What is Private Equity?
Private Equity (‘PE’) is an alternative investment class that concentrates purely on private companies (i.e. firms that are not publicly-traded). PE firms utilise large amounts of capital (equity and/or debt) to purchase private companies in order to restructure the acquired company before selling them at a higher price. Typically, PE firms will invest in undervalued companies so that its restructuring can increase the company’s intrinsic value. By increasing the share value, these firms can improve their returns when exiting the acquired company. Due to the intricate nature of these transactions, PE deals tend to be long-term investments, in contrast to the approaches typically employed by hedge funds and investment banks.
Common investment strategies within PE include:
The past decade has been one of unprecedented success for the private equity industry. Emerging from the ruins left by the Global Financial Crisis, the PE industry has grown rapidly since the late 2000s in both available capital and the dollar value of PE deals. In fact, PE firms across the world have amassed $1.5 trillion in unspent capital as of 2019, a record for year-end total.
An annual Public Pension study perfectly underscores the dominance of private equity against their investment counterparts – PE deals have provided an annualised return of 8.6% over the past ten years, an entire 2.5% ahead of the following asset class.
The current low-interest-rate environment combined with a lacklustre performance from hedge funds has further pushed investors to private equity in search of higher returns. More recently, investment firms such as Vanguard and Goldman Sachs along with pension funds are allocating funds towards the private capital industry in the search for sustainable yield which has lead to $450 billion USD in deal flow.
To truly understand the nature of PE deals, we turn to Australian Private Equity Firm- Allegro Funds and their investment in the Great Southern Rail (GSR), an Adelaide-based train operator, in 2015. Purchased purely through equity (a 100% stake), the PE firm partnered with GSR’s existing management team to focus on boosting the high-end tourism market.
“It wasn’t the right fit under its previous owner but it had a strong management team in place, iconic assets and was well-positioned to capitalise on the forecast growth of the luxury experiential tourism sector,” Mr Loader (Allegro MD) said in a statement.
Following this acquisition, Allegro analysts worked alongside the GSR management team to improve the performance, and the profitability, of the train operator company. This allowed the PE firm to promptly reduce its investment in the train operator in 2016 with a profitable margin by selling a controlling stake to Quadrant Private Equity.
This deal, whilst insignificant in the grand scheme of investments, perfectly describes the long-term strategy driving PE deals. Unlike short-term investment classes, PE deals are a hands-on business-building task that works intricately with the acquired companies before exiting with significant profit margins.
What is Venture Capital?
Venture Capital (‘VC‘) exists to service a gap created by the structures and rules of capital markets. In essence, when an entrepreneur comes up with an innovative and novel idea, there are no other institutions to which the inventor can turn to in order to obtain funds to realise their concept into a viable commercial business.
First, the founder would often not have adequate funds personally, or from friends and family, to match the heavy costs associated with starting or expanding the business. Second, bootstrapping (using one period’s profits to fund growth for the next period) would fail to meet the demands of rapid growth. Last, usury laws limit the interest rate banks can charge on loans and due to the high-risk nature of start-ups who often have few assets which can be used as collateral, banks would require higher rates than would be allowed by law, meaning bank loans are also not an option.
How does a VC deal work?
The Venture Capitalist will usually offer to invest in the business in exchange for a large equity position. The invested funds generally go towards building the infrastructure required to grow the business – expense investments (manufacturing, marketing, and sales) and the balance sheet (provided fixed assets and working capital) – and only a relatively small proportion is used for research and development. VC investments are not long-term (around 5 years), with the premise of funding growth being geared towards lucrative exit events such as selling the invested firm to a corporation or enlisting an investment bank to push the firm towards an initial public offering (‘IPO’) and float the firm on the public markets.
*Source: Harvard Business Review
In reality, VC firms open ‘funds’ to pool money together from wealthy individuals, companies, pension funds, university endowments, etc. to invest into some number of companies. Each firm and each fund would have its own investment profile. For instance, a firm might specialise in biotechnology start-ups and has 2 funds set up with different risk profiles, one high-risk and one low-risk.
The Australian PE & VC index outperformed public markets by 200 to 400 basis points in Q3 2018, which signals strong potential for private capital to attract significant future inflows.
*Source: Cambridge Associates’ Private Investments Database, December 2018
Australia’s IPO market has followed the global trend of flat growth. More entrepreneurs are increasingly adopting the perspective that the costs associated with listing on a stock exchange are outweighing the benefits. These costs predominately arise from compliance and regulatory requirements which consume the firm’s financial resources and management time. Further, entrepreneurs are more sceptical of the short-term focus of equity markets – they believe in order to grow their venture in the long-run they are better off remaining private to avoid the public market’s constant focus on quarterly results. This has inverted the traditional notion that an IPO is the hallmark of success for a business venture.
