FNEX - Alternatives & Private Investments on the Rise...

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Information about FNEX - Alternatives & Private Investments on the Rise...
Economy & Finance

Published on September 30, 2014

Author: DealMarket_com

Source: slideshare.net

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Does your portfolio have adequate diversification? The five-year bull market in equities has been breathtaking, with the Dow Jones Industrial Average gaining more than 150% since the Great Recession. So, it’s easy to forget that in the last 15 years investors in stocks have suffered two major
setbacks: a decline of 38% after the Internet Bubble collapsed in 2001, and an even bigger crash of 54% following the start of the Financial Crisis in 2008. With
the DJIA again at record highs, is the time nearing for another major correction?

A Whitepaper from FNEX Alternatives & Private Investments on the Rise... 1.7 trillion reasons to consider alternatives. One place to source them.

30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 1 A Whitepaper from FNEX Does your portfolio have adequate diversification? The five-year bull market in equities has been breathtaking, with the Dow Jones Industrial Average gaining more than 150% since the Great Recession. So, it’s easy to forget that in the last 15 years investors in stocks have suffered two major setbacks: a decline of 38% after the Internet Bubble collapsed in 2001, and an even bigger crash of 54% following the start of the Financial Crisis in 2008. With the DJIA again at record highs, is the time nearing for another major correction? No one can predict the future with any accuracy, of course, but history teaches us that since World War II, less than one third of bull markets have lasted longer than five years. Another concern is the fixed income markets, where the government and companies sell bonds. The Federal Reserve has engineered a 30-year bond bull market, with the aim more recently of stimulating the economy and avoiding deflation. With short-term interest rates now near zero and the outlook for inflation uncertain, at current levels the fixed income market offers little potential reward and significant risk, according to prominent asset managers. Why should you be concerned about protecting your portfolio? In the future, retirements will be much longer than in the past and will have to be financed primarily from savings. According to the Social Security Administration, a man reaching age 65 today can expect to live, on average, until 84. A woman will live approximately two years more. Could your portfolio weather another substantial downturn? With so much uncertainty, many institutional advisers and high-net-worth private investors have

A Whitepaper from FNEX 30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 2 been adding more diversity and protection to their portfolios with alternative investments. While the name alternatives sometimes conjure up images of exotic, risky investments, in fact the name simply means an alternative to stocks and bonds. Most alternatives are designed to be less, not more risky than traditional assets. Such investments can take many forms, but some of the most common are hedge funds, private equity funds, real estate, managed futures and private company stock. In the past, traditional investment portfolios often used a mixture of 60% stocks and 40% bonds because it had been observed that these two asset classes often move in opposite directions. When stock prices were falling, for example, bonds were usually headed up. So, owning bonds would protect your portfolio against falling stock prices and vice versa. In the language of investment professionals, stocks and bonds were uncorrelated. But a strange thing happened during the 2008 Financial Crisis. Because of the globalization of markets, stocks and bonds began to fall in lockstep. Ever since then, these two asset classes have become more and more correlated — both bonds and stocks rose in the first half of 2014, for example — so the old mix of 60/40 no longer offers the same portfolio protection it once did. Even worse, when economists studied those 60/40 portfolios and looked at the underlying risks involved, it turned out that 90% of the risk — the possibility of losing money — was in the stock portion of the portfolio, far higher than the 60% that the allocation to equities suggested. It became clear that something else was needed. View slide

A Whitepaper from FNEX 30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 3 The Case for Alternatives/Private Investment The rationale for owning alternatives is relatively simple. Compared with stocks and bonds, hedge funds, private equity funds, real estate, managed futures and private company stock tend to be much more uncorrelated, meaning that they move in different directions than equities and bonds and at different times. Adding alternatives to a portfolio makes it possible to enhance returns while reducing risk by increasing the overall diversification of assets. Numerous academic studies have shown that portfolios with a higher degree of diversification using uncorrelated assets tend to perform better over the long haul. The idea is to maximize returns in up markets while reducing the risk of loss in down markets. Of course, alternatives can also lose in those markets, but the historical record shows a clear benefit to portfolio diversification. For example, look at Exhibit 1, which shows the returns on various asset classes. For the decade ending in 2013, private equity had an annual average return of 15.1% and hedge funds 5.8%, while the S&P 500 had an annual return of 7.4% and Barclays Aggregate Bond Index returned 4.5%. For those concerned about protecting their portfolios, it is useful to know that in the past decade and a half one widely accepted measure of alternatives performance called the HFRI Fund of Funds Composite Index has lost 4% or more in only two monthly periods, while the global measure of equity performance known as the MSCI World Index has been down 4% in 25 monthly periods. What’s more, a large number of academic papers have demonstrated that by including alternatives such as hedge funds and managed futures in a portfolio; it is possible to reduce the volatility of the entire portfolio. Volatility is the rise and fall of stock prices and higher volatility frequently means View slide

