2. Inflation-Linked Investment Products
Inflated Optimism February 2004 page 96.
The largest jump in the consumer price index in 25 years pummeled the markets in September, but those investors who had taken advantage of the economy’s decade-plus hiatus from inflation to hedge their portfolios against just such a development could breathe a bit easier than most. With the threat of inflation—and worrying comments from members of the Federal Reserve about the need to raise short-term rates well north of 5 percent—many traditional investments may be set to underperform on a real basis, while inflation-linked products could shine.

Even so, it has been a mixed year for the main inflation-hedged investment product, the government’s Treasury Inflation Protected Securities (TIPS) bonds. TIPS have a payoff that rises in line with the Consumer Price Index for Urban Areas (CPI-U), the most common measure of inflation. TIPS also perform well in a rising interest rate environment. However, they underperform other government securities when inflation falls or is stagnant.

Some funds that invest in TIPs are currently showing negative returns. The three-month cumulative rate of return on financial services company TIAA-CREF’s Inflation-Linked Bond fund, for example, was –0.04 percent at the end of September. However, this could be the result of surprisingly low inflation figures in May and June.

Despite this, bond investors have signaled their higher inflation expectations through the TIPS market. The spread between the yield on 10-year Treasuries and 10-year TIPS, which reflects the market’s expectation for the average rate of inflation over the period, rose to 2.48 percentage points in October, up from 2.3 percentage points three months earlier. If inflation turns out to be higher than this figure, called the breakeven rate, then TIPS will prove to have been relatively cheap; if it falls below this average, then TIPS are currently overpriced.

THEN AND NOW The lack of serious inflationary pressures in the U.S. in recent years created scant demand for inflation-linked products. Innovation was confined to Europe and to the wholesale derivatives markets, where inflation swaps, economic derivatives and CPI futures gained ground. But since September’s spike in CPI, attention has once again turned to this product line, with interest in TIPS and other retail products growing.

TIPS remain one of the few direct ways to gain a direct hedge for inflation, short of participating in the wholesale inflation derivatives markets (using inflation swaps, economic derivatives or CPI futures, for example). Other popular inflation-hedging strategies, such as direct investments in commodities and investments in commodity futures contracts, only provide a second-order exposure, and expose investors to commodity market risks and, in the case of companies, business risks. Inflation-linked structured products remain very popular in Europe, where the memory of interwar and postwar hyperinflation remains vivid, but they remain fairly rare in the U.S.

3. Merger Arbitrage Hedge Funds
Unlocking the M&A Bounty June 2004, page 90.
Despite the barrage of mergers and acquisitions in 2005, merger arbitrage hedge funds performed much as they have in the past. They returned 3.99 percent from the beginning of the year to the end of August, according to the Barclay/Global HedgeSource merger arbitrage index.

The merger arb investing style has failed to match the upward trajectory of activity in the M&A market, but its proponents say it remains profitable. Merger arb seeks to profit from acquisitions by betting on their chance of success. A fund seeking to bet that a deal will succeed, for example, would accumulate the stock of the company being bought and short the stock of the acquirer, under the assumption that the two will converge as the deal nears consummation.

THEN AND NOW Returns from merger arbitrage (also called risk arbitrage) did not follow M&A volumes upward in 2004 and 2005, as many had hoped. Some blame the preponderance of private equity firms in these transactions; merger arb backers say that no, the strategy remains viable even where private firms are the buyers, and its performance is in line with its modest return, low-risk goals.

Some observers believe merger arb strategies are hamstrung somewhat by the fact that private equity firms are now driving the lion’s share of M&A activity. Since these funds have no listed shares, arb funds cannot short their stock.

But the arb funds themselves dismiss this. “The explosion in cash held by the private equity firms is one factor leading to the high level of deal activity,” agrees John Orrico, portfolio manager with the Arbitrage Fund, based in Rye, N.Y. However, he notes, “About one-half of all transactions announced are cash only, but since we receive cash as consideration, there is no need to sell short any shares of the acquirer.”

Orrico adds that private equity firms do bring an additional risk to these deals because of their use of leverage. “We examine the financing needs of each deal and pay close attention to the fixed-income markets to gauge the ability of these private buyers to raise the necessary funds in order to complete the transaction,” he says.

The merger arbitrage style remains a low-volatility, moderate-return strategy. In 2004, for example, arbitrageurs had hoped for juicy payouts, given the number of mega-deals beginning to appear, such as JP Morgan Chase’s $60 billion acquisition of Bank One. In February of that year the value of transactions announced globally rose to $238.6 billion, the highest level since October 2000. Yet the Barclay/Global HedgeSource merger arbitrage index registered a return of just 5.2 percent. Net of inflation, that is a very modest return, given hedge fund liquidity constraints and risk. But proponents insist returns, never spectacular, should be consistent.