*Source: EY Global IPO Trends, 4Q18
In April of 2012, the popular photo-sharing application Instagram was acquired by Facebook for a total of $1 billion USD. To truly grasp the tremendous scope of this deal, we can turn to the VC firm Andreesen Horowtiz, whose initial $250,000 of seed money translated into $78,000,000 at acquisition, representing a 312 times return on investment.
Founded in 2010, Instagram quickly rose to the number one free photo-sharing app on Apple’s App Store by 2012. At the time, Facebook was facing a decline in its handset users and hoped to leverage the Instagram purchase to increase its share of that market. When Instagram eventually made its way to Android, it added millions of users in a matter of days, which spurred frenzied negotiations that culminated in the $1 billion acquisition. In hindsight, this valuation was relatively cheap, given that in 2019 alone, Instagram generated $20 billion in revenue and accounted for more than a quarter of its parent company’s total revenue (Bloomberg).
However, to put this into perspective, Horowitz emphasised these types of deals are exceedingly rare – for every company like that, they are literally thousands of failures.
What is a Hedge Fund?
Hedge Funds are an alternative investment vehicle that pools capital from accredited and/or institutional investors to invest aggressively in relatively liquid assets. Unlike the PE and VC industry, the investment strategies employed by hedge fund managers vary drastically between firms as they actively search for excess returns, or alpha, for their investors.
Characteristics of a Hedge Fund
Given that hedge funds engage in a diverse range of investment strategies and financial instruments, it is more practical to focus on the defining characteristics of a hedge fund.
Market Direction Neutrality – A form of investment strategy that aims to profit regardless of which direction the market moves. This is typically accomplished by taking both long and short positions in different stocks. Returns are generated through good stock selection rather than market movement.
Accredited Investors – Accredited investors consist of banks, insurance companies and also high net-worth individuals. Accreditation is earnt by meeting the requirements set out by the SEC such as annual income and net worth.
Leverage-Reliant – The capital used by the fund manager is only borrowed from investors. Fund managers may also use credit lines or buy securities on a margin to increase the size of their market bet.
Fee Structure – The fee is usually structured with a fixed management fee and an additional performance fee. The most common structure is known as the ‘2 and 20’ where the fund manager takes 2% as fixed fees and an additional 20% of all the profits earned as a performance fee.
Lock-in Period – This is a period where investors are not allowed to withdraw their money. Generally, the fund manager is given a 30 to 90-day notice so that they have time to liquidate some shares in their portfolio.
Little Regulatory Oversight – Hedge funds are not subject to the same degree of regulatory oversight as other investment types such as mutual funds. This is because the US Securities Exchange Commission believes that accredited investors who run the hedge fund have a fundamental idea about the strategies they will be utilising and their associated risks.
Popular Hedge Fund Strategies
Long/Short Equity – The fundamental concept of this investment strategy is to take a long position on a stock that is projected to outperform a competing company whilst holding a short position with the competing company. This investment strategy hedges the firm’s market exposure and generates returns based on the idiosyncrasies associated with individual stocks.
Equity Market Neutral – Similar to the Long/Short Equity strategy where stocks are both longed and shorted to decrease market risk exposure. The returns are generated by exploiting the idiosyncrasies and investment opportunities unique to different industries, sectors or regions.
Global Macro – This investment strategy is heavily reliant on the macroeconomic trends that affect the interest rates, exchange rates, commodity prices and equity prices. Fund managers will take either a long or short position in the asset classes that are most sensitive to price movements. Global macro funds usually trade futures due to its high liquidity.
Quantitative Trading – These hedge funds engage in quantitative analysis and systematic strategies to execute trades. The success of these hedge funds are typically reliant on the firm’s algorithmic model that is created and back tested against historical data. Quantitative hedge funds will then engage in high-frequency trading strategies that exploit price volatility, leveraging on small price fluctuations through large transactions.
Key Themes Shaping the Hedge Fund Industry
Emerging Manager Demand: Investors are increasingly looking to smaller or newer funds in search of outperformance or favourable fee terms
Industry Consolidation: The number of fund launches in 2019 trailed fund liquidations for the first time on record. The number of active hedge funds is therefore shrinking, creating a consolidated and leaner industry
Market Slowdown: 43% of surveyed investors are looking to position their hedge fund portfolio more defensively in 2020 in response to our position in the business cycle
Recovering Performance: Capitalizing on strong equity market tailwinds, the asset class returned +11.45% over 2019, bouncing back from the -3.06% return recorded the year before. It is the only time in the last 6 years that the annual return has reached two digits.
Fee Pressure: Following pressure from investors, the mean management fee of funds launching in the market has been decreasing. Managers are altering their structures in a bid to attract capital in a competitive market. Although a 3% increase in assets is expected, it will not be enough to offset record low fees of 1.51% on average, causing overall revenue to decline.