A Whitepaper from FNEX 30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 4 an increased risk of loss. Since the financial crisis, double-digit ups and downs in the DJIA have become a much more frequent occurrence. That combination — better risk-adjusted returns — has attracted institutional investors to alternative investments in recent years. Some of the greatest advocates for using alternatives have been the endowments of major universities such as Harvard, Yale and Stanford. And it’s clear why: Yale has experienced a 20-year record of 13.5% average annual returns thanks largely to its nearly 70% exposure to alternative investments. Pension funds increase allocations. Even institutions with much shorter time horizons have gravitated to alternatives because of their better risk/return profile. For example, pension funds, which have the lowest risk tolerance of any institutional investor because they have to pay out pensions every year, had only 5% of their assets allocated to alternatives in 1995, but by 2013 had reserved 19% of their funds for alternatives, according to a recent global study. Because of these benefits, many high-net-worth retail investors are now including a 15- 20% allocation to a basket of alternative investments in their portfolios. Some investors worry that alternatives are by definition risky because fund managers can use borrowed money, a process called leverage and can make bets against the market, a process called shorting. In addition, a few prominent hedge fund managers have been in the headlines lately for making controversial comments about their investments. But a good analogy for the alternatives market is to the airlines industry: air disasters regrettably make occasional headlines, but most people continue to fly because there is

A Whitepaper from FNEX 30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 5 overwhelming evidence that air travel is the safest form of transport available, beating cars and trains. The same is true for alternatives: despite the media coverage, most funds are conservatively managed to reduce risk, not increase it. Accredited Investors: Who qualifies? Because most alternative investments are exempt from the registration requirements of the Securities and Exchange Commission, the SEC has adopted rules limiting ownership of these unregistered securities to what are termed “accredited investors.” There are two ways an investor can qualify as accredited: 1. They must have earned income above $200,000 (or $300,000 together with a spouse) in each of the past two years, and expect to have similar income in the current year, or 2. Have a net worth over $1 million, with or without a spouse and not including their principal residence. Many alternative investments are offered in the form of partnerships, with the investment manager known as the general partner, who manages and markets the fund, and the investors known as the limited partners. Because they are partnerships, many alternative investments are not considered as liquid as stocks and bonds because the money invested can be withdrawn only at certain times of the year. This makes alternatives ideal for long-term investing strategies such as planning for your retirement. As part of this tradeoff, investors expect and often reap higher rewards for the illiquidity of their investments compared to traditional asset classes.

A Whitepaper from FNEX 30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 6 Here is a brief guide to what is available on the market: Hedge funds: As the name implies, these funds were originally designed to “hedge” or lower risk by taking short positions against the market. There are now hundreds of different hedge funds available using many different strategies to make a profit. Some of the most prominent are long/short funds, which still bet against the market to limit risk; global macro funds, which can invest anywhere in the world their managers see a profit potential; market neutral funds, which try to capture differences in prices among related securities like stocks and bonds; event driven funds, which seek to profit from such things as mergers and bankruptcies and distressed credit funds, which try to identify such things as mispriced bonds and loans. Private Equity: These partnerships are run by a financial sponsor who often uses leverage to buy a majority stake in a mature but faltering company, takes it private, and improves the management of the company in hopes of either selling it to another firm or floating its shares on the stock market for a large profit. Managed Futures: These are accounts managed by professional money managers who invest the funds typically in futures contracts in commodities, equities, interest rates or currencies. They can buy contracts that reflect either long or short positions. The accounts often use what is called notional funding, allowing an investor to put up only 25-50% of the amount to be invested. Private Company Stock: These private placements allow a limited number of investors to buy non-public shares in a private company that is not registered with the SEC. These tend to be smaller companies than those listed on exchanges and

A Whitepaper from FNEX 30 S. Meridian St., Suite 250 Indianapolis, IN 46204 888.580.2588 www.FNEX.com 7 have a greater potential to return profits. But these shares can be highly illiquid and investments are generally for the very long term. One thing these assets all have in common is that they tend to be uncorrelated with traditional stock and bond investments. Thanks to their uncorrelated nature and excellent risk/return profiles, alternative investments are gaining ground not only with institutional investors, but with many retail investors as well. A recent report from market analyst McKinsey said that alternative investments by retail customers are growing at 5% a year and are expected to reach $13 trillion in 2015, double the amount retail customers invested in alternatives in 2005. “Growth is expected to continue, fueled by increasing allocations by institutional investors and the movement of alternatives into the retail investment mainsteam,” McKinsey said. DISCLAIMER NOTICE: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product. FNEX is not a broker-dealer or a registered investment advisor and does not originate any securities. FNEX does not advise or consult any member on the merits of any investment or securities offering. The information contained herein has been obtained from sources believed to be reliable, but FNEX, LLC does not guarantee accuracy or completeness. FNEX 2014 © All rights reserved.

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