Asia Real Estate, Especially China, has Come a Long Way Since 2008

The Wall Street Journal today Friday, July 17, 2020  has an article “The $52 Trillion Bubble : China Grapples With Epic Property Boom”

Asian Real Estate markets have come a long long way over the last decade plus. I remember tracking them way back in 2008 when they were beginning to take off just around the time of the global financial crisis.

Here is my research note of 2008 for download :

Asia Real Estate – CAI_Journal_Summer2008

Bringing an Investing Mindset to Active Funds Due Diligence

In seeking risk transparency without seeking position level specifics of a hedge fund we need to know, at minimum, a few things usually captured in a risk report. Risk reports are a useful starting point, but they are of course a static snapshot and do not tell us the entire story. For each hedge fund we can develop a better story using the understated approach and reasons for the approach:

  • Position level information: Provides a static picture of where the fund stands. These measures are most relevant for short term shocks where the actual position held matters much more than a manager’s behavior or trading strategy to define performance. These are especially useful during volatile markets as well as periods of market stress.

For medium term horizons this needs to be coupled with a fund’s trading strategy.

  • Trading strategy information: This helps us understand how (magnitude and direction) the previous static position will change over time when external market factors change i.e. trading strategy should explain sensitivity of the fund to market rises and falls.

In addition, we need to be clear about a fund’s exposure, leverage and counter party risk depending on the specifics of the hedge fund. Exposure is generic risk proxy and specifics are important.

  • Exposure as sensitivity to ‘what’ i.e. to which few important factors?

Is it net exposure? : i.e. the sum of – Short positions and + Long positions; but we should use this measure for tightly correlated positions with similar volatility for this gives a sense of sensitivity to market factors i.e. how much we stand to lose or win when a market factor moves.

Is it gross exposure: Sum of absolute positions; we should use this measure for loosely or uncorrelated positions with dissimilar volatility such as for example global equities.

  • If the hedge fund trading strategy employs futures and derivatives it helps us to see a future’s contract as a +Long position in the underlying with -Short position in cash/funding and variation margin. The “exposure” to a future’s contract is equivalent position in the underlying funding position. Therefore, we must separate the funding position from the future’s position in a risk report. Likewise, for derivatives, we can see it as a case of ‘futures’ i.e. a +Long position in underlying with -Short position in cash/funding but with the underlying changing dynamically.

 

  • Long Short: If +Longed and -Shorted assets are correlated (as often happens in relative value trades) we should look at net exposure as measure of leverage. If less correlated, we should look at gross exposure.

The key point here is to answer the question exposure to ‘what?’ for there is usually no one single exposure measure to characterize a position’s risk. For the same position we may be interested in different exposures and we may meaningfully aggregate the same sensitivities only

  • Leverage which is the ratio of fund assets to equity contributed where leverage may be explicit from borrowing or embedded from derivatives. Leverage provides us with a simple relative indication of risk to answer how large will losses or gains be to an un-leveraged portfolio. It is important to bear in mind that higher leverage does not automatically imply greater risk. It is a relative measure for a twice leveraged portfolio is twice as risky as an un-levered portfolio provided the two portfolios invest in exactly same underlying assets.

The way to analyze leverage is to decompose positions to make implicit borrowing (from derivatives) explicit. One can for example replicate a forward contract by borrowing the present value of future fixed price X at X^e-rt + F(today) and buying the asset. The futures position contributes to leverage, but when matched with an equivalent cash position, may serve as an alternative to buying the underlying. When so coupled we cannot say that just because a fund uses futures or derivatives to gain exposure, we are increasing leverage. Therefore, we need to know the risky underlying asset position and the cash positions together. It is for this reason a risk report should separate the two.

  • Risk of total loss to fund equity capital; This is an important measure that every risk report should continuously monitor. i.e. at what loss will equity get wiped out.

 

  • Risk of a fund, including from its explicit loans and from its implicit derivatives or leverage producing positions, should be less than or equal to X times ( as mentioned in the fund documents usually) the risk of the fund’s unleveraged counterpart/risk benchmark. A fund’s performance benchmark may be used as risk benchmark as a rule of thumb.