Trends in Hedge Fund Strategies
Despite the 11-year bull market during which hedge funds have faced tougher market conditions, investors are still looking to the asset class in search of portfolio diversification and high uncorrelated returns. Over the last decade, robust economic growth and narrow credit spreads have seen credit strategies succeed, while niche strategies have also been picking up inflows with investors looking for something different in the crowd. However, with 69% of investors believing that we may be at the peak of the cycle amidst slowing global economic growth more defensive strategies such as relative value strategies are in higher demand.
Hedge funds using artificial intelligence/machine learning (‘AIML’) are delivering long-term outperformance. The proportion of systematic hedge funds launched in 2019 that use AIML is over double the proportion in 2016 (23% vs. 10% respectively) and in a tough fundraising environment, AIML can help fund managers to differentiate themselves from competitors and appeal to investors.
One of the most successful hedge funds to date is the Medallion Fund, a famous portfolio established by Renaissance Technologies in 1988. It has shown immense trading success, with an annualised return of 66%. Interestingly enough, the Medallion Fund was founded by Jim Simons, an ex-codebreaker and mathematician, who in unison with other mathematicians and cryptologists, was able to produce a mathematical model that predicted price changes in easily-traded financial instruments. Later, Robert Mercer and Peter Brown developed a highly profitable arbitrage system which complemented Medallion’s model. By employing cutting-edge computer models, advanced mathematics and being fed abundant financial data, the algorithms of the Medallion Fund were able to exploit patterns, generating small profits which amounted to impressive gains, evident from 1990 and onwards.
Strangely, the proliferation of other hedge funds has barely affected Medallion’s performance. This could be due to its intricate models and unique strategies in the works – even a minutely superior execution relative to Medallion’s competitors, when summed up over millions of trades, leads to immense profits. Indeed, given such exceptional performance, Renaissance Technologies’ Medallion Fund is a unique and famous case, but also a rather secretive one – its funds have been closed to external investors since 2003, and are currently owned by Jim Simmons and other Renaissance employees.
What is a Commodity?
Commodities are a fungible good/service that are often used as inputs for the production of other goods/services. To put more simply, commodities of the same type and similar quality are of equal monetary value, much like how two $100 bills are of the same value (i.e. 1kg of gold has the same monetary value regardless of the location or company in which it was extracted from).
Commodities were traditionally seen as a direct product of agriculture or mining (see below). Recently, this definition has expanded to include financial products such as foreign currencies and indexes. Technological advancements have also led to new types of commodities being traded such as cell phone minutes and bandwidth.
Commodities are usually purchased and sold through futures contracts that have the quantity and quality of the product standardised. Unlike currency, commodities have practical uses such as being used as an input in a production line. Hence there are two general parties who trade certain commodities: those who need to use it, and traders.
There are two main strategies involved in trading commodities. The first is to hedge against price fluctuations of the commodity that may occur in the future. Essentially, the buyer will pay today’s market price for the futures contract. At the expiration of the contract, the commodity is delivered. The second is to speculate on the direction of price movements of the underlying commodity. These traders don’t deliver or receive the commodity and only aim to profit off the volatile price movements of the commodities. They close their positions by purchasing a contract opposite to their original open position.
Commodities are split into two types: hard and soft commodities.
Hard commodities are metals or energy resources, mined or extracted from natural resources. They form the basis of the economic health of a country, and global demand for such resources can be monitored to gauge the future stability of an economy. It is because the supply and demand for the products are largely predictable due to its fixed nature.
Hard commodities can be further subdivided into:
Metals: Metal commodities include gold, platinum, silver and copper. These commodities are typically popular for their reliable status during periods of high volatility or high inflation and currency depreciation.
Energy: Energy commodities include crude oil, natural gas and gasoline. These tend to be volatile as economic conditions, shifts in production enforced by the Organization of Petroleum Exporting Countries (OPEC) and technological advances in renewable energy sources have a large impact on energy prices.
Soft commodities consist of products that must be grown and cared for. Soft commodities can include livestock and meat as well as corn, soybeans, rice, coffee and other agricultural products.
They are more volatile as their price-setting mechanism relies on multiple external factors. Weather-related or seasonal transitions heavily impact prices and population growth combined with dwindling supply typically provide opportunities for profit. The production of such goods depends largely on the environmental conditions of a country. It is one reason why agrarian economies suffer more due to events such as climate change.
Despite its limited industrial viability, gold remains a highly popular commodity that is often seen as a global store of value and medium of exchange. This precious metal cannot be counterfeited or produced in bulk and is generally used as jewelry, technology or simply stored in gold reserves. It has always stood out against other precious metals as it is primarily driven by investment and a store of value; in fact, many governments hold onto large gold reserves, with the US having the largest gold reserve of 4583 tons at a market value of $240 million.
