Portfolio management: The use of alternative investments for the
purpose of diversification
Johan Jacob Hattingh
Dissertation
submitted in fulfillment of the requirements
for the degree
Magister Commercii
in
Investment Management
in the
Faculty of Economic and Management Sciences
at the
Rand Afrikaans University
Johannesburg
Study leader:
Miss JE Pretorius
May 2004
Co-study leader:
Prof. CH van Schalkwyk
INDEX
CHAPTER 1: INTRODUCTION
1
1.1 INTRODUCTION AND PROBLEM STATEMENT
1
1.2 RESEARCH OBJECTIVES
2
1.3 BENEFITS OF THE RESEARCH
3
1.4 STUDY METHODOLOGY
3
1.5 LIMITATION OF THE STUDY
4
CHAPTER 2: HISTORY AND DEVELOPMENT OF MODERN
PORTFOLIO THEORY
5
2.1 INTRODUCTION
5
2.2 MARKOWITZ PORTFOLIO THEORY
5
2.2.1 Overview
5
2.2.2 Risk
6
2.2.3 Return
8
2.2.4 The efficient frontier
8
2.3 CAPITAL MARKET THEORY
12
2.3.1 Introduction
12
2.3.2 Overview of the capital market theory (CMT)
13
2.3.2.1 Assumptions of the theory
13
2.3.2.2 Addressing the information need
14
2.3.2.3 Inclusion of a risk-free asset
14
2.4 THE SIGNIFICANCE OF PORTFOLIO THEORY FOR THIS
STUDY
2.5 CONCLUSION
16
17
I
CHAPTER 3: RISK DIVERSIFICATION: BASIC DEFINITIONS
AND APPLICATIONS
19
3.1. INTRODUCTION
19
3.2. RISK
19
3.2.1 Overview
19
3.2.2 Types of risk
20
3.2.3 Risk measurement
21
3.3. RETURN
24
3.3.1 Overview
24
3.3.2 Required rate of return
25
3.3.3 Measurement
27
3.4. THE RELATIONSHIP BETWEEN RISK AND RETURN
27
3.5. PORTFOLIO CONSTRUCTION
29
3.5.1 Introduction
29
3.5.2 Constructing the capital market line (CML)
30
3.5.3 Optimal risky portfolio’s
35
3.5.3.1 Diversification
35
3.5.3.1.1 Definition
35
3.5.3.1.2 Systematic vs. unsystematic risk
36
3.5.3.1.3 Methods of establishing diversification
37
I. Different asset classes
37
II. Different market sectors
38
III. Different entities
38
IV. Gaining global exposure
38
V. Exposure to different investment
styles
3.5.4 The effect of diversification on the portfolio
38
39
3.5.4.1 Benefits of diversification
40
3.5.5 Constructing the optimal risky portfolio
41
3.5.5.1 Two-asset portfolio
41
3.5.6 Constructing complete portfolios
44
3.6 SUMMARY
47
II
CHAPTER 4: IDENTIFICATION OF ALTERNATIVE
INVESTMENTS
49
4.1 INTRODUCTION
49
4.2 DEFINING AN INVESTMENT
49
4.3 DEFINING ALTERNATIVE INVESTMENT INSTRUMENTS
50
4.4 ALTERNATIVE INVESTMENT CATEGORIES
51
4.5 ANTIQUES
52
4.5.1 Definition of an antique
52
4.5.2 Furniture
52
4.5.3 Military memorabilia
55
4.5.4 Clocks and watches
56
4.5.5 Ceramics
58
4.5.6 Glass
59
4.5.7 Books
59
4.5.8 Silver and metalware
60
4.5.9 Firearms
62
4.5.10 Musical instruments
63
4.6 COLLECTABLES
64
4.6.1 Defining collectables
64
4.6.2 Stamps
64
4.6.3 Toys
65
4.6.3.1 Wood and die-cast toys
66
4.6.3.2 Dolls
66
4.6.3.3 Bears
67
4.6.4 Sports memorabilia
68
4.6.5 Precious stones
69
4.6.6 Cars
69
4.6.7 Oriental rugs
71
4.6.8 Autographs
71
4.6.9 Wine
72
4.6.10 Rare, collectable and bullion coins
75
4.6.10.1 Numismatic coins
75
4.6.10.2 Bullion coins
76
III
4.6.10.3 Kruger Rands
77
4.7. ART
77
4.8 GENERAL
80
4.8.1 Containers
80
4.8.2 Racehorses
81
4.8.3 Investing in people (Justin Wilson)
82
4.9. GENERIC FACTORS TO CONSIDER
83
4.9.1 Authenticity
83
4.9.2 Condition
84
4.9.3 Rarity
84
4.9.4 Provenance
85
4.9.5 Familiarity
85
4.9.6 Importance of the asset
86
4.9.7 Technique/workmanship
86
4.9.8 Buying what you like
86
4.10. ADVANTAGES AND DISADVANTAGES OF INVESTING IN
ALTERNATIVE INVESTMENTS
87
4.10.1 Advantages
87
4.10.2 Disadvantages
88
4.11 SUMMARY
90
CHAPTER 5: EFFICIENT MARKETS AND ALTERNATIVE
INVESTMENTS
91
5.1. INTRODUCTION
91
5.2. DEFINING A MARKET
91
5.3. CHARACTERISTICS OF GOOD MARKETS
93
5.4. EFFICIENT MARKETS
94
5.5. THE EFFICIENT MARKET HYPOTHESIS (EMH)
94
5.5.1 Weak form EMH
95
5.5.2 Semi-strong form EMH
96
5.5.3 Strong-form EMH
96
5.5.4 Implications of the EMH
97
5.6. EXISTING MARKETS
98
IV
5.6.1 Bond and equity markets
98
5.6.2 Real estate markets
99
5.7. ALTERNATIVE INVESTMENT MARKETS
100
5.7.1 Defining alternative investment markets
100
5.7.2 Are alternative markets good markets?
100
5.7.2.1 Availability of information
101
5.7.2.2 Liquidity
101
5.7.2.3 Transaction costs
102
5.7.2.4 Informational efficiency
103
5.7.3 Are alternative markets efficient markets?
103
5.8. CONCLUSION
104
5.9. SUMMARY
104
CHAPTER 6: APPLICATION OF PORTFOLIO THEORY
106
6.1 INTRODUCTION
106
6.2 INCLUSION OF KRUGER RANDS
107
6.2.1 Introduction
107
6.2.2 Assets used in the construction of the portfolios
108
6.2.2.1 Debt instruments
108
6.2.2.1.1 Definition
108
6.2.2.1.2 Assumptions
108
6.2.2.2 Equity investments
109
6.2.2.2.1 Definition
109
6.2.2.2.2 Assumptions
109
6.2.2.3 Cash
110
6.2.2.4 Kruger Rands
110
6.2.2.4.1 Definition
110
6.2.2.4.2 Assumptions
111
6.2.3 Analysis of the assets used to construct the diversified
portfolios
111
6.2.3.1 Performance analysis
111
6.2.3.2 Risk analysis
118
V
6.2.4 Portfolio construction
121
6.2.4.1 Co-movements between the assets
121
6.2.4.2 Initial diversified portfolio
124
6.2.4.3 The alternative portfolio
126
6.3 INCLUSION OF WINE ASSETS
128
6.3.1 Introduction
128
6.3.2 Assets used in the construction of the portfolios
130
6.3.3 Analysis of the assets used in the construction of portfolios 131
6.3.3.1 Performance analysis
131
6.3.3.2 Risk analysis
136
6.3.4 Portfolio construction
6.3.4.1 Construction of the diversified portfolio
138
139
6.3.4.2 Construction of the Mouton-Rothschild (MR) portfolio 142
6.3.4.3 Construction of the Montrose portfolio
6.4 INCLUSION OF ART INVESTMENTS
146
150
6.4.1 Introduction and assumptions
150
6.4.2 Assets used in the portfolio construction
151
6.4.3 Analysis of the assets used in the construction of the
portfolios
152
6.4.3.1 Performance analysis
152
6.4.3.2 Risk analysis
159
6.4.4 Portfolio construction
160
6.4.4.1 Construction of the diversified portfolio
161
6.4.4.2 Construction of the art portfolio
164
6.5 SUMMARY
166
CHAPTER 7: CONCLUSION
167
7.1 FURTHER RESEARCH POSSIBILITIES
170
BIBLIOGRAPHY
171
VI
LIST OF FIGURES
Figure 2.1:
Probability distribution of assets with different
levels of risk
7
Figure 2.2:
Risk/Return combinations of two different assets
9
Figure 2.3:
Fictitious Efficient Frontier
10
Figure 2.4:
Efficient Frontier and Utility Curves
11
Figure 2.5:
Combining the Risk-Free Asset and a Risky Portfolio 15
Figure 3.1:
Probability Distribution
21
Figure 3.2:
The Relationship between Risk and Return
33
Figure 3.3:
Systematic risk and Unsystematic risk
40
Figure 3.4:
Expected return of the portfolio
43
Figure 3.5:
Standard deviation of the portfolio
43
Figure 3.6:
Efficient frontiers given different correlations
44
Figure 6.1:
Weekly All Bond Index (ALBI) movements
1990 – 2003
Figure 6.2:
Weekly All Share Index (ALSI) movements
1990 – 2003
Figure 6.3:
112
112
Weekly 90-Day BA-rate (BA) movements
1990 – 2003
113
Figure 6.4:
Weekly price movement of the Kruger Rand
114
Figure 6.5:
Weekly HPY for the ALBI (1990 – 2003)
115
Figure 6.6:
Weekly HPY for the ALSI (1990 – 2003)
116
Figure 6.7:
Weekly HPY for the BA (1990 – 2003)
116
Figure 6.8:
Weekly HPY for the Kruger Rand (1990 – 2003)
117
Figure 6.9:
Probability distributions of assets
119
Figure 6.10: Scatter plot matrix of asset returns
122
Figure 6.11: Efficient frontier
125
Figure 6.12: Asset mix of a diversified portfolio
125
Figure 6.13: Efficient frontier of the alternative portfolio
126
Figure 6.14: Asset mix of the alternative portfolio
127
Figure 6.15: Monthly price movement of the ALBI
131
Figure 6.16: Monthly price movements of the ALSI
132
Figure 6.17: Monthly rate movements of the 90-day BA-rate
133
VII
Figure 6.18: Monthly price movements of the Mouton-Rothschild
1982
133
Figure 6.19: Monthly price movements of the Montrose
134
Figure 6.20: Holding Period Yields on assets
135
Figure 6.21: Probability distributions of assets
137
Figure 6.22: Scatter plot matrix of asset returns
139
Figure 6.23: Efficient frontier for the diversified portfolio
141
Figure 6.24: Asset mix of the diversified portfolio
142
Figure 6.25: Scatter plot matrix of the returns on the assets
used in the MR portfolio
143
Figure 6.26: Efficient frontier for the MR portfolio
144
Figure 6.27: Asset mix of the MR portfolio
145
Figure 6.28: Scatter plot matrix of the returns on the assets
used in the MR portfolio
147
Figure 6.29: Efficient frontier for the MR portfolio
148
Figure 6.30: Asset mix of the Montrose portfolio
149
Figure 6.31: All Bond Index Movements
152
Figure 6.32: All Share Index Movements
153
Figure 6.33: Annual BA-rates
154
Figure 6.34: Annual movements of the FAI
155
Figure 6.35: HPY movements of the ALBI
156
Figure 6.36: HPY movements of the ALSI
156
Figure 6.37: HPY of the BA
157
Figure 6.38: HPY of the FAI
158
Figure 6.39: Probability distributions of assets
159
Figure 6.40: Scatter plot matrix of asset returns
161
Figure 6.41: Efficient frontier for the diversified portfolio
163
Figure 6.42: Asset mix of the diversified portfolio
163
Figure 6.43: Efficient frontier for the art portfolio
164
Figure 6.44: Asset mix of the art portfolio
165
VIII
LIST OF TABLES
Table 3.1:
Test Data
32
Table 3.2:
Test Data
34
Table 3.3:
Standard deviation for a given correlation
42
Table 4.1:
Performance of the AFPI versus various other assets 54
Table 6.1:
Table of comparative performance measures
118
Table 6.2:
Variance and standard deviations of assets
120
Table 6.3:
Covariance matrix
123
Table 6.4:
Correlation coefficient matrix
124
Table 6.5:
Portfolio risk and return figures
128
Table 6.6:
Table of comparative performance measures
136
Table 6.7:
Variance and standard deviation of assets
138
Table 6.8:
Correlation coefficient matrix of asset returns
140
Table 6.9:
Correlation matrix
144
Table 6.10:
Portfolio statistics of the diversified portfolio and
the MR portfolio
146
Table 6.11:
Correlation matrix
148
Table 6.12:
Portfolio statistics of the diversified portfolio,
MR portfolio and Montrose portfolio
150
Table 6.13:
Table of comparative performance measures
158
Table 6.14:
Variance and standard deviation of assets
160
Table 6.15:
Correlation coefficient matrix of asset returns
162
Table 6.16:
Portfolio statistics of the diversified portfolio and
the art portfolio
165
IX
CHAPTER 1: INTRODUCTION
1.1 INTRODUCTION AND PROBLEM STATEMENT
Modern financial markets are highly developed and efficient, with market
participants having access to seemingly endless amounts of information
related to an ever-growing asset selection. Amidst this the basic building
blocks for sound investment portfolio construction remain the same.