“Two years ago, on a low-risk deal, the annualized rate of return would have been 4 to 6 percent. Now it’s 8 to 10 percent,” Orrico says. He adds that because merger arbitrage is a nonleveraged strategy, rising short-term interest rates have improved prospects relative to other hedge fund styles, which rely on leverage and are sensitive to interest rates. “We’re finally at a point where, not only is the deal flow rate good, but the risk-free rate of return is helping us. So I’m cautiously optimistic, as long as we don’t see the economy stumble.”

4. Bond Ladders
Rung Out July 2004, page 88.
Bond ladders, the fixed-income world’s answer to passive dollar-cost averaging, were not as successful as dynamic trading strategies over the past two years at wringing the most real return out of the flailing and flattening yield curve. “It’s an interesting passive strategy,” notes Zane Brown, partner and director of fixed income at Lord Abbett, a Jersey City, N.J., investment company. “But active portfolio management is still likely to offer more value, and I think the movement of the yield curve over the past 12 months reinforces that.”

THEN AND NOW  Bond ladders have performed in line with expectations, despite the flattening of the yield curve over the past 18 months, because losses at the short end have been offset by gains in longer-tenor bonds. However, fixed-income portfolio managers say they have beaten this passive strategy by taking aggressive advantage of opportunities presented by the flattening.

As an example, he notes, “In 2004 we emphasized buying securities beyond the five-year area. Now we can go back and purchase the lower maturities at a much lower price than was available.”

The bond ladder strategy, by contrast, is not designed to identify market opportunities. It simply involves putting a like amount of capital into each of a series of bonds with staggered maturities, using the capital from bonds that mature to reinvest in new instruments. It is designed so that periodically—typically either annually or biannually—the investor always has a segment of the portfolio maturing. If you were to design a 10-year laddered program, for example, you would divide the amount to be invested into 10 equal portions and buy bonds that mature in each of the 10 years. As one set of bonds matures, they are replaced automatically with another set of 10-year bonds, rather like climbing a maturity ladder.

As Worth went to press, increases in the Federal Reserve’s short-term lending rate has made these securities cheaper to buy. However, these pressures have not pushed up rates at or beyond the 10-year section of the curve. A year ago, the 10-year Treasury was trading at 4.24 percent, but its yield has since fallen to 4.14 percent, while the three-month Treasury rate has gone up by around 1.85 percentage points.

This yield curve flattening has been mostly a wash in terms of the performance of bond ladders. In aggregate, the prices of the short-term securities in the ladder portfolio have fallen, but the long-term securities have gone up a bit in value. “So on a net basis, I don’t think [the flattening] should have affected the ladder itself,” Brown notes.

5. Timber Investments
Wooden Performance August 2004, page 86.
Timber has been the darling of private client investment strategists for the last several years, but there are now concerns over its reliance on demand from the increasingly tepid housing sector. Despite this, in 2004 and 2005 timber investments continued to perform well and exhibited very low volatility.

“Fundamentals appear to be relatively well balanced, and absent any shock to the system, we expect that to continue,” notes Kurt Akers, director of research for Global Forest Partners, a timber investment management organization (TIMO) that raised a $300 million fund in early 2004. “While housing might decline in a cyclical manner, we believe that demographics are positive over the long term,” he adds. “Also, the impact of Hurricane Katrina could be positive for the sector, given the amount of rebuilding that will be necessary.”

The timber fund of Hancock Timber Resource Group, a Boston-based asset manager, returned an average of 13.9 percent per year, after fees, between its inception in 1985 and at the start of 2005. Compare this with the 9.3 percent returned by the S&P 500 over the same period and the 8.8 percent return on long-term corporate bonds, in light of the fact that the volatility of timber is quite a bit lower than the other two asset classes, and it is easy to see why investors enjoy this wooden performance. The emergence of TIMOs—which offer investment funds that purchase, maintain and manage timberland for institutions, individuals and family offices—has facilitated the expansion of this sector.

THEN AND NOW Timber investments have performed well over the past several years, with concerns about the negative effects of a housing market downturn now largely offset by the belief that post-Katrina rebuilding needs will support demand for lumber. But the volume of investment capital now chasing timber may dampen the returns enjoyed by new investors.

Probably the most significant event affecting the industry at the moment is the disaggregation of forests from other assets held by integrated paper companies, Akers says. “Firms such as International Paper, Carter Holt Harvey, Louisiana Pacific, Bowater and MeadWestvaco have embarked on significant land sales programs in an effort to focus their operations, win back the hearts of Wall Street and take advantage of the large amounts of capital that is now interested in timber as an asset class,” he says.