Many countries continue to hold massive amounts of gold reserves simply as an insurance against economic catastrophes or hyperinflation (i.e. gold is viewed as a hedge against inflation). While fiat money (e.g. the AUD or US dollar) generally serves as a good currency, its value is controlled by economic variables that the central banks have control over, meaning it can be unstable, especially in economically difficult times. In comparison, gold is stable for its limited supply and is inversely related to the dollar value, thereby gaining value (in terms of fiat currency) as the value of the currency falls.
In uncertain times like COVID-19, gold is an asset that is highly sought after and unsurprisingly, its prices and stock values are on the rise. With large stimulus packages being released across many large economies, including Australia, the inflation of currency has made gold an attractive investment. Gold can be invested in through purchasing physical gold, gold futures, investing in gold ETFs (exchange-traded funds) or investing in gold-mining companies
What is Real Estate?
Real estate is a tangible asset, made up of land and anything attached to the land space, i.e. the buildings and any natural resources within the land space (natural resources refer to uncultivated flora and fauna, farmed crops, livestock and also mineral deposits). Real estate is commonly subdivided into 3 categories:
Residential real estate includes undeveloped land and housing complexes, which may be either owner occupied or rental properties.
Commercial real estate includes non residential structures, such as office buildings, warehouses and retail buildings. Apartment buildings (despite being residential) are also often considered commercial as they are owned to produce income.
Industrial real estate includes manufacturing buildings and property, such as warehouses.
In the past 50 years, investments in real estate have averaged returns of 11%, much higher than the average of other asset classes. With the exception of a national recession, real estate investments are considered to be a profitable and steady investment, with low risk due to the low market volatility (which occurs due to the long amount of time it takes to liquidate a property asset). Real estate investments generate a passive income through a steady cash flow, which likely increase over time due to capital appreciation (increase in the property’s value). Real estate investments also offer portfolio diversification as real estate has low correlation with other asset classes, allowing for diversified assets with a higher return per unit of risk. Investors also have potential for tax benefits as tax can be deducted for the reasonable costs of owning, operating and managing a property. Other reasons for investing in real estate include the building of one’s net worth and wealth, the use of real estate as a hedge against inflation (in an expanding economy), and the increase of return through use of debt (real estate leverage).
It is important to prepare and research before planning to invest in property; while real estate investments can produce greater returns comparatively to other investment options, there are inevitable risks associated with it (entry and exit costs are expensive, rental income is not guaranteed and property value can fluctuate undesirably and illiquid/difficult to convert to cash).
Ways to invest in Real Estate
Retail investors can gain exposure to real estate through the following investment vehicles:
Real Estate Investment Trust
A REIT (Real Estate Investment Trust) is a company that owns and typically operates income-producing real estate or related assets. They provide a way for individual investors to earn a share of income generated through commercial real estate ownership without owning a property themselves. The two main types of REITs are equity and mortgage REITs. Equity REITs own and operate properties to generate revenue primarily through rental income. Mortgage REITs on the other hand on the other hand focus on interest income derived from mortgages and mortgage-backed securities.
Mortgage-Backed Security ETF
Mortgage-backed security (MBS) ETFs are another way to invest in real estate. A MBS is an investment collateralized by a pool of home loans bought from banks. Investors in MBS receive periodic payments similar to bond coupon payments. MBS ETFs give investors access to the domestic mortgage-backed bond market including those issued by government-sponsored corporations like Fannie Mae and Freddie Mac.
Real Estate Investment Group
Real estate investment groups (REIGs) buy, renovate, sell, finance, manage or lease property in search of profits. They differ from REITs in that they do not have specific limitations on business structure or ways in which real estate investments are carried out. REIGs are an entity with multiple partners or shareholders. Multiple sources of capital investments provide a greater pool of capital and greater diversification benefits.
The Federal National Mortgage Association, more commonly known as Fannie Mae, is a corporation that enables investors to invest in the mortgage market through Mortgage Backed Securities (MBS). “What exactly are Mortgage Backed Securities and why would investors choose to invest in these financial instruments?” you might ask. Well simply put, Mortgage Backed Securities are basically coupon paying bonds. Mortgages are contracts between a bank and a borrower that entitles the bank to receive periodic payments of the principal (amount lent) and interest over a long duration of time (usually over 20 years). All seems well, the borrower gets to buy a house, the bank earns interest payment. Except, the bank has to keep the mortgage in its books for the duration of the loan, which ties up capital and resources. So the bank plays it smart and decides to sell the mortgage as a Mortgage Backed Security to investors, essentially acting as a middleman between the borrower and investor. This way, the bank will simply earn money through fees associated with setting up the mortgage and the investor is entitled to all the interest payment.