The high levels of efficiency make the process of attaining above-average
risk-adjusted returns more difficult than ever before. This should prompt
investors to shift their focus to effective portfolio diversification. The following
quotes emphasise the importance and some of the characteristics of
diversification:
•
“Modern portfolio theory suggests that diversification is rational…”
(Dobbins, Witt and Fielding 1996:12).
•
“Diversification means that many assets are held in the portfolio so that
the exposure to any particular asset is limited.” (Bodie, Kane and
Marcus 2003:10).
•
“This portfolio that includes all risky assets is referred to as the market
portfolio…because the market portfolio contains all risky assets, it is a
completely diversified portfolio.” (Reilly and Brown 2000:244)
•
“…given that investors should only take on that part of risk for which
they expect to be rewarded.” (Dobbins et al 1996:12)
These statements form the basis of any successful investment strategy, be it
for the individual investor or the institutional investor.
Most advisors, journalists and the like will recommend a healthy balance
between cash, equities and debt (bonds), many even recommend holding
property in one’s portfolio.
1
The central question being addressed in this study is whether or not cash,
equities, bonds and property should be the only assets that investors
consider, or are there other alternatives that may hold significant benefits for
investors in the form of increased diversification?
1.2 RESEARCH OBJECTIVES
The aim of this study is to investigate the potential benefits of including
alternative assets (used as a synonym for hard assets throughout the study)
in portfolios that are constructed in such a way that they are diversified.
The study will start by providing an overview of modern portfolio theory and its
most important elements, namely risk, return and diversification. Secondly,
the study will identify and discuss various alternative assets that are believed
to hold the potential for better diversification and move investors closer to
attaining a true market portfolio. Lastly, the study will attempt to prove the
hypothesis that these investments do hold the potential of improving the
diversification of existing portfolios. Specifically the paper will consider three
assets, namely gold coins (in the form of Kruger Rands), wine and art.
Focusing on these three aspects will allow the study to verify some of the
findings of previous studies, which have shown that the correlations between
different alternative investments, such as art and furniture, vary substantially
from positive to negative (with more traditional assets), allowing for
diversification via the use of these assets.
2
1.3 BENEFITS OF THE RESEARCH
The study will aim to emphasise the following:
•
Any benefits to be gained from using these alternative investments in
the construction of a diversified portfolio.
•
The viability of the use of alternative investments.
•
Secondary benefits to be obtained from investing in these assets, for
example emotional dividends to be gained.
The result of this study is believed to be important because:
•
It will show the diversification effects that these assets might have on
existing portfolios.
•
It will investigate the risk and return pay-off structures of these assets,
thus allowing the reader to consider these “alternative” investments as
viable additions to his/her portfolio.
•
If the initial hypotheses are proven to be true, the reader’s investment
universe may broaden substantially, allowing for better and more
efficient portfolios.
1.4 STUDY METHODOLOGY
Initially the study will concentrate on a literature study and overview of basic
portfolio theory, after which it will progress into a more detailed study of the
key concepts of portfolio theory namely risk, return and diversification.
The study will then aim to identify and discuss various alternative investments.
This section will give consideration to, among others, the basic constituency
of each of the identified asset classes, key characteristics of each of the asset
classes and basic determinants of value. This section will also focus on the
3
identification of universal factors which may affect the “investability” of
alternative assets in general.
The study will conclude with an empirical analysis, aimed at proving the
inherent benefits that these assets hold for prospective investors. This section
will give consideration to three prominent alternative assets, namely gold
coins, wine and art. The study will aim to prove that portfolios, which are
believed to be diversified, may be diversified even further via the inclusion of
these assets in the portfolio. Consideration, be it direct or indirect, will be
given to the effects of changing investment time frames and asset quality.
1.5 LIMITATION OF THE STUDY
The limitations of this study, which will become clear as the study progresses
include the following:
•
Due to the fact that none of these alternative assets are traded on
formal exchanges (even though progress has been made in at least the
wine market), the availability of historical information is limited in
various ways. In some instances performance figures had to be
generated (based on reasonable assumptions) whilst in other instances
(such as was the case for art investments) the extent of the study was
limited by the frequency of data, as well as the range of data.
•
Literature
and
research
aimed
specifically
at
addressing
the
diversification benefits of alternative assets on existing portfolios, is
very limited.
4
CHAPTER 2: HISTORY AND DEVELOPMENT OF MODERN
PORTFOLIO THEORY
2.1 INTRODUCTION
The purpose of this chapter is to serve as an introductory chapter to the
history and development of what may be loosely termed “modern portfolio
theory.”
This chapter will consider the origination and development of some of the
concepts which form the basis of this study. The chapter starts with an
overview of the Markowitz portfolio theory and progresses into a discussion
regarding later developments such as the Capital Market Theory.
2.2 MARKOWITZ PORTFOLIO THEORY
2.2.1 Overview
According to Correia, Flynn, Uliana and Wormald (2000:90) modern portfolio
theory is based on the culmination of the work of various researchers, but was
pioneered by Markowitz (1959) and later Sharpe (1964).
Harry Markowitz developed the basic portfolio model at a time when investors
were seeking a measure to quantify the risk variable. Bodie, Kane and Marcus
(2002:223) state that, according to Markowitz, the variance of the rate of
return [on an asset] is a meaningful measure of portfolio risk under a
reasonable set of assumptions.
5
These assumptions, as stated by Reilly and Brown (2003:260), are listed
below:
•
Investors will evaluate an investment opportunity as being presented
by a probability distribution of expected returns over some period of
time;
•
Investors maximize one-period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth;
•
Risk of a specific investment will be measured by the deviation from
expected return;
•
Investors’ utility curves are functions of risk and return only; and
•
For a given level of risk, investors will aim to maximize the level of
return.
Therefore under the above-mentioned set of assumptions, a single asset or
portfolio of assets is considered to be efficient if no other asset or portfolio of
assets offers higher expected return with the same (or lower) risk, or lower
risk with the same (or higher) expected return.
2.2.2 Risk
The risk associated with an asset may be graphically illustrated via a
probability distribution that illustrates the dispersion of the realized returns
around the mean level of expected return. Greater levels of dispersion imply
greater levels of risk associated with the specific asset. (D’Ambrosio
1976:301)
Figure 2.1 illustrates the probability distributions of the returns on two different
assets.
6
Figure 2.1
Probability distribution of assets with different levels of risk
Source: Mason, Lind and Marchal
From figure 2.1 it is clear that curve A represents the probability distribution of
a low variance (low risk) asset, whilst curve B represents the probability
distribution of a high variance (high risk) asset. This conclusion follows on the
fact that curve B is flatter (platykurtic) than curve A and therefore the returns
on the high risk asset will be more dispersed around a central value, normally
the mean rate of return or expected rate of return.
A standardized measure of variance around a mean is known as standard
deviation. According to Reilly et al (2003:212) standard deviation is an
appropriate measure of risk because it:
•
Is somewhat intuitive;
•
Is correct and widely recognized; and
•
Has been used in most theoretical asset pricing models.
According to Wilcox (1999:12) Harry Markowitz derived the formula for the
calculation of the standard deviation of a portfolio. The formula shown below
indicates that the standard deviation of a portfolio is a function of the
individual asset variances as well as their weight in the portfolio.
7
n
n
n
∑ wi2σ i2 + ∑∑ wi w j Covij
σ port =
i =1
[2.1]
i =1 i =1
Where:
σ port = the standard deviation of the portfolio
w i = the weights of the individual assets as determined by their proportion
of value in the portfolio
σ = the variance in the rates of return in i
2
i
Cov ij = the covariance between the rates of return for assets i and j
What is important is the fact that the variance of the portfolio is also a function
of the covariance/co-movement of the assets included in the portfolio.
Therefore when constructing a portfolio the focus of the investor should not be
on the variance of the individual asset but more on the average covariance
with the other assets in an existing portfolio.
2.2.3 Return
The expected return on a portfolio may be calculated as the sum of the
weighted average expected return on the individual assets that make up the
total portfolio. (Farrell 1997:21)
A detailed discussion on the concepts of risk and return follows in chapter 3.
2.2.4 The efficient frontier
D’Ambrosio (1976:326) states that the portfolios on the efficient frontier
dominate all portfolios below the frontier, thus the efficient frontier represents
8
that set of portfolios that has the maximum rate of return for every given level
of risk, or the minimum risk for every level of return.
An efficient frontier may be derived by considering different risk and return
scenarios resulting from different combinations of two or more assets. Figure
2.2.4.1 illustrates a fictitious example of a graph that may be derived in this
way.
Figure 2.2
Risk/Return combinations of two different assets
Source: Fischer and Jordan (1975:511)
The envelope curve that represents the best of all the possible combinations
represents the efficient frontier. Figure 2.2.4.2 represents a fictitious efficient
frontier.
9
Figure 2.3
Fictitious Efficient Frontier
Source: D’Ambrosio (1976:326)
The benefits associated with diversification lead investors/theorists to believe
that the efficient frontier will be made up of investment portfolios rather than
individual assets, except at the extremes where a portfolio consists of only
one asset or security.
Investors will invest in combinations of assets (portfolios) that fall along the
efficient frontier based on their utility curve. The investor’s utility curves are
functions of expected return and expected variance (this follows on the basic
assumptions of the Markowitz portfolio theory). These utility curves indicate
the trade-off that investors are willing to make between risk and return.
According to Stevenson and Jennings (1976:233) the optimal portfolio on the
efficient frontier for a given investor, lies at the point of tangency between the
efficient frontier and the curve with the highest possible utility, as illustrated in
figure 2.4.
10
Figure 2.4
Efficient Frontier and Utility Curves
Source: Correia et al (2000:100)
According to Correia et al the following can be seen from figure 2.4:
•
Three discrete indifference curves of investor X (X1, X2, X3). The curves
proceed in an upward and leftward direction, depicting the increasing
return being sought for increased risk. The slope of the curve reflects
the risk preference of the investor. Curve X1 doesn’t encounter any
investment opportunity. Curve X2 offers less utility but is the first to
contact the set of feasible portfolios on the efficient frontier. Curve X3
encounters the efficient frontier on two occasions, but because curve
X2 offers a higher level of utility the investor will prefer to invest in
portfolio X.
•
The three indifference curves of investor Y (Y1,Y2,Y3) represent the
utility curves of a more risk-averse investor (as opposed to investor X).
This is evident in the increased steepness of the utility curves of
investor Y. The steepness implies that a greater level of return is
required per unit of risk incurred (Francis 1986:798). In other words this
means that a risk-averse investor will require return to increase by a
substantial margin for an increase in the level of risk, as opposed to a
11
less risk-averse investor who might only require a small increase in the
level of return given an increase in the level of risk.
According to Bodie, Kane and Marcus (2002:157) investors assign a welfare
or utility score to competing investment portfolios based on the expected
return and risk of those portfolios. Portfolios with attractive risk-return
characteristics are assigned higher utility values. The utility value of a portfolio
will increase if expected return increased and decrease if expected variability
(risk) increased.
2.3 CAPITAL MARKET THEORY
2.3.1 Introduction
Following the development of the Markowitz portfolio theory, various studies
have been performed to address some of the shortfalls identified in the theory.
One of the major shortfalls associated with this theory is the need for large
amounts of information. Specifically, the investor needs information on the risk
and return characteristics of each asset considered as well as information
relating to the covariance of each asset pair. The inclusion of a risk-free asset
into a portfolio also gave rise to some of the major developments which
followed the Markowitz portfolio theory.
A breakthrough with regard to the problems posed by the Markowitz portfolio
theory came in 1963 when Sharpe developed the Market (or single-index, or
diagonal) model.
12
2.3.2 Overview of the capital market theory
2.3.2.1 Assumptions of the theory
As was the case for the Markowitz portfolio theory, the Capital Market Theory
(CMT) was developed on the basis of a set of assumptions. These
assumptions as listed by Dobbins et al (1993:45) are reproduced below:
•
All investors are Markowitz efficient investors who want to target points
on the efficient frontier based on their utility curves. This assumption
underlines the fact that the Capital Market Theory (CMT) builds on the
Markowitz theory.
•
Investors are able to borrow or lend any amount of money at the riskfree rate of return (RFR).
•
All investors have homogeneous expectations. This implies that all
investors have similar expectations of the probability distributions of
future rates of return.
•
All investors share the same investment time horizon i.e. 1 month, 6
months, 12 months etc.
•
All investments in the market are infinitely divisible i.e. investors are
able to buy and sell fractions of assets.
•
There are no taxes or transaction costs involved in the purchase and
sale of assets.
•
There is no inflation or any change in interest rates, or inflation is fully
anticipated.
•
Capital markets are in equilibrium.
The aim of the preceding section was not to question the reasonableness of
the listed assumptions, but to provide an overview of the theory.
13
2.3.2.2 Addressing the information need
As was mentioned in the introduction to this section, one of the shortfalls of
the Markowitz portfolio theory identified by theorists is the need for large
amounts of information.
According to Sharpe, who developed the CMT, “each security’s price
movement can be related to the price of the market portfolio – that is, a
portfolio comprising a weighted average of all the securities traded on the
market.” (Dobbins et al (1993:46). Furthermore returns on different securities
within an asset universe are assumed to be related only through common
dependence upon the market [portfolio], and as such the necessity to specify
the covariance (and correlation coefficients) of returns between security pairs
is eliminated.
2.3.2.3 Inclusion of a risk-free asset
The concept of a risk-free asset has various implications on the basic
Markowitz portfolio model and the inclusion of these types of asset have
allowed for various developments in asset pricing.