 

  • Exposure to credit risk/counterparty. This is the cost to replace the contract or a set of positions if the counterparty defaults; it may be a loan equivalent amount measure. One can develop a forecast of distribution of future exposures in which case qualitative questions range around long term forecasts of underlying risk factors, accounting for collateral, netting, and credit risk mitigation techniques etc.

We should ask for a risk report with the above as basics so that we can have; (i) a consistent set of scenarios side by side; (ii) effect of scenarios as short term shocks based on position level information and; (iii)effect of scenarios over medium horizons based on factor models and a fund’s stated strategy.

It is important to be cognizant of some issues that surround active strategies.

  • Since hedge funds hold non-linear instruments they trade dynamically and produce non- linear payoffs. So, we can say that while funds are certainly exposed to markets, the exposure is non-linear. Using multi factor models here is akin to using mis-specified linear models and inevitably leads to erroneous conclusions. So how do we then capture non linearity through appropriate factor construction? The literature is replete with suggestions including; (i) perfect trend follower replicated through a look back straddle options;  (ii) momentum trades; (iii) use of factor regressions over rolling windows to see if a hedge fund has significantly altered its strategy or compare the regression results on either side of a market event. In interpreting such we need to examine both position level results and factor sensitivities.

We can use current price information and pricing model and not need historic data dependency for:

  • Sensitivity measures: The effect of a small movement in spreads on the present value of a position. this is typically at the security level and not at portfolio level.

 

  • Stress test or scenario analysis: Modeling ‘what happens if spreads widen by X with variants such as parallel spread stress test or historic volatility of spread moves.

 

  • Relative value investors: Buying a bond and simultaneously buying credit protection through CDS (i. if the basis between them is historically very wide and investor will profit if basis returns to normal typical. Or if basis is negative and investor receives difference between bond spread and cost of CDS protection without taking any credit risk.

 

For relative value fixed income hedge funds, we need to be aware of special issues around performance and risk forecasting.

  • Forecast the overall portfolio risk: an example is to isolate interest rate risk where hold credit spreads constant, while allowing the base interest rate curve to change. And similarly, to isolate credit risk, we should hold interest rate curve constant while allowing credit spreads to change.

 

  • When credit spreads are strongly correlated to the interest rate base curve, the distinction between interest rate risk and credit spread risk is not relevant. Therefore, it is important to decompose risk across factors that are independent of each other. Spreads on CDS often exhibit little correlation with base rates and are a good mechanism to decompose risk.

 

  • We may also decompose the risk and estimate the portion from spread movements in which case we need historical data that has statistical properties amenable to forecasting. So, we cannot use Yield Spread to treasury as the benchmark T Bill rate will be changed and this change should not reflect in change in creditworthiness of a corporate bond. Also, spread volatility tends to be greater for longer maturity bonds and it is better to create spread curves on each day and apply stats on data for a constant maturity point.

 

  • Series to be analyzed: Whether we use OAS (OAS added to the base curve gives us a discount curve for cashflows promised by a bond issuer) or CDS spreads the objective is the same i.e. to ascertain how much compensation an investor should receive for bearing credit risk. The two are not interchangeable as for a CDS , upon a credit event, the receiver gets par-amount irrespective of the prevailing interest rate; to make them strictly comparable we may need a fixed to floating IRS which cancels at the event of default . ((CDS and Bonds risk free value: discount all cash flows by base curve)) – (Default probability * loss given default at the same time points)); can give us a ‘bond implied CDS’.

 

  • A single risk measure or a single risk factor to describe all positions on a single issuer is almost never relevant. For example, if the mark to market value of negative basis trade moves against investor, a previously predictable ‘zero risk’ position would suddenly become risky. Therefore, it is important to separate the two distinct sources of risk – bond and CDS market spread where simplification to a single source of risk for relative value trades would be inappropriate.

 

  • Since volatility changes there is a limit to how much historic data we need to use; using more history will not improve forecasts.