Due to regulations, Mortgage Backed Securities can only be issued to the market by Government Sponsored Enterprises (GSE) such as Fannie Mae. These corporations ensure that the securities are appropriately bundled and the risk level is appropriately classified, the latter being one of the prime factors behind the GFC due to negligence. Those who invest in Mortgage Backed Securities issued by Fannie Mae receive timely interest and principal payments. As these payments are both timely and guaranteed, Fannie Mae will charge a fee.
Fund of Funds
What is a Fund of Funds?
Well, you’ve all heard of the benefits of diversification thanks to Mr Markowitz. For the financially illiterate, investing is undoubtedly going to be a very difficult task. That’s why fund managers exist – to take your money and do all that financial nonsense for a handsome fee.
But how can you tell which fund manager will perform the best?
Well, if you don’t want to put all your faith in a single person, why not invest in a bunch of them. That is exactly what a fund of funds is for. Fund of Funds allows for broader diversification by holding a portfolio that contains different underlying portfolios of other funds. These holdings replace any investing directly in bonds, stocks, and other types of securities. Instead, these fund of funds will invest in other mutual funds or hedge funds.
FOF’s can be “fettered” meaning only investments are made only on funds run by the company itself, or “unfettered” meaning investments can be made in funds across the entire market.
Advantages and Disadvantages
Fund of funds allow small investors access to high minimum funds, such as hedge funds which typically have minimum investments of 6 figures and require investors to have a minimum net worth. Small investors, who do not typically have access to such investments are therefore able to get better exposure to assets and further diversify their portfolio. The diversification within a fund of funds also has a reduced level of risk and has less exposure to market volatility, benefiting the investor.
Furthermore, the FOF managers are typically experienced fund managers who typically stem from a good background and have good credentials in the security industry. Theoretically, the extensive research on the initial underlying investments by the managers add an additional layer of protection.
At the same time, selecting market beating fund managers who are able to generate good returns is costly. The company or companies (depending on whether your funds are fettered or unfettered) charge high annual management and incentive feeds, and often pass through the feeds from the underlying funds. These fee burdens make it difficult for the FOF to generate good returns for the investor.
Additionally whilst the diversification in the portfolios also produce lower, more average returns. It is also difficult to monitor the overall holdings of a fund of funds due to limited knowledge of the underlying investments of selected funds.
Perhaps the most infamous Fund of funds was the first one ever, created by Bernie Cornfeld in 1962.
Cornfeld began his career in the 50’s as a mutual fund salesman. In 1956, he moved to Paris to sell popular American mutual funds to Americans living abroad. This was the beginning of Investors Overseas Services (IOS), a company that would end up short-lived. Cornfeld was well-known for his catchphrase “Do you sincerely want to be rich?”.
In the following decade, he raised 2.5 billion overseas dollars for the company’s fund which was coined “people’s capitalism” by the founder Cornfeld. Cornfeld distributed the money to managers like Fred Alger to run funds owned by the company. The company’s operations were often at the edge of the law which attracted the attention of the SEC. The SEC filed a complaint in 1965 accusing the IOS of violating American Securities Law. This complaint was settled in 1967 with the IOS agreeing to sell all of its American operations and buying no more than 3% of any American mutual fund. Share value continued to decrease drastically as investors continued to cash out. The company was finally crippled when financier Robert Vesco looted 500 million of IOS’s funds to cover his own investments.
Following the collapse of IOS, Cornfeld was jailed for defrauding his employees by selling them stock of the crippling company. Despite serving almost a year in prison and being unable to salvage his financial empire, Cornfeld lived out the rest of his days lavishly. So did Vesco, who managed to flee to Cuba where he fought off many extradition requests using his political influence in the region.
What is a Collectible?
As the name would suggest, collectibles are items that are collected and resold for a much higher value than originally bought at. The price hike for future resells are due to popularity and/or rarity of the item (i.e. it is based on the perceived value). An item is classified as a collectible if it is less than 100 years old, and an antique otherwise. These items can be anything, ranging from cars, vinyl records, furniture, clothing, wine and well, a collectible may even be something unassuming like a toy. Anyone can invest in collectibles, but it certainly helps to have passion and great knowledge about the items you invest in as it will help you make more informed decisions.
Generally, collectibles are only items that are no longer produced as the resell market would not sustainable otherwise. Say, if the manufacturer sees their products being successfully resold at absurdly high prices, they could simply increase the supply to meet the demands. On the other hand, companies have also realised that they themselves can hike up the initial cost by manufacturing the rarity aspect, and label the product as a collectible – the marketing strategy by Supreme perfectly illustrates such practices. Overall, collectibles are not considered to be a great investment option as you may be led to believe, as the condition of the item is also of great importance.