In order to fully appreciate the implication of the inclusion of a risk-free asset
on the basic portfolio theory it is necessary to define the term. Francis
(1986:760) defines a riskless asset (or risk-free asset) as an asset that
produces a positive level of return, but it has zero variability and therefore
future returns are known. This implies a standard deviation (Markowitz’s
measure of risk) that is equal to zero. It may also be proved that the
covariance of these assets with any other asset or portfolio of assets will be
equal to zero.
14
The effects of the inclusion of a risk-free asset into an existing portfolio are
listed below:
•
The rate of return generated by the portfolio, which now includes a riskfree asset, remains the weighted average of the returns generated by
the assets included in the portfolio.
•
According to Francis (1986:760) the standard deviation of a portfolio
that combines a risk-free asset with risky assets is the linear proportion
of the standard deviation of the risky asset portfolio.
Because of the above-mentioned effects the graph that may be drawn to
illustrate possible risk and return characteristics of the portfolio is a straight
line between two assets, as illustrated in figure 2.5.
Figure 2.5
Combining the Risk-Free Asset and a Risky Portfolio
Source: Stevenson and Jennings (1976:257)
The investors will be able to attain any point along line RFR-A and RFR-B by
investing a portion of their wealth in the risk-free asset and a portion in the
risky-portfolio on the efficient frontier (i.e. portfolio A or B). Any combination
on these lines dominates all risky portfolios on the efficient frontier that fall
below this point, the reason being that these portfolios have equal variance
15
and higher rates of return than any portfolio on the original efficient frontier
that falls below the selected portfolio. From this it appears that all portfolios on
line RFR-B will dominate all portfolios on line RFR-A.
At the point of tangency between the line drawn from RFR to the efficient
frontier, that portfolio (portfolio M) dominates all portfolios below that point.
Because portfolio M lies at the point of tangency with the efficient frontier, it
has the highest portfolio possibility line and therefore all investors will aim to
invest in portfolios that lie on line RFR-CM. This portfolio represents a
portfolio which includes all risky assets. This portfolio is referred to as the
market portfolio and represents a completely diversified portfolio. According to
Reilly et al (2003:244) this portfolio includes not only common stocks but also
all risky assets such as bonds, options, real estate, coins, stamps, art or
antiques. In effect line RFR-CM which may also be termed the Capital Market
Line (CML), becomes the new efficient frontier, as all investors will want to
target points on the CML.
From the above discussions it follows that the relevant risk measure for all
risky assets should be their covariance with the market portfolio, this is the
risk often referred to as systematic risk. The concepts of risk (systematic and
unsystematic) as well as diversification, will be discussed in a later chapter.
2.4 THE SIGNIFICANCE OF PORTFOLIO THEORY FOR THIS STUDY
The general principles of portfolio theory as reviewed in this chapter will have
a significant bearing on the remainder of the study. As will be seen in later
chapters, portfolios constructed during the course of this study will be
constructed based on the Markowitz portfolio theory.
It should also become evident that the focus of this text will be to study those
alternative assets which, at least in theory, form part of the fully diversified
market portfolio. Often these assets are forgotten or ignored, but the question
16
arises whether or not these assets may add to the diversification of existing
portfolios.
The benefits that may be associated with these assets may include, in
addition to diversification benefits, improved levels of portfolio return.
2.5 CONCLUSION
This chapter provided a literature review of basic modern portfolio theory.
From this review it followed that the Markowitz Portfolio Theory, as developed
by Harry Markowitz, established the basis for modern portfolio theory, whilst
subsequent developments in this field of study included amongst others the
Capital Market Theory (CMT).
Markowitz showed that the two most important factors to be considered when
constructing a portfolio is risk and return. Prior to his findings most investors
constructed portfolios based purely on expected return, or at best constructed
portfolios based on separate considerations of risk and return. Markowitz
provided a measure that enables investors to consider risk and return
simultaneously. In addition to this Markowitz identified variance as the
appropriate risk measure in a portfolio management and construction setting.
Application of the Markowitz Portfolio Theory enable investors to derive
Markowitz efficient frontiers which, in addition to their utility curves, would
allow them to determine optimal portfolios given their unique risk preferences.
Following the discussion on the Markowitz Portfolio Theory this chapter briefly
considered the Capital Market Theory (CMT) which introduces the concept of
the risk-free asset. In terms of this theory the investor has to decide to invest
in a combination of the risky portfolio, i.e. that portfolio that contains all the
risky assets traded in the market, and the risk-free asset. According to the
CMT the only other decision that the investor has to make, other than
deciding to invest, is the whether or not he or she would be willing to borrow
17
or lend at the risk-free rate. This set of decisions, namely the investing
decision and the financing decision, gives rise to the separation theorem.
For the purpose of this study the Markowitz Portfolio Theory was used in the
construction and identification of optimal portfolios. This was done because
only the market portfolio (risky portfolio) as identified by the CMT can be
diversified.
18
CHAPTER 3: RISK DIVERSIFICATION: BASIC DEFINITIONS
AND APPLICATIONS
3.1. INTRODUCTION
In the modern investment setting investors are faced with the complicated
task of selecting good investments, in addition to this they have to consider
trade-offs between risk and return and finally they are required to combine
various types of investments in optimal portfolios.
This chapter builds on the basic concepts noted in the previous chapter and
aims to introduce the reader to a more complicated and detailed discussion of
concepts such as risk and return when selecting investments, the
consideration of risk and return measurement for individual investments, as
well as the impact that the inclusion of assets will have on the risk and return
characteristics of existing asset portfolios. Furthermore, the chapter will serve
as an overview of the concept of risk diversification and the bearing that
diversification has on the investment decision. Diversification as a concept will
be discussed as well as the methods used to measure and achieve
diversification.
3.2. RISK
3.2.1 Overview
Risk manifests itself in various forms, these include amongst others, business
risk, country risk, exchange rate risk and financial risk. For the purpose of this
chapter, risk (in its broadest sense) may be defined as the uncertainty of
future returns, or alternatively as “the uncertainty that an investment will earn
its expected return.”(Reilly et al 2000:1210). According to Mason et al
(1997:99) the larger the range of expected returns of an asset, the larger the
19
dispersion of the returns and the riskier the asset. Therefore the higher the
range of the expected returns (or historical returns) the riskier the asset will
be. Bodie, Kane and Marcus 2002:155 reason that the presence of risk
means that more than one outcome is possible.
The risk associated with an asset consists of two elements, namely:
•
Systematic risk. According to Francis and Archer (1979:155)
systematic risk is the minimum level of risk that may be achieved by
means of diversification. All assets carry this risk; as all assets are
influenced to some greater or lesser extent by changes in factors such
as money supply, interest rates, exchange rates and taxation (Dobbins
et al 1996:8).
•
Unsystematic risk. Cohen, Zinbarg and Zeikel define unsystematic risk
as risk that is unique to a specific asset, derived from its particular
characteristics. It can be eliminated in a diversified portfolio. The
existence of the unique risks and the idea that investors should not
expect to be rewarded for taking on risk which can be avoided
(Dobbins et al 1996:8) warrants an investigation into the existence of
alternative means of reducing unique risks.
3.2.2 Types of risk
It is important to note that the term risk is a collective term encompassing
various types of risks, including, amongst others, the following:
•
Business risk;
•
Financial risk;
•
Market risk;
•
Interest rate risk;
•
Reinvestment rate risk;
20
•
Purchasing power risk;
•
Exchange rate risk; and
•
Country risk.
3.2.3 Risk measurement
The most established measure of risk is standard deviation. Standard
deviation may be defined as a measure of variability equal to the square root
of variance (Mason, Lind and Marchal 1996:11). It is a measure of dispersion
around a mean value. A larger dispersion around a mean value would indicate
more variability and presents the investor with greater risk.
Figure 3.1
Probability Distribution
Source: Dobbins et al (1996:6).
As mentioned earlier standard deviation measures dispersion around a mean.
According to Dobbins et al. (1996:6) approximately 66.67% of all occurrences
should, on average, lie within one standard deviation of the expected
outcome, considering the figure 3.1 this implies that 66.67% of the
21
occurrences should fall within the 10% to 22% range and the implied standard
deviation should be 6%. The aforementioned statement is made assuming
that the return distribution is a normal distribution. Dobbins et al (1994:7) go
on to say that 83.33% of occurrences (relating to the above mentioned figure)
should fall above 22% (upside potential) and below 10% (downside risk).
Variance may be calculated as follows:
[r (s ) − R ]
=∑
2
σ
2
s
n
[3.1]
Where : σ 2 = variance
R = the mean rate of return on the asset
r(s) = the realized return given scenario s
From this formula (3.1) it follows that variance of an asset equals the sum of
the probability of a given scenario multiplied by the squared difference
between realised return and expected return (the mean value).
It should be noted that this measurement of risk is based on the past
performance of the asset, hence there is no guarantee that the risk
characteristics of the asset will remain constant. To eliminate this shortfall as
much as possible, investors should use as much historical data as possible.
The mathematical equation for the calculation of standard deviation may be
represented as follows:
σ = σ2
Where:
[3.2]
σ 2 = Variance as calculated using formulas 3.1.
22
According to Bodie, Kane and Marcus (2002:165) the risk of single assets in a
portfolio should be measured in the context of the effect that their returns will
have on the variability of the overall portfolio. The fact that the amount of risk
associated with a portfolio is dependent on the extent to which the assets in
the portfolio move together, results in the assumption that the risk of a
portfolio isn’t simply the weighted average risk of the assets that make up the
portfolio.
Bodie et al (2002:165) further state “covariance measures how much the
returns of two risky assets move in tandem.” The following equation is used to
calculate the covariance of two assets:
Cov AB = ∑ [r A − E (r A )][rB − E (rB )] / n
[3.3]
Where : P(s) = the probability of scenario s
rX = the realized return on asset X
E(rX ) = the expected return on asset X
From this it seems that the covariance of a portfolio is reliant on two factors,
namely:
•
Variability (standard deviation) of the individual assets, and
•
The relationship (correlation) amongst different assets included in the
portfolio.
The correlation coefficient of returns is calculated by using the following
formula:
ρ AB =
Cov AB
σ Aσ B
[3.4]
Where : ρ AB = the correlation coefficien t of assets A and B
23
The portfolio standard deviation, for a three-asset portfolio, may be calculated
by using the following formula:
2
σ port
= W A2σ A2 + W B2σ B2 + WC2σ C2 + 2W AW BCov AB + 2W AWC Cov AC + 2WBWC Cov BC
[3.5]
σ
=
σ
2
port
[3.6]
Where : W X = the weight that each asset carries in the portfolio
σ X2 = the variance of asset X
Cov XY = the covariance between the returns on assets X and Y
The formulae indicate that factors such as the weight that an asset carries in
the portfolio, its standard deviation (risk), as well as the correlation/comovement of the asset with other assets in the portfolio, is essential in the
calculation of portfolio variance.
This study uses the risk measurement as identified by Harry Markowitz in his
portfolio theory. This does not, however, mean that other measures of risk
such as beta-coefficients aren’t considered to be applicable or sufficient
measures of risk.
3.3. RETURN
3.3.1 Overview
Fischer and Jordan (1983:4) define an investment as the current commitment
of Dollars for a period of time in order to derive future payments that will
compensate the investor for (1) the time the funds are committed, (2) the
expected rate of inflation, and (3) the uncertainty of future payments.
24
The return generated by an asset may be defined as the sum of all sources of
income or capital gains realized on that asset during the holding period. From
the definition mentioned above it follows that these income sources should
compensate the investor in terms of time, inflation and risk.
The rate of return demanded by an individual investor is known as the
investor’s required rate of return.
3.3.2 Required rate of return
The investor’s required rate of return is made up of three factors or
alternatively it has three dimensions. According to Reilly and Brown (2000:16)
these are:
•
The time value of money during the period of investment,
•
The expected rate of inflation during the period, and
•
The risk involved.
In order to analyse the investor’s required rate of return, the investor has to
take into account the real risk-free rate (RRFR). According to Reilly et al
(2000:16) “The real risk-free rate is the basic interest rate, assuming no
inflation and no uncertainty about future [cash] flows.” The RRFR is
essentially the rate of return that investors would demand if they knew with
certainty what cash flows they would receive and when. From this it appears
that the RRFR addresses the time value of money dimension of the investor’s
required rate of return. Reilly and Brown (2000:17) identify two factors that will
influence this rate of return namely, the time frame of the investor and the
investment opportunities in the economy. Longer time frames or investment
horizons results in the greater probability of opportunity cost and therefore a
higher level of return will be commanded by investors.
25
Farrell (1997:126) states that [nominal] rates of interest that prevail in the
market are determined by real rates of interest, plus factors that will affect the
nominal rate of interest, such as the expected rate of inflation. From this it
appears that the nominal risk-free rate of return is equal to the RRFR adjusted
for conditions in the capital markets and the inflation rate.
A required rate of return that exceeds the NRFR is said to have a risk
premium. This risk premium represents the composite of all uncertainty, but
certain fundamental elements are identifiable namely business risk, financial
risk, liquidity risk etc. (as was discussed earlier).
According to Dobbins et al. (1996:7) “investors do not like risk, and the greater
the riskiness of returns of an investment, the greater will be the return
expected (or required) by investors.”
The required or expected rate of return of an investor may be calculated using
the following equation:
k i = rf + β ( r m − rf )
Where :
[3.7]
ki = required rate of return on asset i
rf = the nominal risk-free rate of return
rm = the market return
β = the beta of the asset
Beta is a standardized measure of the extent to which an asset moves
in relation to the market. Beta measures the covariance between the
asset returns and the market returns in relation to the variance of the
market. Therefore the market portfolio (the portfolio that consists of all
risky assets) has a beta coefficient of 1. An asset with a beta of more
than one has high levels of systematic risk, whilst assets with low or
negative betas have low levels of systematic risk (Francis 1986:260).