 

  • Qualitative questions too can lead to better understanding of relative value / fixed income hedge funds: What type of pricing model do you use to arrive at the NAV? How do you mark your positions to market? Is it to a model? Have you stress tested the value of your portfolio against alternative methods for marking to market? What did you conclude? How long would it take to liquidate your portfolio and what will be the incremental effect on NAV? Why would you not? What is your data source for volatility? How do you deal with correlation assumptions during these stressful times? How do you build your volatility curve?  Give us a breakdown of your trades (at the position level) by major strategy types.

While VAR alone is a reasonable measure of market risk for some portfolios, the risks of many arbitrage type strategies are better represented by stress tests and scenario analysis. Stress tests should be chosen based on the nature of the portfolio, but might include:

  • Large market shocks
  • Changes in the level of volatility, the shape of the yield curve or the volatility curve, sector definitions, correlations
  • Changes in liquidity
  • Some variables, given a small move, cause a large move in price or risk valuation
  • Some variables important to a portfolio that have a high likelihood of change
  • Those variables or exposures that offset each other

The Capital Allocator’s Perspective – Framework for Operational & Investment Due Diligence

The record of Operational & Investment Due Diligence within private equity, real estate, hedge funds and traditional investing has been dismal through the ages. An after the fact event, it is usually about shutting the barn after the horse has bolted. The function has done very little to insulate investor portfolios from losses. The activity has devolved to fiduciary CYA, designed to protect the wealth management firm, pension or sovereign fund, consultant or product purveyor from liability. In going through a roster of standardized questions, to which are offered standardized answers, it is about dotting the ‘i’ and crossing the ‘t’.  One now sees new digital platforms that collate, collect, structure, and offer fund manager data for easy access to prospective investors.

The Capital Allocator is in the business of entering into partnerships with fund sponsors to potentially generate significant returns, mainly through long-term capital appreciation, by making, holding and disposing of privately negotiated equity and related investments.

Such investments are usually made as a passive investor in vehicles directed by a third party fund sponsor; as a result, the investor has only indirect influence over-achieving ultimate investment objectives. We believe that a methodical approach to selecting sponsors—which combines scientific rigor with seasoned subjective judgment— may contribute to creating strong results in a variety of economic environments. We present here a ‘best practices’ framework for selecting financial sponsors. We draw attention to important issues, metrics and considerations deemed worthy of exploration.

What follows does not represent an exhaustive list, of course. Each investment and operational diligence mission inevitably take one down paths that are not common to other missions. One must be prepared for this—and even seek it and relish it. For, it is forays beyond the common and readily available, that enable real insight into the people with whom one entrusts with one’s capital.

What is missing is the capital allocator’s nuanced perspective. We suggest one here.

Download PDF here:

Direct_Investing_DueDiligence_5-20-ActiveAllocator

Investing in Distressed Debt

Download white paper authored by Sameer Jain to explain the characteristics of distressed debt.

investing in distressed debt

#ActiveAllocator Research – Distressed Debt. WSJ today, May 19 page B2, reports that 59 distressed debt funds are in the process of raising $67 billion. I have long advocated that opportunistic and distressed debt may have a useful role in investor portfolios. I had authored one of the early white papers explaining the characteristics of distressed debt which whilst dated in the data is still very useful.

Watch video: The updated 2020 opportunity

 

Venture Funds Should Stop Throwing Good Money After Bad

I am of the view that LPs prevail on their GPs to stop throwing good money after bad in their risky early stage series A/B investments, especially within FinTech. They now need start writing down investments, close down follow-on funding and institute layoffs and firm closures. The U.S. economy is expected to languish over the next two years as policy stabilization efforts are unlikely to provide a boost to financial conditions in the short term. My recession scenarios capture the potential for more crippling damage to financial inter-mediation and slower economic growth beyond the cyclical horizon. Things are going to be rough and risky early stage FinTech firms will be worst affected.

The biggest issue is GPs will disregard this advice for they have a vested interest in keeping investments going and perpetuating management fees. I had written a proprietary game ( game theory) to arrive at Nash Equilibrium in the LP-GP relationship some years ago. Some of my findings are expressed in a dated research piece, that I think is very relevant in 2020.