This is good news for investors, as it means there is a supply of wood out there that TIMOs can absorb. But Akers gives one warning: “There is a lot of capital from institutional investors that has been allocated to the asset class,” he says, “so many of these assets seem to be fully priced. Given the rather benign global investment climate, interest is not expected to wane anytime soon, so investors entering the asset class now can expect lower future returns, all else being equal, than those who have been in the asset class for some time.”

6. Premium Finance Life Insurance
Financing the Future September 2004, page 98.
The economics underpinning this strategy, which involves borrowing to finance the premium on a life insurance policy, have been eroded by the Federal Reserve’s series of rate hikes since June 2004. When short-term interest rates bottomed out in the wake of the dot-com bubble’s bursting, borrowing the money needed to pay the premium on a life insurance policy seemed an especially clever way to conserve cash while establishing a legacy that would be immune to estate taxes.

Although the details of these policies varied depending on who sold them, the client borrowed to fund the premium in a whole life policy. The deal was predicated on the assumption that the value of the whole life policy’s investments would outstrip the cost of the loan; the principal would be paid using the proceeds after the buyer died.

THEN AND NOW The advantages of these deals, predicated on the return of a whole life policy’s investments outpacing the costs of the debt used to finance its premia, have become less compelling as short-term interest rates have risen. However, they are still a useful way to avoid gift taxes.

The concept gained ground due to its appeal to those with wealth tied up in illiquid or volatile assets, such as family businesses. For these individuals, borrowing to finance an insurance premium frees up cash that can be invested in other business ventures.

The transactions are typically priced at a spread of 1.25 to 2.5 percent over Libor. The difference between the overall cost and the return on the universal life contract—the most common policy utilized—is the leverage component. “The higher Libor has gone in the past year, the more pressure there is on the leverage,” notes Ken Godfrey, life insurance product manager at Wachovia Insurance Services in Charlotte, N.C.

However, the rising rates have not killed this strategy off: One of its main advantages, the ability to avoid the gift tax on the amount that would otherwise be paid into a trust to fund an insurance policy’s premiums, remains attractive.

7. Oil & Gas Private Equity
Crude Investments November 2004, page 94.
With crude oil prices soaring because of rising demand and geopolitical instability, some niche energy private equity players have made a killing. “We had a company that we put less than $50 million of equity into 18 months ago, bought $350 million worth of assets for it, and just sold it for $800 million,” says Wil VanLoh, cofounder of Quantum Energy Partners, a Houston private equity company.

But returns like that only come with taking a massive amount of risk. Private equity firms that focus on energy  place their money with small exploration and production drilling ventures, or they may invest in oil-related service and technology businesses or pipeline companies. The idea is that with their leaner overheads, they can make money from reserves too small for the big players to bother with. Quantum, Dallas-based Gas Partners and Westport, Conn.-based Lime Rock Partners are some of the private equity firms active in the area.

THEN AND NOW While private equity deals in the energy sector continue to be very lucrative for those firms with the requisite expertise, the recent rush of capital into the sector has pushed acquisition multiples up to the point where much of the smart money is hanging back. If the price of oil falls much below its autumn 2005 highs, current multiples could prove far too rich.

Hurricane Katrina did not severely dent the energy private equity market, because most of these investments tend to be onshore. VanLoh notes that the increase in demand for oil-related exposures is working against those already in the market. “Everybody thinks they’ve got to be in energy now,” he says, “and so they’re bidding up the prices on these [private equity purchase] deals. For the established, private equity, energy-focused funds, we’re looking at the market and saying that these prices aren’t justified.”

Ironically then, despite high energy price levels, VanLoh says his company has been reluctant to make new investments over the past year. “We have literally seen case after case of deals where the valuation in our minds is anywhere from 25 to 60 percent higher than where we would price it,” he says. Anyone wishing to step into the market now needs a strong constitution. “You almost have to argue that oil is going to be somewhere between $70 and $100 a barrel for the foreseeable future just for these deals to work out OK,” VanLoh says. “But we believe oil is probably going to average somewhere between $40 and $60 in that time.”

8. Business Development Corporations
Private Equity’s Wide Embrace December 2004, page 96.
Business development corporations—essentially companies that are set up by private equity firms to tap the public stock markets to raise long-term investment capital from a broader base of investors—were all the rage in 2004, when more than a dozen leading investment firms filed to publicly offer stock. But the products fizzled when investors stayed away in droves, turned off by high fees and the negative arbitrage (i.e., they raise the money before investing it productively, as opposed to how traditional partnerships only call capital when it is needed) inherent in the structures. “They have been having some tough times,” points out Thomas Herzfeld, a Miami-based investment advisor specializing in closed-end funds.