26
3.3.3 Measurement
According to Bodie, Kane and Marcus (2002:162) the mean or expected
return of an asset is a probability-weighted average of its return in all
scenarios. The equation may be written as follows:
R=
∑ R (s )
[3.8]
n
Where : R(s) = return in scenario s.
Bodie et al (2002:163) state that “[t]he rate of return on a portfolio is a
weighted average of the rates of return of each asset comprising the
portfolio.” Thus, when calculating the return generated by a portfolio of
investments over a period of time, the investor uses the weighted average
return of all assets in the portfolio. For example a portfolio made up of asset A
and asset B (assume equal weighting), where asset A yielded a return of 40%
and asset B a return of 10%, will yield a 25% return over the investment
period. The equation for the calculation of the portfolio return will be as
follows:
R port = W A r A + W B rB + ... + W ∞ r ∞
Where :
[3.9]
A = portfolio A
B = portfolio B
3.4. THE RELATIONSHIP BETWEEN RISK AND RETURN
According to Corgel, Ling and Smith (2001:149) investors are risk averse and
because of this the relationship between risk (as measured by standard
deviation) and return is positive.
Dobbins et al. (1996:9) state that “[t]he
capital asset pricing model shows that the expected return of an investment is
27
a positive linear function of market risk (measured by beta)”. Basic investment
theory states that as risk increases so too should return, in order to
compensate the investor for the increased degree of uncertainty. The
risk/return relationship is of critical importance to investors. Investors need to
determine their individual risk preferences and should aim to minimize their
risk exposure at their required rate of return.
According to Bodie, Kane and Marcus (2002:157) investors who are risk
averse reject investment portfolios that are fair games or worse. For the
purposes of this text fair games may be defined as “prospect[s] that have a
zero risk premium”. From this it seems that a risk averse investor will only
accept those prospects which offer a positive risk premium. The Markowitz
portfolio theory assumes that investors have utility curves, which are functions
of risk and return. This needs to be explained.
According to Bodie et al (2002:157) “[m]any particular “scoring” systems are
legitimate.” One reasonable function that is commonly employed by financial
theorists and the Chartered Financial Analyst Institute assigns a portfolio with
expected return E(r) and variance σ 2 the following utility score:
U = E (r ) − 0.005 Aσ 2
Where:
[3.10]
U = utility score
A = an index of the investor’s risk aversion
The factor 0.005 is a scaling convention, allowing the use of absolute values.
From the equation it is apparent that the utility score (U) is a function of
expected return and variance. Furthermore it may be said that the effect that
variance has on the utility score is dependent on the value of A. Larger values
of A indicate a greater degree of risk aversion. The utility score derived in this
fashion should be compared to the rate of return offered by risk-free
investments.
28
The following should apply:
•
If U minus rate of return offered by the risk-free investment > 0 the
investor will opt for the risky portfolio.
•
If U minus rate of return offered by the risk-free investment = 0 the
investor should be indifferent towards the two options but by virtue of
the definition of a risk averse investor, the investor should opt for the
risk-free alternative.
•
If U minus rate of return offered by the risk-free investment < 0 the
investor will opt for the risk-free alternative.
3.5. PORTFOLIO CONSTRUCTION
3.5.1 Introduction
It is widely accepted that investors should aim to maximize the level of return
for a given level of risk. Alternatively they aim at minimizing the risk for a given
level of return. This is done by constructing a portfolio of assets which as a
whole is subject to the investor’s risk appetite.
According to Reilly and Brown (2000:259) an investor’s portfolio includes all of
his or her assets and liabilities, not only stocks or marketable securities, but
also items such as houses, cars, antiques etc.
As was noted earlier Corgel et al (2001:149) believe that all investors are risk
averse and therefore the risk-return relationship is positive. It holds true that if
investors were faced with a choice between two assets that promise the same
level of return they would opt for the asset with the lower level of risk. In order
to accept a higher level of risk, investors will demand a higher level of
potential return to compensate them for the higher degree of uncertainty.
When constructing diversified investment portfolios investors should consider
different investments based on their risk and return pay-off structures.
29
Investors should identify their specific investment goals and constraints when
determining their risk appetite.
3.5.2 Constructing the capital market line (CML)
According to Bodie et al (2002:183) the make-up of any portfolio is subject to
decisions being made on one of three levels namely:
•
The capital allocation decision – which refers to the choice investors
need to make between investing in a risk-free asset and a risky asset
portfolio.
•
The asset allocation decision – which describes the distribution of risky
investments across different asset classes. (Construction of the optimal
risky asset portfolio).
•
Security selection decision – which describes the choice of particular
securities held within each asset class.
This section is concerned with the first of these decisions.
For illustration purposes certain assumptions need to be made. It should be
kept in mind that the aim of this section is to find the balance between
investing in a risk-free asset and a risky portfolio. The assumptions are as
follows:
•
The risky portfolio’s composition remains constant throughout the
exercise.
•
The risky portfolio is made up of two assets, namely two mutual funds,
one of which is invested in equities and one which is invested in bonds.
•
The allocation between the two assets in the risky portfolio will be 60%
invested in equities and 40% invested in bonds.
30
•
As it was assumed that the mix between equities and bonds remains
constant, any shift of funds will be from the risky portfolio to the riskfree asset and vice versa.
•
The risky portfolio essentially becomes a risky asset.
•
According to Bodie et al. (2002:186) it is common practice to view TBills as the risk-free asset, this study will comply with this assumption.
The following values will be used for the illustrations, which follow later in this
chapter:
rRA
=
return on the risky asset.
E (rRA )
=
expected return on the risky asset, assumed to be
15%.
σ RA
=
standard deviation of the risky asset, assumed to
be 22%.
rf
=
return on the risk-free asset, assumed to be 7%.
y
=
the portion of the portfolio invested in
asset RA.
c
=
the complete portfolio.
(1 − y )
=
the portion of the portfolio invested in the
risk-free asset (F).
By applying the reasoning and equations discussed in the section on portfolio
return and variance one would be able to calculate the expected return on
portfolio C (the complete portfolio) as follows:
E (rc ) = [y × E (rRA )][(1 − y ) × E (rf )]
[3.11]
= y(15) + (1-y)(7)
= 7 + 8y
From this equation it appears that the base rate of the entire portfolio will be
equal to rf and that the portfolio is expected to earn a risk-premium which is
31
dependent on the position in the risky asset and the risk premium of the risky
portfolio.
From the results of a previous discussion one would be able to calculate the
risk (standard deviation) of the entire portfolio (portfolio C) by using the
following equation:
σ c = yσ RA
[3.12]
When a risky asset and a risk-free asset are combined in a portfolio, the
standard deviation of that portfolio will be a function of the standard deviation
of the risky asset (RA) and its weighting in the portfolio.
The data in the table 3.1 was used to construct the graph depicted in figure
3.2.
Table 3.1
Test Data
Y
Standard Deviation C
E(r) complete
0
0.0
7.0
0.1
2.2
7.8
0.2
4.4
8.6
0.3
6.6
9.4
0.4
8.8
10.2
0.5
11.0
11.0
0.6
13.2
11.8
0.7
15.4
12.6
0.8
17.6
13.4
0.9
19.8
14.2
1
22.0
15.0
Figure 3.2 depicts the relationship between standard deviation (risk) and
expected return for the entire portfolio given different weightings in the risky
asset RA.
32
Figure 3.2
Expected return
The Relationship between Risk and Return
16.0
14.0
12.0
10.0
8.0
6.0
4.0
2.0
0.0
0.0
5.0
10.0
15.0
20.0
25.0
Standard deviation
After determining the Capital Market Line (as depicted in figure 3.2) investors
need to determine the optimum mix between investing in the risky asset (RA)
and the risk-free asset (F).
By assuming three different levels of risk-aversion (A levels), namely five,
three and one, and combining them with the information in table 3.1, one
would be able to calculate the following utility levels (U) (note that equation
3.14 which is used in the calculation of U is discussed elsewhere).
33
Table 3.2
Test Data
Y
0
A=5
7.000
A=3
A=1
7.000
7.000
0.1
7.679
7.727
7.776
0.2
8.116
8.310
8.503
0.3
8.311
8.747
9.182
0.4
8.264
9.038
9.813
0.5
7.975
9.185
10.395
0.6
7.444
9.186
10.929
0.7
6.671
9.043
11.414
0.8
5.656
8.754
11.851
0.9
4.399
8.319
12.240
1
2.900
7.740
12.580
From this it appears that the optimum level of investment in the risky asset
(RA) will differ as the aversion to risk changes. A level of A = 5 denotes the
risk aversion of an investor with a relatively high level of risk aversion, whilst
an A level of 1 denotes the risk-aversion of an investor with a large appetite
for risk.
Based on the data presented in this section it is evident that where A = 5
investors should carry a weighting of approximately 30% in the risky asset
and 70% in the risk-free asset, where A = 3 the optimum weighting should be
approximately 60% in asset RA and 40% in asset F, whilst the weighting for A
= 1 should be 100% in asset RA.
The maximum utility level may be calculated by using the following equation:
MaxU y = E (rc ) − 0.005 Aσ c2 = rf + (y × (E (r p ) − rf ) − 0.005 Ay 2σ p2
[3.13]
34
In order to solve the maximization problem the derivative of the abovementioned expression should be used. This may be written as follows:
y* =
E (r p ) − rf
0.01Aσ p2
[3.14]
By substituting the relevant information into the equation the following
optimum weightings may be calculated:
A=5 :
33.06% in the risky asset.
A=3 :
55.10% in the risky asset.
A=1 :
100% in the risky asset, this investor might even consider using
margin to increase his exposure to the risky asset.
3.5.3 Optimal risky portfolios
3.5.3.1 Diversification
3.5.3.1.1 Definition
Diversification may be defined as an active attempt to manage the
relationship between risk and return. According to Reilly and Brown
(2000:292) diversification aims to reduce the standard deviation of the total
portfolio and this assumes imperfect correlations among securities.
Dobbins et al (1996:12) states that spreading of risk, or diversification, makes
sense, as it removes unique, specific or diversifiable risk.
Dobbins et al (1996:12) furthermore state that diversification is rational, given
the fact that investors should only take part in risks for which they can expect
to be rewarded.
35
3.5.3.1.2 Systematic vs. unsystematic risk
Investors face two types of risk, namely:
•
Systematic risk, and
•
Unsystematic risk.
According to Fischer and Jordan (1983:108) systematic risk or market risk is
the form of risk that affects all comparable investments that are available in
the marketplace. Accordingly this risk cannot be eliminated via diversification.
This risk is also known as non-diversifiable risk. At some point a fully
diversified portfolio will reach the world systematic-risk level. It is at this point
that no further diversification is possible.
Unsystematic risk is caused by factors that are unique to a specific asset or
factors that affect only that specific asset. This risk is diversifiable, and may
be eliminated by acquiring various different assets. The basic reasoning is
that factors that influence one asset, will not necessarily affect other assets in
the same manner. The result of the influence on all the assets should
counteract one another.
Therefore diversification is the process of constructing a portfolio in such a
manner that it contains different types of assets, with the specific aim of
eliminating the risks associated with any individual assets. This entails that
the investor hopes that the variability of the returns on a particular asset will
be offset, to some extent, by the variability of another asset in the portfolio.
36
3.5.3.1.3 Methods of establishing diversification
According to Liberty Life Ltd there are various ways in which a portfolio may
be diversified. These include:
•
Gaining exposure to different asset classes;
•
Gaining exposure to different sectors of a market;
•
Exposure to different entities within the same market sector;
•
Gaining Global exposure; and
•
Exposing the portfolio to different investment styles.
I. Different asset classes
This method of diversification requires that the investor allocates the funds in
his portfolio to different assets, such as stocks, bonds and property. The asset
selection i.e. the selection between stock, bonds, property and so on,
constitutes the first tier of confinement to the investor’s risk preference. The
risk associated with different assets is not the same, for example stocks are
generally more risky than bonds.
Different assets respond differently to the same variables. Equities wouldn’t
necessarily respond in the same manner as bonds to an interest rate change
or some other variable. Ideally assets should be totally autonomous in their
movement and response to influencing factors. This is, unfortunately, rarely
the case, as there tends to be some form of inter-relation between the
movements of different asset classes.
In many ways the remainder of this study will focus on the diversification value
embedded in exposure to different asset classes.
37
II. Different market sectors
In this instance the investor or portfolio manager will aim to invest in different
industries or sectors within a certain market. In their discussion on the Topdown approach to equity valuation Reilly and Brown (2000:440) note that
“alternative industries react to economic changes at different points in the
business cycle.” Therefore exposure to different industries within a market will
lessen the effect of the change of a specific variable.
III. Different entities
By investing in different entities within the same industry investors lessen or
reduce (to an absolute minimum level) the effect of risk associated with a
specific entity, such as financial risk, business risk, etcetera.
IV. Gaining global exposure
According to Reilly and Brown (2000:78) gaining exposure to assets both
locally and internationally “will almost certainly reduce the risk of the portfolio
and can possibly increase its average return.”
V. Exposure to different investment styles
There are various investment styles which will afford the investor the
opportunity of making an investment decision. These include, but are not
limited to:
•
Investment based on fundamental analysis;
•
Growth investing;
•
Value investing;
38
•
Event driven investment; and
•
Investment based on technical analysis.
Gaining exposure to different investment styles eliminates the bias embedded
in a single investment style, which should lead to better investment decisions
and better diversification.