Advantages and Disadvantages
Collectibles are an interesting alternative investment asset class that enables investors to pursue personal interests, reaping benefits beyond the collections monetary value. Collectibles can often gain capital value above the average rate of inflation and are a great way to enjoy your investment while its value appreciates.
However, collectibles are a difficult investment with many associated risks. There are many costs associated with handling a collectible which includes, but is not limited to, handling, storage, marketing and insurance of the collectible item. Little information or detail about the relevant market or buyers may further exacerbate the challenges in reselling a collectible.
Maintenance is also important to the collectibles value; collectibles in good condition will see an increase in value, but if their condition have deteriorated over time, the collectibles will likely not have much value remaining at all. Also, note that while time likely appreciates the value of the collectible, there is no guarantee that the value will increase over time. So, while they may be an interesting addition to your investment portfolio, make sure to consider the drawbacks before investing in them.
The Swatch, which is an abbreviation for the Swiss watch, was introduced in 1983 in a high-stakes effort by the lagging Swiss watch industry to combat the quartz crisis and win back market share from Japanese competitors such as Seiko, Casio and Citizen. While the Swatch group has become one of the largest watch manufacturers in the world (highest market share at 18.3% in 2016) by acquiring other brands such as Omega, Longines and Tissot, its origins are well known for the global marketing phenomenon known as the “Swatch fever”.
Rather than a timekeeping device, Swatches were marketed as a trendy fashion statement, presented as a work of art that was released in fresh collections seasonally. Unusual designs, the use of famous artists to design special edition watches, exhibitions and auctions reframed Swatches as an art form which also contributed to their collectible status. In addition, imperfections such as misprints, faded dials or missing calendar dates were deliberately added to further create financial value for its collectors.
Furthermore, Swatch manufactured highly differentiated products where each design typically stayed on the market for a limited time only. Limited edition watches included artist-designed watches, food-themed (shaped as red chilli peppers, cucumbers, bacon and eggs), environmental-themed (1992 UN Earth Summit) and even Wall Street-themed watches that often created seasonal hype for collectors. Indeed, a Swatch Collectors Club was introduced to promote trading and auctioning of watches whilst encouraging preservation to prevent price depreciation due to usage or opened packaging. Auctions in which $80 dollar plastic Swatches were sold for up to $20,500 in 1990 were advertised on the Wall Street Journal as good investments. Although these initial auctions were a setup, real auctions (with similar results) followed, validating a real market for Swatches.
Cryptocurrency and Blockchain Technology
What is cryptocurrency?
Cryptocurrency can be thought of as a digital virtual currency secured by encryption techniques that make it impossible to duplicate or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology – a distributed, decentralized, public ledger.
What is blockchain technology?
Blockchain technology is essentially a collection of digital information (“blocks”) stored linearly and chronologically in a public database (“chain”). Blocks store information about the nature and detail of a transaction as well as participants in a transaction. Each block also stores a unique code called a “hash” once the transaction is verified by a network of computers (the transaction is said to be “hashed”) and this unique ID allows it to be distinguished from other blocks that form the blockchain. The blockchain is a public and continually updating (identical) database distributed across each computer in the blockchain network. As such information transparency is maintained without compromising data security as a hacker would need to manipulate every copy of the blockchain on the network to completely alter transaction data. Due to their transparency, decentralization and improved accuracy, blockchain has the potential to be used in a range of applications including cryptocurrency, banking and health care provider data.
Cryptocurrencies have gained popularity due to the removal of a third-party needed to verify transactions. Funds are transferred directly between two parties and verification is snow using computerised techniques such as Proof of Work or Proof of Stake. Removing the involvement of a third party also allows users to avoid high fees charged by financial institutions for wire transfers. Cryptocurrencies are also outside the influence of central banks and governments and tend to be inflation resistant. The semi-anonymous nature of cryptocurrencies does however make them attractive for illegal activities such as money laundering and tax evasion. Furthermore, cryptocurrencies have been criticised by some economists to be highly speculative experiencing high exchange rate volatility.
The Wide World of Cryptocurrency
Surprisingly, cryptocurrency doesn’t only come in the form of Bitcoin. There are quite a number of alternatives, but none have even come close to having recognition of the likes of Bitcoin. Bitcoin is considered by many as the original cryptocurrency since its inception in 2008, and as of today, there are over 18.5 million bitcoins in circulation. Like in any system that has been proven to function well, many alternatives have emerged. New blockchains such as Ethereum offer the same functionalities as Bitcoin but with different protocols, which will change things like transaction time. These blockchains offer their own cryptocurrency which is categorised into two forms: alternative cryptocurrency coins (altcoins) or tokens.
Altcoins refer to any coin that isn’t Bitcoin, like Dogecoin, Peercoin or Litecoin. Think of this as if Bitcoin were gold, the alternatives would be any different types of metal. However, as these alternatives aren’t as well known or accepted, they may experience low liquidity and extremely volatile price changes.