THEN AND NOW Business development corporations looked like an interesting way for investors to obtain liquid exposure to leading private equity firms after Apollo Advisors successfully raised $930 million in 2004. But investors soon realized the deals’ high fees and negative arbitrage made them a losing proposition. Only a few ever limped to market.

Elizabeth Fries, a partner in the fund formation group at Goodwin Procter, an investment company in Boston, notes that interest in business development corporations (BDCs) has fallen dramatically, and no new issues are expected to come to market soon. “I don’t think this will be the big opportunity for private equity firms to go public that people thought it would be,” she says.

The prospect of gaining a private equity-type exposure through a publicly traded, liquid investment seemed enticing for wealthy investors back in 2004. Fries notes that private equity firms’ interest in BDCs grew after a leading partnerships, Apollo Advisors, raised $930 million in April 2004. “Private equity firms then rushed to market to try to capitalize on the opportunity they perceived to be there,” she says. But, she adds, “Investment banks decided they didn’t want to underwrite the products anymore because it was a retail product with such a high fee structure.” BDCs charge an upfront load fee (in the case of the Apollo deal this was 6.25 percent), as well as annual management fees of 2 percent. In retail terms, this is very high. Another aspect that puts retail investors off is the fact that once listed, the products trade at a discount, given the fact that private equity ventures draw down capital as and when needed before returns, if any, are made.

9. The Secondary Private Equity Market
The Backdoor Investor January 2005, page 86.
Interest in the secondary market for private equity, which lets investors sell unwanted assets and buyers pick up private equity exposures at a discount, continues to increase on the back of unabated demand for alternative asset allocations, says Lawrence Penn, managing director at the Camelot Group International, a New York–based advisory firm that manages and facilitates secondary market transactions. “Our deal flow has never been at a higher level,” he maintains. “I’ve just talked to around 13 different investors in Dubai, and they are all interested in this.”

Firms that specialize in these transactions work with both buyers and sellers to tailor a range of transaction types, from simple buy-sell agreements to more sophisticated collateralized loans and swaps.

Penn says Camelot believes a number of factors are driving the secondary market’s continued growth. For example, limited partners in private equity funds are seeing a slowdown in distributions, forcing them to source liquidity in the secondary market. Camelot says the volume of deals offered by wealthy individuals and families looking for liquidity has risen sharply.

THEN AND NOW The secondary market for private equity interests blossomed in the wake of the sector’s crash in 2001–2002, as families struggling to make capital calls or those who simply needed more liquidity used it to bail out. But despite the private equity boomlet of 2004–2005, the secondary market continues to grow, as investors take advantage of it to restructure and rebalance their portfolios.

For now the future of the secondary private equity market looks rosy, and Penn sees no limit to its eventual growth. “There is a constant need for people to restructure their investments, so the market continues to grow on a global basis,” he says.

10. Economic Derivatives
Macro Machinations August 2005, page 92.
The market for economic derivatives, which let investors hedge or take market risk directly associated with the release of key economic indicators, such as the nonfarm payroll number or GDP, is developing quickly. Last year, the main markets for the products, which are run by Goldman Sachs and Deutsche Bank in affiliation with broker Icap, were limited to professional traders. However, at the end of June, Goldman announced a partnership agreement with the Chicago Mercantile Exchange (CME) to broaden access to economic derivatives beginning this year.

The CME agreed to provide electronic order routing to Goldman’s auction market starting in the first quarter. “This new partnership is expected to significantly broaden access to the economic derivatives market and increase the level of investor participation,” CME officials said in a press release following the agreement.

THEN AND NOW Only six months ago, the most powerful tools for hedging against adverse changes in macroeconomic variables like unemployment or GDP growth were the exclusive province of the professional investor community. Since then, their purveyors have worked to broaden access to these instruments.

Economic derivatives could be used by entrepreneurs as a hedging tool against a loss of business due to an economic downturn, or by investors as a hedge against a spike in inflation. Bets can currently be taken on GDP, U.S nonfarm payrolls, the Institute of Supply Management’s PMI index, weekly initial jobless claims, retail sales, European inflation, U.S. inflation and the international trade balance.

Meanwhile, an economic hedging market of a different stripe has now emerged. HedgeStreet, a San Mateo, Calif.-based company, is offering economic hedging tools online to retail investors. HedgeStreet sells special contracts called hedgelets, which allow investors to speculate on whether or not a particular economic statistic will come in at a given level. Last year the company launched contracts on real estate price movements and the cost of gasoline. HedgeStreet says those contracts are rapidly gaining popularity. On the back of oil price volatility, energy contracts represented 42 percent of the company’s trading volume in July.

John Ferry is a senior correspondent for Worth.