It is nearly impossible for one investor or portfolio manager to master each of
the styles mentioned above. The easiest route to diversification in this way
would be to gain exposure to managed funds which invest by using different
styles.
3.5.4 The effect of diversification on the portfolio
According to Correia (2000:89) “[a]t the time of investment, it is not known
with certainty which investments will succeed and which will fail. It is therefore
sensible to diversify into a number of investments in the expectation that
those which are profitable will at least compensate for the losses sustained
from those that are not.” This effectively means that diversification is the
simplest (though not exact) form of hedging.
Including various assets, with “imperfect correlations” into a portfolio, will allow
the investor to reduce the general level of risk of that portfolio. According to
Francis and Jordan (1983:23) diversification may be defined as the process of
combining securities with less than perfectly correlated returns into a portfolio.
This process serves to eliminate all unique risk from the portfolio. The
standard deviation of a portfolio will eventually reach the level of the market
portfolio, where you will have diversified away all unsystematic risk, but
market or systematic risk will still exist.
39
Figure 3.3
Systematic risk and Unsystematic risk
Source: Farrell (1997:74).
Figure 3.3 graphically illustrates what the effect of diversification is on the
level of risk of the investor’s portfolio.
3.5.4.1 Benefits of diversification
The benefits of diversification include the following:
•
Diversification lessens the effect of a single adverse price movement,
due to the fact that the loss will be offset by the gains made on other
assets.
•
Diversification allows the investor to structure his/her portfolio in such a
manner that it reflects his/her risk profile and allows the investor to plan
his/her financial position.
40
•
It should be mentioned that in order to gain maximum diversification it
is advisable for investors to include assets in their portfolio with
negative or low positive correlations.
3.5.5 Constructing the optimal risky portfolio
The previous section considered the determination of the optimal mix between
the risk-free asset and the ‘optimal’ risky portfolio. This section will consider
the construction of the optimal risky portfolio. After considering the effects of
diversification on a two-asset portfolio, excluding a risk-free asset, a portfolio
which includes a risk-free asset will be constructed and discussed.
3.5.5.1 Two-asset portfolio
For purposes of illustration the following assumptions will be made with
regards to the two-asset portfolio:
•
The portfolio will consist of an equity portion (E) and a debt portion (D).
•
The equity asset has an E (re ) (expected return) of 13% and a
σ e (standard deviation) of 20%.
•
The debt asset has an E (rd ) (expected return) of 8% and a σ e
(standard deviation) of 12%.
•
The covariance of the assets is 72.
•
The correlation coefficient ( ρ ) is 0.30.
The following table was generated using the equations for calculating the
portfolio’s expected return (equation 3.9) as well as its standard deviation
(equations 3.5 and 3.6).
41
Table 3.3
Standard deviation for a given correlation
Wd
We
E(r) portfolio Correlation = -1 Correlation = 0 Correlation = 0.30 Correlation = 1
0% 100%
13.00%
20.00
20.00
20.00
20.00
10% 90%
12.50%
16.80
18.04
18.40
19.20
20% 80%
12.00%
13.60
16.18
16.88
18.40
30% 70%
11.50%
10.40
14.46
15.47
17.60
40% 60%
11.00%
7.20
12.92
14.20
16.80
50% 50%
10.50%
4.00
11.66
13.11
16.00
60% 40%
10.00%
0.80
10.76
12.26
15.20
70% 30%
9.50%
2.40
10.32
11.70
14.40
80% 20%
9.00%
5.60
10.40
11.45
13.60
90% 10%
8.50%
8.80
10.98
11.56
12.80
100% 0%
8.00%
12.00
12.00
12.00
12.00
Of table 3.3 it may be said that the following weightings are the optimum
weightings for the given correlation:
Correlation = -1
:
Approximately 60% debt and 40% equity.
Correlation = 0
:
Approximately 70% debt and 30% equity.
Correlation = 0.30
:
Approximately 80% debt and 20% equity.
Determining the minimum variance portfolio weighting, may be done by using
the following equation:
Wmin ( Asset d) =
σ e2 − Cov de
σ d2 + σ e2 − 2Cov de
Wmin ( Asset e) = (1 - Wmin ( Asset d))
[3.15]
[3.16]
42
Solving the minimization problem through the use of these equations yields
the following optimum weightings given the correlation:
Correlation = -1
:
Approximately 62.5% debt and 37.5% equity.
Correlation = 0
:
Approximately 73.53% debt and 26.47% equity.
Correlation = 0.30
:
Approximately 82% debt and 18% equity.
Figure 3.4
Expected return of the portfolio
Return
15.00%
10.00%
5.00%
0.00%
0
1
2
3
4
5
6
7
8
9
10
Return 8.00% 8.50% 9.00% 9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00%
Equity Weighting
Figure 3.4 is a graphical representation of the expected return on the total
portfolio, given different weightings in the two assets.
Figure 3.5
Standard deviation of the portfolio
Standard deviation
25.00%
20.00%
Correlation = -1
15.00%
Correlation = 0
Correlation = 0.3
10.00%
Correlation = 1
5.00%
0.00%
0
1
2
3
4
5
6
7
8
9
10
Weight in equity
43
Figure 3.5 illustrates the standard deviation of the complete portfolio for
different weightings in the assets. As can be seen from the figure the
portfolio’s standard deviation is minimized where the portfolio consists of 40%
equity investments and 60% debt investments.
Figure 3.6
Efficient frontiers given different correlations
14.00%
12.00%
Correlation = -1
10.00%
Correlation = 0
8.00%
Correlation = 0.3
6.00%
Correlation = 1
4.00%
2.00%
0.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Figure 3.6 combines the information in the previous two graphs. This new
graph allows the investor to target those portfolios that will provide the highest
level of return for a given level of risk or alternatively those portfolios that
provide the lowest level of risk for a given level of return. These conclusions
imply that the graph illustrated in figure 3.6 represents the Markowitz efficient
frontier.
3.5.6 Constructing complete portfolios
In practice investors aren’t faced with the simple problem of deciding to invest
in either the risky portfolio or the risk-free asset, under normal circumstances
they will have to construct the optimal risky portfolio and combine it with the
risk-free asset to construct a complete portfolio.
44
According to Bodie et al. (2002:218) the risky portfolio opportunity set with the
highest feasible risk-return payoff will form a tangent with the CML (derived in
section 3.5.2). The objective of this exercise will be to find the invested weight
in equity and debt (see section 3.5.4) that will result in the maximum slope of
the CML.
The problem of determining the weighting between bonds and equities may
be solved using the following mathematical procedure. (Note that the same
assumptions with regard to the expected return, variance and covariance of
debt and equity as mentioned in section 3.5.4 will be used in this section of
the text). The assumption is made that the risk-free asset will yield a return of
5%.
The objective function will be:
Max S p =
Where:
E (r p ) − rf
σp
[3.17]
S p = the slope of the CML
The following equation should be used to calculate the risky-portfolio’s
expected return:
E ( r p ) = W d E ( rd ) + W e E ( re )
[3.18]
E (r p ) = W d 8 + W e 13
The variance of the portfolio may be calculated by using the following
equation:
2
σ port
= [W d2σ d2 + W e2σ e2 ] + 2[W d W eσ d σ e ρ de ]
[3.19]
2
σ port
= [W d2 144 + W e2 400 ] + 2[W d W e 240 ρ de ]
45
The weight assigned to the debt portion of the portfolio may be calculated as
follows:
Wd =
[E (rd ) − rf ]× σ e2 − [E (re ) − rf ]× Cov de
[E (rd ) − rf ]× σ e2 + [E (re ) − rf ]× σ d2 − [(E (rd ) − rf ) + (E (re ) − rf )]× Cov de
[3.20]
Substituting the relevant data into equation 3.24 yields that the optimal risky
portfolio will have a debt weighting of 40% and an equity weighting of 60%.
Solving the maximization equation results in a S p of 0.42.
The investor’s complete portfolio (i.e. consisting of a mix between the risky
and risk-free assets) will be a function of his/her risk aversion. The function
(equation 3.24) for solving the complete portfolio’s weighting problem is given
below:
y* =
E (r p ) − rf
0.01Aσ p2
[3.21]
Assuming a risk aversion coefficient of A = 3 and A = 5 results in the following
answers for the mix of the complete portfolio:
A=3 :
Percentage invested in risky portfolio = 99.19% (D = 39.67%
and E = 59.52%)
Percentage invested in the risk-free asset = 100% - 99.19% =
0.18%.
A=5 :
Percentage invested in risky portfolio = 59.51% (D = 23.8%
and E = 35.71%)
Percentage invested in the risk-free asset = 100% - 59.51% =
40.49%.
46
From the above-mentioned analysis it follows that investors have different
levels of risk aversion, and therefore the asset allocation decision is unique to
each individual investor. Specifically factors such as the utility score of the
investor and his/her level of risk tolerance are the main determinants of the
optimal asset mix. What should be noted further is that return objectives
should be considered in conjunction with risk tolerance.
3.6 SUMMARY
This chapter builds on chapter 2, in that it considers the key concepts of
effective portfolio construction, namely:
•
Risk;
•
Return; and
•
Diversification.
This section identified variance and standard deviation as the appropriate
measures of risk to be used in an investment environment. The sector also
underlines the fact that portfolio risk isn’t simply a function of the weighted
standard deviations or variances of the individual assets used in the portfolio,
but that the co-movement of the assets’ returns (measured via covariance and
correlation) played an integral part of measuring portfolio risk.
From this section it followed that the combination of assets with low positive or
negative correlations, with the assets in the existing portfolio, provided the
highest degree of portfolio diversification.
Apart from identifying the appropriate measurement ‘tools’ for risk, the chapter
identified various potential sources of risk. In general the chapter identifies
two major components of risk, namely systematic and unsystematic risk.
The chapter also introduced various methods that may be used to diversify
existing portfolios. These methods included amongst others spreading funds
47
between different asset classes and using different management or
investment styles when constructing a portfolio.
In terms of return the chapter provided ‘tools’ to measure the returns on both
individual assets and portfolios.
Lastly the chapter provided a practical application of the theories discussed in
this and the previous chapter.
48
CHAPTER 4: IDENTIFICATION OF ALTERNATIVE
INVESTMENTS
4.1 INTRODUCTION
Following the discussion in Chapter 2 surrounding the various benefits and
requirements for diversification of investment portfolios the rest of the study
will aim to identify and study the diversification benefits of including alternative
investments in the investor’s portfolio.
The objective of this chapter is to identify various alternative investments. The
alternative investment universe is an extensive one and therefore the focus of
this chapter will be on the more prominent alternative assets. The assets
below are by no means the only alternative assets that investors might
consider for investment purposes. The chapter will first consider the definition
of an investment. Secondly the different categories of alternative investments
will be identified including definitions and explanations of the different assets
which fall under each of the different categories. In conclusion the chapter will
aim to identify generic factors which might assist the investor when identifying
assets for inclusion in his/her portfolio.
4.2 DEFINING AN INVESTMENT
In order to identify alternative assets it is important to define investments.
Mayo (1997:12) distinguishes between two forms of investments namely:
•
Economic investments: These investments refer to the purchase of a
physical asset that will result in an increase of productive assets. Mayo
relates this to a transaction made in the primary market. An example
would be where a company sells shares to the public for the first time,
known as an initial public offering (IPO). As the sale of shares during
49
the IPO will result in an increase in productive assets in the form of
cash, this is an economic investment.
•
General investments: When individuals or corporate investors invest in
stocks or bonds this generally doesn’t influence the level of productive
assets. These are investments made with the objective of storing and
hopefully increasing value. Acquisitions of these assets are made in
secondary markets. The investor utilizes these investments with the
intent of transferring purchasing power into the future.
Hull (2002:40) distinguishes between two types of assets, namely:
•
Investment assets, which refer to those assets which are held solely for
investment purposes by a significant number of investors. These
include assets such as stocks and bonds.
•
Consumption assets, which are assets held primarily for consumption.
These include commodities such as oil and copper.
4.3 DEFINING ALTERNATIVE INVESTMENT INSTRUMENTS
Alternative investment instruments could be defined as those instruments that
offer alternative investment opportunities to those offered by traditional
financial instruments such as stocks and bonds, whilst at the same time
serving largely the same purpose as traditional investment vehicles, which
includes the preserving and transferring of wealth and purchasing power into
the future. This causes alternative investment instruments to fall under the
category of general investments in terms of Mayo’s classification. Alternative
investments may take on many forms ranging from hedge funds to antiques.
The focus of this study will be on physical assets (“hard assets”) that are
traded in secondary markets. In this text the term alternative asset and hard
asset will be used interchangeably unless specified otherwise.
50
4.4 ALTERNATIVE INVESTMENT CATEGORIES
The study places an alternative investment asset into one of four categories
which, together with the basis for the divisions, are listed and explained
below.
•
Antiques
This category includes various different assets, as will be discussed in
a later part of the chapter, with age being the common denominator
between the various assets and the determination of their value. The
South African Antiques Dealers’ Association (SAADA) defines an
antique as being an item which is more than 100 years old. This
definition is accepted in terms of international trade.
•
Collectables
This category includes assets which are desirable due to factors such
as rarity, desirability and importance (provenance). These assets aren’t
antiques but are expected to appreciate in value.
•
Art
Art in itself is difficult to define. Shah Jahan, who studied the theories of
the philosopher Baruch Spinoza, defines art as any human creation
which contains an idea other than its utilitarian purpose. Art, as a hard
asset class, includes various assets ranging from paintings and
sculptures to photographs and drawings.