Tokens are cryptocurrencies that don’t have their own blockchain. Instead, they live off another blockchain. In practice, there aren’t any clear differences between tokens and coins. They both have some sort of value. The general consensus is that coins are equivalent to cash whilst tokens are everything else.
The biggest corporate endorsement of cryptocurrency has come in the form of Libra, proposed by Facebook Inc. It is still currently in the beta stage and is projected to be released in 2020. Unlike Bitcoin, Libra will be centralised, pegged to fiat currencies, and governed by demand and supply, making it a more stable asset.
Bitcoin was invented in 2008 as the first blockchain-based cryptocurrency and dominates a large 79% of the cryptocurrency market. Launched in 2009, the price of one bitcoin remained a few dollars for years but has developed a very volatile trading history. In fact, in the fall of 2017, the price of bitcoin began to rise and peaked in December at a staggering $20,000 USD. Many deemed it a bubble and indeed, shortly after in 2018, there was a large sell-off of cryptocurrencies. Known as the Bitcoin crash and Great crypto cash, the price of Bitcoin fell by 65 percent from January to February and by September, the MVIS Crypto Compare Digital Assets 10 index had lost 80 percent of its value. Percentage-wise, this bubble burst was larger than that of the Dotcom bubble in 2002. There were a few catalysts that led to the burst of the Bitcoin and cryptocurrency bubble in 2018.
Many governments were starting to place stricter regulations on cryptocurrencies and some countries were looking to ban ICOs (initial coin offering is an unregulated way of funding using cryptocurrency), which defeats the pseudo-anonymous nature of Bitcoin. There was also a suspicion that much of the rise in Bitcoin’s prices was due to coordinated price manipulation revolving between Bitfinex and Tether. Bitfinex was (and still is) a major cryptocurrency exchange and was a go-to platform for traders which also had control over Tether, a cryptocurrency backed by equivalent fiat currencies. It was suspected that Tether was being used to stabilise and manipulate Bitcoin by pushing the price of Bitcoin up when it fell below certain thresholds. There were also concerns that Tether did not hold enough US dollars to back all its digital coins in circulation. In general, there was just a lot of questionable, potentially illegal activity in cryptocurrencies.
As a final note, cryptocurrency investments have continually been characterised as a speculative bubble, with big investors like Warren Buffet constantly slating cryptocurrencies. As an unproductive asset whose value solely relies on its trades, it is extremely volatile, unsuitable for long term investing and too unpredictable to short. In short, don’t invest in cryptocurrency unless you know what you are doing.
What is a derivative?
A derivative is a synthetic security that derives its price from a physical market commodity or underlying asset; mainly used to manage risk exposures. The value of the underlying asset controls the derivative value. As such, derivatives do not have a fixed value over time and market conditions play an important role in deciding the value of a derivative.
Features and uses of Derivatives
Features of derivatives:
Derivatives have a maturity date after which they terminate automatically, for example an option cannot be exercised after its maturity date.
Derivatives, by themselves, have no independent value. Their value is derived out of the underlying instruments
All the transactions in the derivative take place at a future specified date.
Derivatives can be used as leverage instruments; big volumes can be traded with a small initial outlay of funds (small percentage of the entire contract value)
There are no limits on the number of derivative contracts that can be transacted as there are no physical assets for transaction
Derivatives improve the liquidity of the underlying instrument by performing the function of price discovery. The derivative market is therefore liquid.
Derivatives are used effectively as risk management tools because they shift the risk from the buyer of the derivative product to the seller.
Other uses include:
Hedging: Hedgers are risk-averse traders that seek an opposite position in the derivatives market to protect themselves against market risk and price fluctuations
Speculating: Speculators are risk-loving traders who use derivatives to make quick money by taking advantage of high market volatility
Arbitrage: Arbitrageurs carry out riskless trades when the same securities are being quoted at different prices in two markets. The simultaneous purchase of securities done in one market is matched by a corresponding sale in another market, allowing arbitrageurs to make profit.
A futures derivative is a contract that obligates the holder of the contract to buy the specified asset at a predetermined price at the expiration of the contract. The quality and quantity of the asset are standardised. Because this contract is exchange-traded, there is very high liquidity where delivery of the asset rarely occurs. Instead, traders generally ‘close out’ their position by taking the opposite position on the same contract. For example, a trader with a long position on a gold future will want to take a short position to essentially neutralise their position and cash out.
A forwards derivative is a customised contract between two parties to buy or sell an asset at a predetermined price at some future date. The contract is traded over-the-counter and is not standardised. There will be deliverance of the asset or a cash settlement at expiration of the contract.