Download:

key contractual considerations in private equity fund placements

Anatomy of a Master Limted Partnership and Asset Allocation

ActiveAllocator converges competencies in asset and wealth management, investment banking and computer science in an example. We in minutes analyze, given what you own if Master Limited Partnerships ( MLP) may be accretive or detract from your portfolio. We explain the general idea behind investing in MLPs and provide a supportive deck which explains the anatomy of a MLP.

MLP anatomy deck PDF: email me

Allocating to MLPs video:

 

 

Key Contractual Considerations in Private Fund Placements

LP-GP negotiations : the more things change the more they have remained the same in private equity land over the last two decades. I had analyzed contract negotiation dynamics during an earlier phase of my career on Wall Street – attached .. (It also lends itself to be formulated as a gigantic Game Theory problem, I imagine )

Download :

key contractual considerations in private equity fund placements.pdf

Investing in Distressed Debt

ActiveAllocator analyzes portfolios and tells you exactly how much, if at all, you ought to allocate to the Private Debt asset class (inter alia). I had analyzed the characteristics of a variant, Distressed Debt, early on in my career. Attached is an excerpt reproduced by CAIA in their alternative investments journal from my more comprehensive white paper – hopefully active investors find it useful….

Download:

investing_in_distressed_debt_caia

Investing in Private Equity

 

ActiveAllocator analyzes portfolios and tells you exactly how much, if at all, you ought to allocate to the Private Equity asset class (inter alia). I had analyzed its characteristics early on in my career. Attached is how I explained it then and reproduced in many books now. While the data here is now outdated, active investors tell me they still find it very useful….as I hope you do too.

Download:

Private Equity Compendium

Investing in Mezzanine Debt

 

ActiveAllocator analyzes portfolios and tells you exactly how much, if at all, you ought to allocate to the Private Debt asset class (inter alia). I had analyzed the characteristics of a variant, Mezzanine Debt, early on in my career. Attached is how I explained it then and reproduced in many books now. While the data here is now outdated, active investors tell me they still find it very useful….as I hope you do too.

Download:

Investing in Mezzanine Debt

Allocating to Activist and M&A Hedge Funds

ActiveAllocator, is pleased to share with you our latest research piece ” M&A and Activist Hedge Funds”. Given our unique vantage point we see trades, that such firms do. These secretive funds have long been subject of folklore . Preserving confidentiality , we introduce here the ‘anatomy’ of how such deals get played out. In future we also hope to show you 30-40 case studies

email me for pdf

 

Conceptual Approach to Intra-hedgefund Strategies Allocation

ActiveAllocator is pleased to share with you our latest research piece ” Intra hedge fund asset allocation framework”. We explain how one may intelligently choose from +20 hedge fund sub-strategies, sift jargon, and combine in the right amounts to meet specific asset allocation objectives, through correct portfolio construction

email me for pdf

M&A Arbitrage – How to Get it Right

ActiveAllocator allocates to major hedge fund strategies and their sub-types including Merger Arbitrage. Given the wide dispersion in returns in M&A funds we believe that hedging the time period deal risk is integral to both profitable trade as well as helpful for diligence. We present the anatomy of the M&A trade by drawing attention to the ‘Collar’ and reconstructing it from first principles.

 

email me for pdf

Non Traded REITs Podcast

Non-Traded REITs have been in the news recently. They typically invest in sector specific real estate programs, targeting stable, fully occupied properties subject to long-term leases to strong credit tenants. They are thus able to generate immediate, durable, rent-driven cash flows from the inception of the investment as capital is deployed without a cash drag. Much like traditional private equity core real estate investing, they aggregate property through acquisitions and build diversified portfolios by tenant, geography, industry and lease duration. They return value from these aggregated portfolios via asset sales, public listings or mergers, usually over a five- to seven-year timeframe.

My take in a past podcast interview: 1:19 The case; 6 Market size;7:30 Investor type;9:55 Illiquidity premia; 11:52 Regulation; 13 Returns; 14:45 Capital raising; 16 Growth; 18 Transparency and industry evolution

Sameer Jain discusses the advantages of non-traded REITs as compared with publicly traded REITs. During this interview he discusses the size and historic returns of the non-traded REIT industry, as well as its regulatory environment, which types of investors they are best suited to, and what investors get in return for the illiquid nature of this particular real estate investment vehicle.