•
General
This category includes all those assets which do not fall into one of the
categories mentioned above but whose values are expected to
increase over time.
51
4.5 ANTIQUES
4.5.1 Definition of an antique
As mentioned earlier it is accepted by the international community that
antiques include all those assets which are at least 100 years old. The
following section will look at the various assets which have been identified as
falling under this category (South African Antiques Dealers’ Association
(SAADA) 2000).
4.5.2 Furniture
Antique furniture is amongst the most popular and practical collectable items.
The antique furniture galaxy consists mainly of items such as tables, chairs,
writing desks, cabinets, bookcases and travelling chests, with samples from
England, Europe (in particular French furniture) and China being the most
significant. In recent times Cape Dutch furniture has also come to the forefront
as being very desirable for investment purposes (SAADA 2000).
Antique furniture of English origin is most sought after by investors and
collectors. English furniture may be subdivided into different periods each with
its
own
unique
characteristics.
These
include
(British
Broadcasting
Corporation (BBC) 2001):
•
Tudor
1485 – 1558
•
Elizabethan
1558 – 1603
•
Jacobean
1603 – 1689
•
William and Mary
1689 – 1702
•
Queen Anne
1702 – 1727
•
Georgian
1727 – 1820
•
Regency
1800 –1830
•
Victorian
1837 – 1901
52
According to Duthy (1986:113) there have been major buyers of 18th century
English furniture for two main reasons:
•
The insufficient supply of American 18th century furniture to
satisfy demand has led to a rise in investor interest in English
antique furniture.
•
English furniture is often more elegant and better made.
French furniture may be sub-divided into the following periods (BBC 2001):
•
Louis XIV
1643 – 1715
•
Louis XV
1715 – 1754
•
Louis XVI
1754 – 1789
•
The Directorate
1789 – 1799
•
First Consul
1799 – 1804
•
Napoleon I
1804 – 1815 (First empire)
•
Louis XVIII
1815 – 1824
•
Charles X
1824 – 1830
•
Louis Philippe
1830 – 1848
•
Louis Napoleon
1848 – 1852 (President)
•
Louis Napoleon III 1852 – 1871 (Second Empire)
Chinese furniture may be sub-divided into two main categories:
•
Ming
1368 - 1644
•
Qing
1644 – 1911
Some of the advantages of antique furniture include the fact that there is such
a wide array of objects to choose from and that most of the objects may be
used for functional as well as display purposes. Objects range in size from
small to large and are generally movable. Well constructed and preserved
articles command relatively low levels of maintenance.
53
The fact that these objects are movable brings with it the possibility of theft
and as a result investors should insure themselves against this possibility.
Wear and tear due to repeated or unusual use may detract from the value of
these items when using them for purposes other than display.
“The Antique Collectors’ Club in England has published an annual review of
the prices of antique furniture” (Fiske and Freeman 2003 [on-line]) known as
the Antique Furniture Price Index (AFPI). Since its inception in 1968 the AFPI
has outperformed most traditional investments including real estate and stock
markets. The following table indicates the comparative growth figures for
various investments.
Table 4.1
Performance of the AFPI versus various other assets*
1968
1988
2000
Stock Market
100
675
1 900
Antique Furniture
100
2 185
3 350
Residential property
100
1 550
2 850
Basket of groceries
100
605
1 000
*Please note that the data pertains to the UK market.
Source: Fiske J and Freeman L.
From the table it is clear that antique furniture outperformed the stock market
and inflation (as represented by the basket of groceries) as well as residential
property. Even though these figures seem to be very promising, Fiske et al
warns that higher transaction costs associated with investments in furniture as
well as liquidity constraints render investment in antique furniture long-term
investments.
In a subsequent article termed “The 2002 Antique Furniture Price Index” Fiske
et al notes that during 2001 the AFPI has shown a remarkable out
performance of all the investments listed above. As an example Early Walnut
Furniture (Queen Anne to George II) increased by 9% from 2000 to 2001, this
54
followed a rise of 19% from 1999 to 2000. It is interesting to note that during
its entire existence the AFPI only had one sustained fall from 2 600 to a level
of 2 300 during the 5-year period between 1990 and 1995.
In his comment on the performance of the AFPI during 2001, John Andrews,
creator of the AFPI, indicates that increases in prices during that year were
negatively affected by events such as the 9/11 attacks and the subsequent
absence of American buyers (lower demand) from the markets.
According to the South African Antiques Dealers’ Association (SAADA) the
two most important factors to keep in mind when buying investment antique
furniture is quality and authenticity.
4.5.3 Military memorabilia
This category of antiques includes a wide range of items including objects
such as (BBC 2001):
•
Antique swords;
•
Old uniforms;
•
Medallions;
•
Archery objects such as bows and arrows;
•
Axes; and
•
Shields.
Items falling within the scope of this category derive their value from their
historical significance. The art of war and warfare forms an integral part of the
history of humankind and therefore these items have a certain degree of
international appeal. Certain items, however, do have great appeal to
investors/collectors from specific regions, such as America, Great Britain and
Europe.
55
It may be said that other drivers of value include decoration, provenance and
importance of the piece being considered.
These objects range from large to small and may be movable and storable
depending on the specific assets. Most objects no longer serve their primary
purpose and therefore are of little value as far as functionality is concerned,
on the other hand they are perfectly suited for display purposes. As is the
case with antique furniture, well-preserved and looked after articles command
minimal maintenance.
An obvious disadvantage of these objects is the fact that they might be
dangerous if not stored and displayed properly, this results in an added
responsibility for the investor to ensure the safety of third parties.
4.5.4 Clocks and watches
The watch as we know it today has undergone an extended evolution,
beginning with articles such as sundials and continuing its evolution on an ongoing basis. Antique clocks and watches constitute a large proportion of this
evolution and therefore they hold substantial historic significance. Because of
their historic importance and man’s fascination with time and general
aesthetic attributes, clocks and watches tend to be highly popular and sought
after amongst collectors (North 2000).
Clocks and watches as antique categories are made up of numerous subdivisions including mantel clocks, pocket watches, water clocks, sandglasses
and tall case clocks (grandfather clocks). The British and other European
nations, such as the French, were the main pioneers in the development of
time measurement and therefore clocks originating from these regions are
very popular collectors items.
Timepieces may be divided into various categories, some of which were
mentioned earlier. The following identifies, lists these categories as well as
56
the names of some of the most significant manufacturers for each of the
categories (Clemens von Halem, Halem-times [on-line]):
•
Wrist watches
:
Patek Philippe, Rolex, Omega, Vacheron &
Constantin,
Cartier,
IWC
(International
Watch Company), Movado, Longines, TAG
Heuer, Breitling.
•
Pocket watches
:
Durrstein & Co., IWC, Longines, Patek
Philippe, Thomas Russel and Son, Ulysse
Nardin and A. Lange & Sohne.
•
Clocks
:
Movado, Lepaute and Prazisionregulator Le
Roy.
•
Chronometers
As a general rule clocks are movable and easily stored and this together with
the fact that they are highly popular results in clocks and watches being one
of the better alternative investment categories. The fact that antique clocks
and watches appeal to a broad base of buyers, ranging from investors and
specialist collectors to the general public, lends a certain degree of liquidity to
them which is found only in a few other categories. There are various designs
available which makes them more popular and increases their visual appeal.
Working examples add a functional element to these assets which together
with their visual qualities enhance the investability of the category.
Because of their desirability investors should insure them adequately against
eventualities such as theft. Buying a clock that is not in a working condition,
with the aim of restoring it, or repairing a clock that has broken down might be
relatively expensive as expert knowledge and workmanship will be required in
such instances (Phillips 1998).
57
4.5.5 Ceramics
According to the British Broadcasting Corporation (BBC) ceramics may be
sub-divided into two main categories, namely, pottery and porcelain. The BBC
furthermore states that porcelain tends to be highly prized and therefore it is
more valuable than pottery.
One of the major risks associated with investment in ceramics is forgery or the
inability to guarantee authenticity. This is especially true if the investor uses
only the maker’s mark to determine authenticity, as many “factories copied
each other’s marks to make their products more desirable” (BBC 2003). On
their website the BBC identifies size, age, rarity, decorative appeal and
condition as the main determinants of value.
Some of the most desirable ceramic pieces are those manufactured by the
Chinese, Japanese, English and Dutch producers. With regard to Chinese
porcelain the most significant pieces are those produced during the Ming and
Qing dynasties. China started producing porcelain as early as the Tang
dynasty (618AD – 906AD) and up until the late Ming period (1368AD –
1644AD) European producers weren’t able to match the quality of Chinese
porcelain. This gave rise to a large import demand from European customers.
“According to legend, the first Japanese porcelain was made in 1616”
(BBC:2003). These pieces have a strong Chinese influence but are
characterized by distinctive use of colours and patterns.
English porcelain can be sub-divided into early and later pieces, the earlier
pieces being characterized by their simplistic designs and inferior quality to
Chinese and Japanese specimens. Later pieces are identifiable based on
their colourful and decorative designs, often providing a “fascinating visual
record of the major events and personalities of the Victorian age” (BBC 2003).
Some of the most prominent manufacturers of English ceramics include
Staffordshire, Chelsea, Bow, Bristol, Worchester and Derby.
58
From a South African point of view the blue and white Dutch porcelain, known
as Delft, holds a significant historical value, especially for investors who are of
Dutch decent.
4.5.6 Glass
Glass objects may adopt various forms including decanters, drinking glasses,
bowls and even paperweights. According to the BBC the major determinants
of value include rarity, shape of the piece, colour and decoration.
There are various types of collectable glass including soda glass, potash and
lead glass. Decorations may also adopt various forms including cutting,
enamelling, fire enamelling, cold enamelling, gilding, engraving and acid
etching.
One of the major risks involved in investing in glass is the possibility of
counterfeiting, and prospective investors should specialize and educate
themselves prior to investing in glass objects.
4.5.7 Books
Investing and collecting antique and rare books appeals to a wide audience.
Books are universal “mascots” of development and therefore they hold a very
prominent historical significance.
First edition books are the most collectable and sought after but other factors
also have a bearing on the desirability and ultimately the value of a book.
These factors include condition, provenance of the book, the importance of
the book as well as whether the book has been autographed by the author
(BBC 2001).
59
One of the major benefits associated with books is certainly the fact that they
have both local, and in many instances international appeal. Books are given
their size, transferable and relatively easy to store.
An obvious disadvantage of investing in books is the possibility of damage
caused by extensive usage and improper storage.
4.5.8 Silver and metalware
The range of items produced by using silver is seemingly endless, such items
include among others:
•
Teapots, chocolate pots and coffee pots;
•
Mugs and jugs;
•
Caddies and coasters;
•
Salvers and Trays;
•
Flatware (knives, forks and spoons); and
•
Candlesticks.
One of the main concerns for the serious silver collector is whether or not an
item was manufactured from silver or if it is in fact a plated item. Even though
silver-plated antiques are highly desirable and collectables in their own right
they tend to command lower prices than similar items manufactured from
sterling silver.
England introduced a silver standard in 1300 after it became apparent that
pure silver was unworkably soft. According to this standard silver objects had
to be tested and marked to ensure that they contained at least 92.25% silver.
The marks have become invaluable tools for investors/collectors to determine
the origin and age of silver items.
60
Collectors/investors distinguish between four marks namely, the:
•
Sterling guarantee mark (all items which consists of 92.25% silver are
termed sterling).
•
Town mark.
•
Date letters.
•
Maker’s mark.
The patina of silver objects, caused by various scratches and knocks, will
most definitely affect the value of the piece. Repolishing silver objects may
render them undesirable and worthless.
Investors/collectors should also be aware of silver “substitutes” such as
Sheffield Plate (made from a fusion between copper and silver), Electroplate
(a technique used to cover a base metal with a thin layer of silver via electrodisposition). These alternatives, as was mentioned earlier, may also provide
the investor/collector with good value, but are usually ‘cheaper’ than sterling
items.
Items made from other metals may also be collectable. These metals include
pewter, brass, copper, Sheffield plate and electroplate. One of the potential
pitfalls of investing/collecting unmarked objects (which is often the case for
other metals) is dating and the investor should have a good understanding
and knowledge of the particular item he/she is considering.
According to TIAS.com certain factors need to be considered by collectors of
metalware be it silver or another alternative. These factors include the
following:
•
Due
to
the
number
of
niche
segments
in
silver
collecting,
investors/collectors are urged to choose a maker, style or era in which
to specialize.
61
•
Collectors are advised to mix-and-match items with different designs
and innovations as this will lend more aesthetic appeal to the collecting
often increasing the level of enjoyment (emotional dividend) drawn
from the collection.
•
Collectors should not refrain from investing/collecting items that show
signs of natural use, as it often enriches the patina of the piece.
•
Investors should be on the lookout for modified items as they often
have little investment value.
4.5.9 Firearms
The invention of the modern firearm has great historical significance as this
invention and the subsequent developments made to the original creation are
responsible for bringing about an entire revolution in the art of warfare.
Throughout its history development of the firearm had very definite objectives
including the ability to fire with great rapidity without constant reloading,
safety, durability and ease of use. These distinct objectives gave rise to the
continuous and on-going development of firearms throughout history (The
History Channel 2004).
Initial designs, especially related to the ignition mechanism, were expensive to
implement. Examples of this include the use of wheel-lock rifles and flintlock
rifles. The cost of production, in addition to strict laws governing the use of
guns ensured that guns, were rare and ownership concentrated to a select
few, the likes of which included Heads of State, royalty and the rich minority.
From the previous paragraph it follows that firearms derive their value from
factors such as rarity, historical significance, condition and to a certain extent
decoration (guns were often tailor-made and customized to suit the needs of
the owner).
