked into too low a rate for too long a period. They may, for example, have locked in a yield to maturity of 2% for five years, whereas a year or two later the yields rose to 3–4%. They would have been better off investing for a shorter period, then reinvesting in a year or two.
It is also useful to note that depending on supply and demand levels, aside from the size of the issue and liquidity factors, the difference between the purchase and sale price can be considerable. It would, therefore, be possible to find a theoretical price in between the two. Thus, investors should only consider the market price, as the calculation of theoretical prices is not really any help in making a decision.
They obviously must make a choice between the different types of bonds and issuers (sovereign or corporate) with their associated rating. Investors finally have to compare the returns offered by bonds to those of other asset classes. However, through a government bond (a country with strong finances) can be compared to a money market investment, a high yield bond should be compared to a riskier asset class.
In addition, depending on the outlook for interest rates and the attractiveness of other assets, investors will have to determine whether they should diversify their investments or focus on one or two asset classes. We will finish this blog with a short anecdote. A former bond trader worked for a while next to a young analyst fresh out of university, who spent all his time calculating the theoretical price of bonds and issuing recommendations or reservations when price differences appeared.
One day, the trader said to him: “You know, investors buy and sell bonds according to their performance goals and usually focus on the price set by the market. In all my career, I have rarely seen an investor refuse to buy or sell a bond on the grounds that the listed price was different from its theoretical price. Your best calculator is the market.” Today, the only analyses the market.
For bonds, we believe that the degree of efficiency is fairly high due to the generally high level of certainty about future cash flows (coupons). Information may, however, be less comprehensive and less freely available, meaning it is not as well reflected in prices.
The price of the bond is that listed by the market and investors must decide, according to a given maturity and the desired yield to maturity, if the corresponding price is attractive or not. However, investors may, if desired, place a buy limit order based on the desired performance. With a view to sale, they must assess whether the capital gain generated compared to the original purchase price corresponds to their performance target.
Valuation of Stocks
As we saw in the previous blog, there are several ways of evaluating stock prices and, unlike other asset classes, it is important here to distinguish the stock price set by the market from the intrinsic value, which analysts seek to determine using fundamental analysis. This distinction is important because to quote Philip Fisher's paraphrase of Oscar Wilde, “the stock market is filled with individuals who know the price of everything, but the value of nothing”.
For stocks, the degree of efficiency is much weaker, because of greater uncertainty about future cash flows which, moreover, are only estimates. We believe that not all available information is reflected in prices and, furthermore, that information takes time to be reflected. It is, therefore, worthwhile to analyze stocks as the market price often differs from the stock's true price (intrinsic value).
Valuation of Options
Although options are not regarded as an asset class, it is still worth mentioning the way in which they are valued in practice. Studies have highlighted considerable errors in option pricing. On the currency markets, where 15 million billion options were traded in 2001, a study showed that certain dollar-yen options were undervalued by 84% while other Swiss franc-dollar options were overvalued by 40%.
As Mandelbrot points out, “the most widespread formula was published in 1973 by Fisher Black and Myron Scholes, and we have known for many years that it is purely and simply false. Its assumptions are unrealistic. It assumes that price variations follow a bell curve, that volatility doesn't change over the option's life, that prices show no discontinuities, that taxes and commissions don't exist, and so on. Obviously, these simplifications facilitate mathematical calculations”, but it is clear that the valuation of options based on this formula is flawed and should be rejected, or at least adjusted.
In practice, adjustments are made, especially in terms of volatility. However, for this type of investment, investors must “rely” to some extent on the market price although it is not always correct.
Valuation of Real Estate
There are various methods of valuing or appraising the direct real estate. The sales comparison approach gives an estimate of a property based on the price of comparable transactions. Although it is based on market prices, it is not suitable for heterogeneous goods and ignores differences from one country to another.
The cost approach is based on the so-called intrinsic value of the property and is suitable for properties that suffer little depreciation and are subject to few transactions. However, it relies on a subjective estimate of the economic life of a property and of its residual useful life.