An option acts in a very similar way to a futures contract, except the holder of the contract can choose whether or not to exercise it. However, the party with the short position is obligated to deliver if the option exercised. An option can be either a call option, which gives the contract holder the right to buy the asset at the specified price, or a put option, which gives the contract holder the right to sell the asset at the specified price. All options contracts are standardised and can further categorised based on the exercise period (on expiration, up to and including expiration).
A swap is a derivative contract where two parties exchange the cash flows or liabilities of two different financial instruments. Usually, an unknown variable affecting the cash flows, such as interest rates, foreign exchange rates or future equity price is traded for a known variable such as fixed interest rates. Swaps are over-the-counter traded contracts and are not standardised.
The fundamental issues of the Global Financial crisis (2007-8) lay in the housing market, specifically the subprime mortgage market and the proliferation of mortgage-backed securities. Buyers (typically investment banks) bought ownership of mortgages and bundled them into mortgage-backed securities (MBS), which would later be divided into a bond-like security before being sold to institutional investors. These financial instruments were extremely flexible with various tranches offering varying levels of risk and reward to its investors.
It gets more complicated (and dangerous) when credit default swaps are involved. The financial derivative essentially serves as insurance for higher-risk loans, enabling reimbursements for borrowers in the case of defaults in exchange for an ongoing premium. It doesn’t eliminate the risks, but shifts such risks from the buyer to the CDS seller. Michael Burry, a hedge fund manager, found these highly risky, unstable mortgages and bet against them by going to banks and buying CDSs on mortgages. Many of the investment banks accepted, thinking that financial crisis was unlikely and thought that M.B’s monthly premium of millions was easy money.
The banks were wrong, and M.B’s position grew as the value of MBSs declined due to increasing rates of defaults, while American mortgage holders, investment banks and the world economy lost big time. The financial chaos that ensued from rising default rates and the complex derivative securities also saw the downfall (and bankruptcy) of Lehman Brothers, previously the 4th largest investment bank in America. M.B’s renowned bet against the housing markets highlight the risks & reward associated with speculative derivative investments, with his CDS position arguably cemented as the greatest single investment (although Bill Ackman is knocking at door).
Special Purpose Acquisition Companies (SPACs)
What are SPACs?
A Special Purpose Acquisition Company (SPAC), also commonly known as blank check companies, is a company with no commercial operations that is formed strictly to raise money through an Initial Public Offering (IPO) for the purpose of buying another company. SPACs have seen much growth in recent years, with more than 50 SPACs in the US alone and $21.5 billion worth of IPO funds raised in the first half of 2020. SPACs have grown in popularity over the past several years as the transparency on the net asset value (NAV) and redemption rights make SPACs an attractive deal for investors with significant optionality.
SPAC IPO Transaction Summary by Year
SPACs are sponsored by an asset management company and are usually formed in conjunction with a business executive or reputable manager. The good reputation and extensive experience of the professional executive are essential in the process of identifying a profitable company to acquire.
The SPAC capital raising process differs from traditional IPOs with the cash raised in the IPO placed in a trust account which is not released until the SPAC completes a business combination (or upon a specified date if the SPAC fails to complete a business combination by that date). During this IPO process, SPACs will typically offer a share of common stock and a warrant to purchase additional common stock at a later date. The rationale behind the warrant is simply compensation for the tied-up capital that is held in the trust account until a suitable deal is found for the SPAC. In other words, SPAC’s unique business structure allows investors to contribute money towards a fund which typically collects interest for several years until a deal is found and used to acquire one or more businesses, identified after the IPO.
In July 2020, Bill Ackman launched the largest SPAC IPO in the NYSE. The SPAC, known as Pershing Square Tontine Holdings successfully completed an offering of 200 million shares at $20 per share, raising $4 billion in proceeds. In addition, Ackman has personally invested in the SPAC, pledging to invest capital of up to $3 billion with his hedge fund Pershing Square Capital Management L.P. Each share consists of: a unit of common stock, 1/9th of a redeemable warrant exercisable at $23 and contingent rights to acquire 2/9ths of a warrant exercisable at $23.00 per share provided that investors do not redeem their units prior to the business combination.
There are several unique features of this SPAC, the most dramatic being the “tontine” nature of the warrant structure. The contingent warrants are not detachable and are forfeited if the investor redeems their share. The forgone warrants are distributed pro rata to the shareholders who remain. This unique design encourages a long term investment in the SPAC, leading to greater certainty of closure for the acquisition. Another deviation from traditional SPAC’s is the lack of sponsor shares, which means the sponsor’s returns are entirely reliant on the warrants it purchased. Their compensation from sourcing, negotiating and closing an acquisition will be a 6.21% promotion only after the investors have already received a 20% return, which really emphasises their focus on investors.
It is without a doubt that Bill Ackman’s reputation is shrouded with controversy. It remains to be seen if his new SPAC IPO will be added to the list.