62
As a general rule firearms are moveable objects which may be easily
transferred between parties. There are, however, various drawbacks related
to collecting and investing in firearms, these include the existence of various
laws and regulations governing the ownership and use of firearms as well as
the inherent danger associated with objects of this nature.
4.5.10 Musical instruments
Musical
instruments,
especially
antique
instruments,
offer
the
investor/collector the opportunity to own a piece of history that not only offers
the possibility of capital appreciation but also immeasurable pleasure from
playing it.
Some of the most sought after musical instruments are most certainly pianos,
guitars and violins.
According to Peter Davis (2002) of Lona’s Pianos in Midrand the five most
prominent names in piano manufacturing are Bosendorfer, Julius Bluthner, C
Bechestein, DH Baldwin and Steinway & Sons.
According to Lona Davis (2002) “there is an excellent market in SA for antique
pianos, and that every Rand spent on restoring an antique piano adds at least
R2 to R3 to its value.”
“[V]intage guitars are reaping big dollars as collectors' items, creating a whole
new trade in classic instruments.” (Slack:2003). According to Charles Slack
(2003) larger more ornate guitars and pre-world war II guitars are some of the
most valuable and most suited for investment. The most prominent guitar
brands include Martin, Gibson and Fender.
The main drivers of value in the case of musical instruments are most
certainly the maker/manufacturer, quality of the materials used (for example
63
the type of wood), quality of the craftsmanship, condition of the piece and
originality (with no modifications).
4.6 COLLECTABLES
4.6.1 Defining collectables
Collectables may be defined as assets that derive value from their inherent
rarity. Terms such as “limited edition”, “one of a kind” are familiar expressions
used to describe those assets which form part of this group of alternative
assets. In economic terms collectables have value because there is a limited
supply and a great demand for the asset, but one has to keep in mind the fact
that unquantifiable factors such as emotional or historical significance will
ultimately determine whether or not an asset is collectable. Good examples of
collectables are certain toys (the He-Man and Thundercat ranges are
currently very collectable), autographs, records and comic books.
4.6.2 Stamps
Stamps have always been popular among collectors, with many collecting
from an early age. There are thousands of different stamps to be collected
from various countries and regions.
The fact that many people collect stamps may afford the investor some
degree of liquidity, whilst the sizes of these items allow them to be easily
stored and transferred between parties.
Due to the large variety of stamps that are available the investor needs to
specialise within a certain area of collecting. Stamps are normally unique to a
specific country or region. Investors might find that a stamp isn’t in demand in
regions or countries other than that of its origin.
64
One of the potential problems with stamp collecting is the fact that its appeal
as a hobby in on the decline. The love for stamps is generally “learned” from
an early age and therfore modern developments such as computer games,
the Internet and television have resulted in a lack of interest in stamps.
4.6.3 Toys
According to The Guardian (2001) “[r]are and collectable toys have been
going for record prices over the last decade or so, as the toy market has really
taken off.”
According to the BBC, collectors of toys tend to specialize in a particular area
such as clockwork toys, robots or cars, or in toys produced by a specific
maker.
Collectable toys were mainly manufactured from one of the following
materials:
•
Lead. Used in the production of various soldiers and other toys dating
from the 18th and 19th century. (BBC:2003)
•
Die-cast. First produced in 1910 in France. Currently Dinky Toys,
manufactured in England by the Meccano Co., are some of the most
collectable toys.
•
Wood. Used as the primary material for some of the earliest toys.
•
Celluloid. Used to produce toys prior to the discovery of plastic.
•
Tinplate. Used to produce toys during the late 19th and early 20th
centuries. Most tinplate toys represent icons of the industrial revolution,
especially developments in transport such as trains, planes and
automobiles.
65
4.6.3.1 Wood and die-cast toys
These toys tend to be less sophisticated than toys made from other materials.
Wooden toys in particular have a certain naivety to them. German
manufacturers produced wooden toys in quantity during the 19th and 20th
centuries, and some of the most collectable wooden toys were produced in
America by manufacturers such as the Schoenhut Company.
Toy soldiers from the 18th and 19th century were made from lead using either
solid or hollow-cast manufacturing techniques. The most valuable of these
were manufactured by firms such as Lucotte, Heyde and William Britain.
The market for die-cast toys was dominated by Dinky toys, with rare Dinky toy
advertising vans or unusual series being very valuable.
4.6.3.2 Dolls
Collectors of dolls categorize them “according to the medium of the head”.
(BBC 2003) These mediums include wood, bisque, composition and fabrics.
The value of a doll may be increased by its wardrobe or costume (original
costumes command the highest prices).
During the 19th and 20th centuries the art of doll making was changed by the
discovery of various manufacturing techniques such as rag, parian, celluloid,
wax, papier-mâché, plastic and vinyl. Collectors often opt to concentrate on
one particular sort of doll i.e. wooden dolls, plastic dolls or rag dolls.
Dolls needn’t be old in order to be collectable. Limited edition dolls of ranges
such as Barbie or Sindy are not only collectable but very desirable.
66
4.6.3.3 Bears
The earliest Teddy bears were manufactured in the beginning of the 20th
century by the German company Steiff. Early examples by well-known makers
are the most valuable, with Steiff bears remaining “the most valuable of all
teddies because of their unique historical appeal and exceptionally high
quality”. (BBC 2003)
The Guardian (2001) points out that the main determinants of value for
collectable toys are the maker, the rarity of the particular model and condition.
Toys which are still in their original packaging also tend to command higher
prices than similar toys without the packaging. According to ToyNutz (2003)
collectors are willing to pay premiums of between 5% and 40% for toys in their
original packaging.
Toys are collectable because they have a certain nostalgic value. Collectors
collect toys ranging from dolls to model cars. These items tend to be small in
size rendering them easy to store and transfer between collectors or
investors. A major advantage of toys as an alternative investment class is
the fact that many people are oblivious to the fact that they own a collectable
or valuable toy, thus the investor is afforded the opportunity to acquire toys at
discount prices. Many collectable toys aren’t very old and as such investors
may be able to find bargains at informal markets such as a garage sale.
The fact that these items draw some of their value from an emotional element
may affect the desirability of the asset in as much as toys from certain time
periods will be more significant to one age group than another. In addition to
the fact that toys may only appeal to certain age groups the collector/investor
needs a keen understanding of the toy market and specialized knowledge of
particular toys. Investors/collectors should also be wary of counterfeit toys.
Toys in general tend to acquire value over the longer-term, as toys are usually
readily available initially, they only start to appreciate in value once the
number of specimens in good condition has been significantly reduced.
67
4.6.4 Sports memorabilia
Sport plays a very important role in the modern society. It serves as a central
point of interest bringing together a diverse group of people. In the past few
decades most forms of sport lost their amateur status and became
professional and even corporate activities, bringing with it a high degree of
interest and commercialism. Many people idolise sportsmen and women, and
therefore they are willing to pay large amounts of money to own significant
pieces of sport history. This demand led to the creation of the sport
memorabilia market.
The number of assets falling under this category is seemingly endless ranging
across various sport disciplines. They may hold international appeal, such as
a autographed shirt worn by Michael Jordan or a autographed helmet of
Ayrton Senna or Michael Schumacher, or they may have only local appeal
such as a rugby or soccer jersey signed by some local team.
Assets from those sports which are played on an international level will
provide the investor with universally accepted investments. Sports that would
form part of this section of the market includes the following:
•
Tennis;
•
Soccer;
•
Athletics (particularly the Olympic games); and
•
International motor sports (Formula 1 and Le Mans).
Assets falling under this category tend to be movable and transferable over
international borders. If chosen correctly certain assets might afford a high
degree of liquidity to the investor. It would seem that authentic assets
autographed by the relevant sport personality command higher prices than
those authentic assets which do not bear an autograph.
Investing in local assets will definitely limit the liquidity that the investor may
expect from the investment. Investors should be on the lookout for
68
reproductions or fake assets. Some assets may only have short-lived
investment potential as they form part of a craze or fad, but soon lose their
appeal.
4.6.5 Precious stones
Investing in, or collecting precious stones could be very rewarding in both
emotional and economic terms. The stones form part of the world’s natural
resources and it is safe to assume that these stones are available in limited
quantities. As more and more resources are depleted the more valuable the
stones become, as demand increases and supply remains constant. The cost
of mining precious stones also increases as mines have to go deeper to find
more stones, this increased cost will be factored into the prices of gemstones,
thus increasing their value.
Gems are normally easily transferable and sought after across the globe. The
fact that they hold international value means that the investor has a much
larger market than would be the case for some or other alternative asset with
limited international appeal. Investors should, however, have a specialised
knowledge regarding precious stones but likely there are numerous
information resources available to them.
“[P]rices are dependent on the type, colour, quality and size of the stone”
(Gemworld 2003) Some of the most important gemstones include diamonds,
rubies, emeralds, sapphires and opals. Gemstones should appeal to investors
especially because they are portable, transferable and take up very little
space.
4.6.6 Cars
In many societies the car that you drive affords you some form of social
status, and because of this rare cars are very sought-after. Well known
69
brands such as Porsche, Ferrari, Lamborghini and Lotus are always in high
demand.
An interesting phenomenon has started to emerge in the South African new
car market, where the supply of certain models is controlled by
manufacturers, which in turn leads to transactions in the used car market
being completed at higher prices than those quoted in the primary market. For
example in March 2003 the listed price of a BMW M3 Coupe was R536 000
whilst 2002 models were selling for between R500 000 and R600 000
(wheels24.com, BMW and Autotrader.co.za:2003). Similarly a Mercedes-Benz
SL 500 Convertible had a March 2003 list price of R1 325 000 whilst a similar
car was selling for R1 600 000 in the used car market. Most manufacturers of
luxury vehicles tend to employ a waiting list system whereby a customer will
order a vehicle and be placed on a waiting list, a sort of first-come-first served
system. Waiting periods range from a few months to a number of years, which
allows pro-active investors to generate attractive returns.
Rare vehicles such as certain Porsches, Ferrari’s and Aston Martins will
always offer some form of return on investment, but these makes tend to
demand high capital investments and as such only a select few investors are
able to use them for investment purposes. The emergence of the waiting list
system discussed in the previous paragraph opens this investment category
to a larger investor base.
One of the biggest advantages of investing in cars is the availability of
information. At any one time there will be a number of comparable cars for
sale, allowing the investor to assess whether or not the car is a worthwhile
asset or not.
70
4.6.7 Oriental rugs
Oriental rugs have always been regarded as investments, with many high net
worth individuals purchasing rugs. In recent times, however, investors shied
away from rugs as the market became oversupplied.
Oriental rugs are categorized by their place of origin or the tribe that
manufactured them. The difference between rugs from different tribes or parts
of the world often lies in the distinctive use of colours, patterns, motifs and
weaves (De Araujo 2003).
From a valuation point of view factors such as size, richness of colours,
fineness of knots, intricacy of design and condition play vital roles. According
to De Araujo (2003:7) collectable rugs should be handmade and proof thereof
will ultimately enhance intrinsic value.
4.6.8 Autographs
This category of alternative investments is very similar to that of sport
memorabilia. The demand for certain autographs will decline if they form part
of a fad, whilst some autographs will always be highly sought after such as a
James Dean or Elvis Presley autograph.
Autographs, like sport memorabilia, may have international appeal or only
local appeal depending on the person whose autograph is involved.
Autographs that
hold international appeal tend to be those of major
international musicians, film stars, sports men and women and heads of state.
Again autographs are storable, transferable and if chosen correctly may be
relatively liquid.
71
4.6.9 Wine
In his article “Collecting vs. Investing” James Laube (1997) warns of a
difference between wine collection and investing in wine. According to Laube
a wine collector buys wine with the primary purpose of drinking it at some
point in time. Investing on the other hand, according to Laube, is to buy wine
with the primary purpose of generating a profit. Laube points out that in order
to be a successful wine investor one needs to be able to estimate the future of
the economy, because “when times are good, people spend on fancy wines”.
This emphasizes the fact that the investor should be able to estimate the
future economic performance, but in addition to this the investor should also
be able to foresee which wines will be in demand during the next market
boom. Laube recommends that any wine investor should hold a balanced
portfolio of wines comprising of those wines which he/she expects to perform
well during the next market run, balanced/hedged by holding “blue chip” wines
such as Bordeaux, vintage Port and California Cabernets. Lastly Laube is of
the opinion that one of the major obstacles for any wine investor is that of
emotional attachment to an investment.
According to The Guardian (2001) “wine investment is [within] the reach of
many ordinary investors” this is because ordinary investors are able to acquire
quality wines at reasonable prices.
The wine market is followed by various investors and collectors and is
therefore a global market. Liquidity in the market is created by the existence
of global wine exchanges such as Uvine, allowing a broad base of buyers and
sellers to transact with one another. Uvine operates like most financial
markets where investors are able to obtain bid-and-ask prices.
On their website the Chateaux Management Group (2003) states “the fine
wine market presents a vast untapped source of investment potential.” They
further state that fine wines often outperform traditional investments such as
bonds and equities, and that the negative correlation that fine wines seem to
72
have
with
more
traditional
investments,
should
improve
portfolio
diversification.
Dunbar Fine Wines echo CMG’s general observation that fine wines provide
exciting investment and diversification possibilities. Dunbar (2003) states that
“[w]ine appreciates in value because it is constantly being consumed.” From
this it follows that the value of a fine wine should increase because of a limited
supply, resulting in a higher level of equilibrium between demand and supply.