The income approach, and the discounted cash flow (DCF) method, in particular, takes into account the property's characteristics and ability to generate income. This makes it suitable for real estate that generates regular income, and it has the advantage of being independent of accounting data. However, both future cash flows and residual value are difficult to estimate.
Naegeli's location class method helps determine the relative share of land in relation to the total value of the property. The degree of the class varies according to the quality of the location, building density, attractiveness, infrastructure and market conditions.
Insurance value, replacement value or tax value are other property appraisal methods.
Finally, the hedonic approach entails valuing a property based on the principle that economic agents derive satisfaction from the characteristics of heterogeneous goods. Consequently, the surface, location, condition, age, and maintenance are paramount attributes that will help determine an implicit price depending on each of these characteristics. A property with a certain character will be worth more than one without it.
This method has the advantage of removing subjectivity from the appraisal process but necessitates the implementation of a considerable database. In addition, it is only applicable to the residential property. This valuation technique is used in Switzerland and England for residential property and is, in our opinion, the best approach for real estate appraisal.
However, as indicated earlier, we are only considering indirect real estate as part of our analysis of portfolio construction. Investors should examine the prevailing conditions in a particular real estate market and determine the market outlook, including in terms of interest rates, to decide whether or not to invest in this asset class.
Price valuation becomes somewhat secondary, as once the decision to invest in this asset class has been made, valuation is performed indirectly through the fund. It is therefore strongly recommended to use an expert in the relevant real estate sector (or to invest in a specialized property fund) to determine the attractiveness of this asset class at a given time.
Investors may, however, study the various types of real estate indices to get an idea of recent price movements. Securitized real estate indices are poor indicators of price movements, as indirect real estate behaves more like stocks than like direct real estate. Moreover, international indices do not take into account the differences that exist between countries.
The use of hedonic indices (for a consistent quality) seems the most suitable, in that they are based on transaction data and take into account the characteristics of different properties. This method is used, for example, to appraise residential properties in Switzerland, England, and Sweden.
So-called “valuation” indices are established on the basis of periodic property appraisals by experts and are best suited for evaluating commercial real estate. However, they are prone to smoothing problems, i.e., attenuating variations in value over time.
In terms of future cash flow, real estate lies between stocks and bonds and, consequently, we qualify the degree of efficiency for this asset class as moderate. We suggest performing analyses or consulting experts before investing. Investors should not rely directly on market prices, as they may be different from the intrinsic value of the property.
Valuation of Commodities and Metals
As mentioned previously, the price of both commodities and metals depends essentially on supply and demand conditions for the market in question, which are related to economic cycles and the economic climate.
As they do not generate income, this asset class is difficult to value using the Discounted Cash Flow method or a ratio-based approach. A thorough analysis of supply, demand, macroeconomic and climate conditions, and even of historical price movements, must be undertaken in order to determine the outlook and consequent attractiveness of this asset class.
Once this study has been conducted, investors can decide whether or not to enter a particular market, and will simply pay the market price for a given commodity. The price outlook is therefore crucial.vIn our opinion, when deciding whether to enter a market, it is as essential to evaluate the opportunity risk of the trade as it is to consider the commodity's price.
For commodities and metals, because of the absence of future cash flows, we qualify the degree of efficiency as very low. We consider that information is highly dispersed between different market participants and that it is not evenly reflected in prices. Therefore, it is worth undertaking an analysis in order to profit from the various inefficiencies that may appear in these markets.
Conclusion on Valuation
In view of the above, we may ultimately wonder whether the valuation of a financial asset is really relevant, in that the market provides the price directly according to supply and demand. As Mandelbrot notes, the value is a slippery concept, and “if this value is constantly changing, how can it be of use to an investor or financial analyst weighing their decision to buy or sell? What is the point of a valuation model that requires new parameters for each new calculation?”
Investors should not spend too much time valuing financial assets but should focus instead on the opportunity to invest in one or several asset classes according to their attractiveness and outlook.