Lawrence Hayward and Partners (2003) are of the opinion that investments in
Fine Clarets hold the following advantages:
•
Growth should continue to develop as a result of increased
international demand and limited supply.
•
“Investment in fine Claret tends to be unaffected by unpredictable
events or fluctuating world economies.”
It may be said that these advantages would also apply to all other fine wine
investments.
According to Stephen Reiss (2003) various factors will have an influence on
the quality of the wine. Amongst others the following should be considered as
being very important:
•
Climate. Changes in temperature and rainfall will result in differences in
the final products of various estates.
•
Soil. Tends to remain constant over time.
•
Age of the vines. As time passes vines produce less, but more intense,
fruit.
•
Genetics of the vines. Tends to remain constant over time.
•
Skill of the wine maker. The level of skill of different winemakers will
vary.
73
As was mentioned earlier the demand for wine is a very important determinant
of value. It has to be said that value is also a function of quality, which is
ultimately determined by the above-mentioned factors. Reiss (2003) also
points out that New World Wine prices are primarily determined by demand,
which is often influenced by trends and fads amongst consumers.
From this discussion the following may be identified as some of the
advantages of wine investments:
•
Investors are able to construct personalized portfolios, which take into
account risk-aversion and the expectations of the individual;
•
Investors are able to acquire a tangible asset;
•
Wines are generally transferable between investors and have
international appeal;
•
Wine markets are established with auctions being the primary medium
for trade;
•
There are various tax benefits associated with wine investments
especially as far as capital gains tax is concerned; and
•
The asset may be consumed if expected returns are not realised.
The following are some of the disadvantages or risks of investing in wine:
•
The value of the wine will be adversely affected if it isn’t properly
cellared;
•
Wines may be overpriced upon purchase. This is usually the case
where the price was driven up based on current trends and
speculation;
•
Certain costs need to be considered that may detract from the returns
realized on the investment, these costs include commissions,
insurance and storage costs; and
•
The market is to a large extent unregulated and therefore vulnerable to
abuse.
74
Recent developments in the wine market include the development of wine
futures, where investors are able to purchase wine prior to it being bottled
(Uvine 2004). In terms of these contracts the investor will purchase the
finished product before the grapes are actually harvested. This strategy may
prove to be very profitable, but it is also very risky.
4.6.10 Rare, collectable and bullion coins
“For many years, financial consultants have been advising their clients to hold
coins. Their reasoning is simple: rare coins have been known to be an eventempered and reliable investing tool because coin values seem to keep pace
with other investing classes such as stocks, bonds, funds, and real estate.”
(Wyman:2003)
Investing in coins may be subdivided into three subsections namely, investing
in numismatic coins, investing in semi-numismatic coins and investing in
bullion coins. The focus of this discussion will be on numismatic coins and
bullion coins, as semi-numismatic coins hold little value other than their
collectable value.
4.6.10.1 Numismatic coins
Numismatic coins are legal tender coins that were minted decades ago and
now exist in very limited supply (Searll:2003). From this it seems that these
coins may be antique coins or collectable coins that derive value from
amongst others rarity, age, condition and beauty (Goldfinger.com 2003). The
actual value of the metallic content of the coins is not the primary determinant
of value.
75
From a South African investor’s perspective some of the most sought after
and valuable coins, according to the South African Antiques Dealers’
Association (SAADA), include:
•
1926 Farthing or “oortjie”;
•
1931 Tickey or threepenny;
•
1899 Gold pound of the old Zuid-Afrikaansche Republiek; and
•
“Veldponde” minted in mining workshops.
4.6.10.2 Bullion coins
According to Goldfingercoins.com (2003) a bullion coin is a legal tender coin
whose current market price depends on its [metallic] content, rather than its
rarity or face value. Gold and silver tend to be the most common metals used
to produce these bullion coins.
Some of the most well-known and collected bullion coins include the following:
•
U.S. Gold Eagles;
•
Canadian Maple Leaves;
•
Australian Kangaroos;
•
S.A. Kruger Rands; and
•
Austrian Philharmonics.
Some of the major advantages associated with bullion coins include the
following: (Goldfinger.com:2003)
•
Coins are produced in standard sizes based on their gold/silver
content. Some of the more common sizes include 1oz., 0.5oz., and
0.25oz. and 0.1oz;
•
Coins are accepted and traded on a global basis;
•
Bullion coins are easy to liquidate, especially in comparison with
numismatic coins; and
76
•
Afford the investor the opportunity to gain exposure to gold investments
via alternative routes than acquiring gold bars or ingots.
4.6.10.3 Kruger Rands
As part of the investigation into the possible benefits of investing in alternative
assets, a portfolio which includes a Kruger Rand investment will be
constructed in a later chapter and therefore a further investigation into the
history and characteristics of Kruger Rands is warranted.
“The South African Kruger Rand was first released in 1967. For the first 20
years of its existence, it dominated the gold bullion market, and is still the
most widely held gold coin in the world today.” (Goldfinger.com:2003)
According to the South African coin dealer, InvestGold, the value of a Kruger
Rand is determined by three factors namely:
•
The gold content of the coin and more specifically the current gold
price;
•
The current exchange rate (important for South African investors); and
•
The discount/premium used to determine the bid-ask spread.
According to InvestGold dealers quote bid-prices at a discount of
between 3% and 6% of the current gold price multiplied by the
prevailing exchange rate whilst quoting ask-prices at premiums of
between 3% and 6%.
4.7. ART
It is almost an impossible task to accurately define the term “art” - one man’s
“heap of rubble” is another man’s “masterpiece”. According to kamprint.com
(2003) art captures the deepest aesthetic and cultural qualities, and acquires
77
tangible investment value as a source of these qualities. The allure of
investing in art, as is the case with most other alternative investments, was
most certainly increased via the use of mass media and films. Investing in art
is portrayed as being exclusive and sophisticated. The truth of the matter is
that “speculating in the art market has ruined many more investors than it has
enriched” (kamprint.com:2003). One example of speculation in the art market
and the detrimental effects thereof is that of Mr. Ryoei Saito, who bought a
Van Gogh and a Renoir for $161 million, during the asset inflation of the
1980’s. The pieces were later disposed of by his creditors at a third of their
purchase price. (New York Times:1999)
Examples such as this should not distract from investors considering art as a
viable investment alternative but should serve as a warning. Investing in art
demands that the investor should spend time studying the field before making
any decisions. Some of the main “drivers” of value in the art markets are
authenticity, condition, provenance, familiarity, technique and importance.
In his article titled “Art and Money: Perfect Together” Uhlfelder (2003) states
that “[m]any retail investors might have a hard time getting used to the idea
that anything as hoity-toity as art can be a good investment. But museumquality fine art is a legitimate asset class. So much so, that some brokerages
have added fine art services to their private banking operations.”
Uhlfelder (2003) cites the example of the Monet painting titled Nympheas as a
success story in terms of art investments. This 1906 painting was purchased
at a Sotheby’s auction in 1960 at a price of $50 000, in 1999 it was sold in
New York for a sum of $22.6 million. This resulted in an average return per
annum of 17%, outperforming the S&P 500 by an average of 4.5% per annum
during that period. Uhlfelder warns that art is by no means immune to the
“vagaries” of the economic cycle, citing that the same Monet painting sold
three years later at the price of $18.7 million – a decline of 6% per year (still
outperforming the S&P 500 during the same period).
78
According to Michael Moses, associate professor at the Stern School of
Business at NYU, art auctioned since 1960 has outperformed the broad equity
market
and
with
little
correlation
with
stocks.
Moses
warns
that
investors/collectors of art can expect greater degrees of volatility than is the
case for other asset classes, but adds that the low correlation with equities
make art investments suited for diversification purposes.
Art may take on many forms including paintings, sculpture, drawings and
photographs The development of technology has given rise to artists
expressing themselves in various electronic formats such as DVD and video.
Art investors should apply basic investment principles to their art portfolio
namely balancing the portfolio and ensuring that the risk profile is of such a
nature that the investor’s entire portfolio (art and other investments) suits
his/her risk appetite. As is the case for most asset classes art investments
cater for a wide range of risk appetites. According to Bisaria “[i]f you invest a
part of your total art investments in some young contemporary artists’ works,
the risk is heavier, though the reward too may be higher later. You must
balance these investments with buying some old masters’ works which will
always appreciate in value.”
The price of art, as is the case for any other investment, is determined by the
basic forces of demand and supply. What is unique, however, to the art
market is that the supply side is limited, especially in the case of a deceased
artist. If the investor gives careful consideration to the value drivers in the art
market and adheres to them he/she is almost certain to reap the benefits. It is
suggested that investors take a medium-to-long-term view with regard to art
investments.
79
4.8 GENERAL
4.8.1 Containers
According
to
the
South
African
Tank
Container
Association
(www.satca.co.za:2003) the stainless steel tank container industry, which
operates internationally, is a growing and stable industry. By mid 2001 the
industry had 150 000 units in use and it was expected to show growth of
approximately 7.5% per annum.
According to International Tank Containers Pty (Ltd) (2003:4) investors
purchase tanks through leasing companies such as Intertank. The company
takes delivery and ownership of the tank on behalf of the investor. The
container then forms part of a larger tank container pool. Any income
generated by the pool of containers is distributed amongst the investors in
proportion to the number of tanks owned. This ensures that even though a
specific tank may be out of operation for a period of time, investors still realize
returns. Returns are denominated in US Dollars (paid to South African
investors in Rands at the prevailing exchange rate) and as such these
investments offer a Rand-hedge to South African clients.
One of the major benefits of this investment is the fact that various companies
specialize in financing and managing tank containers on behalf of the
investor. In addition to this it is not uncommon to realize a return of 10% in
Dollar terms before tax incentives (www.satca.co.za 2003) making this a
viable investment alternative for those investors seeking to hedge against the
Rand by means other than investing in the stock market.
Intertank (2003:5) lists the following as potential benefits of tank container
investments:
•
Locally funded investment;
•
Dollar based asset;
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•
No limitation on the number of tanks that may be purchased;
•
No Reserve Bank or Revenue authorization required;
•
Income earned in a basket of currencies, converted to Dollars;
•
All earnings can be retained offshore and freely dealt with;
•
Tax efficiency; and
•
A hedge against adverse Rand movements.
De Araujo (2003:23) identifies the following as possible constraints of tank
container investments:
•
Sudden strengthening of the Rand may affect investors who opt to
convert proceeds to Rand;
•
Various inherent costs such as repair and maintenance costs, as well
as finance charges; and
•
Possibility of cheaper tanks being produced in the future.
4.8.2 Racehorses
“For many adventurous investors, a racehorse investment combines the
excitement of a thrilling hobby with the very real possibility of making a profit.”
(CNNMoney.com:2001)
Racehorses as investments differ from other alternative investments in that
they pose the possibility of producing a periodic income stream for the owner
as well as capital appreciation. Periodic income takes the form of winnings
received from entering track events, whilst the bloodlines of thoroughbreds
result in the horse appreciating in value as it poses the possibility of breeding
future champions.
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Investing in racehorses may take on various forms including the following:
•
Owning a racehorse. This may take the form of an individual owning a
horse but according to CNNMoney (2001) partnerships are becoming
increasingly popular.
•
Owning breeding stock. May also take the form of individual ownership
or syndicated ownership.
•
Pin hooking, which involves buying and selling thoroughbreds in a
similar manner to trading stocks.
Tony Cobitz (2001), racehorse expert, concedes that it is true that investing in
racehorses is speculative when compared to more traditional investment
vehicles, according to Cobitz one major piece of common-sense advice can
make it all worthwhile: Only invest disposable income.
Racehorse investments pose some unique risks including the possibility of the
horse becoming sick or being injured bringing its career and therefore
earnings potential to a premature end.
4.8.3 Investing in people (Justin Wilson)
Recently an up-and-coming racecar driver, Justin Wilson, created an
interesting investment scheme which would allow investors to invest in his
career and performances as a Formula One driver. The following extract
indicates the basis on which investors were able to invest in Justin Wilson.
“The potential return for investors is in two stages, and of course will be
dependent on Justin’s success. The first stage is for investors to double their
money, and this may be paid out after three years and once sufficient capital
has accrued in Justin Wilson plc, which will receive all income related to his
activities as a motor racing driver. Justin will be limited to a personal income
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of £50,000 in 2003, £75,000 in 2004, £100,000 in 2005 and thereafter index
linked until investors have received double their investment.
Once this has been achieved, the second stage is for investors to be
collectively entitled to 10% of all Justin Wilson plc’s income until 2012.”
(Investinwilson.com:2002)
This is an example in which the investing public was given the opportunity to
gain exposure to an “investment” that derives its value from factors other than
economic conditions and company performance. It is also a very good
example of how an alternative investment was made more accessible by
combining it with a traditional investment (that being the company). If this
scheme is successful one might expect to see more athletes creating such
companies.
4.9. GENERIC FACTORS TO CONSIDER
The ultimate objective for any investor is to derive a return on investment that
will compensate him/her for sacrificing current money for future consumption.
When analysing more traditional assets such as stock and bonds there are
certain criteria to which these assets must conform before they are
considered to be investments. The same “rule” applies to hard assets, even
though the factors which are to be considered differ greatly from those of
more traditional assets. The following discussion will study each of the factors
which were identified.
4.9.1 Authenticity
Authenticity refers to the originality of the piece, and as mentioned earlier, one
of the greatest risks involved in investing in hard assets is most definitely
forgery.
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Authenticity also extends further than the mere determination of originality,
according to Kamprint.com (2003) “[w]orkshop practices in times and places
which valued originality less than we do today also play a part in evaluating
authenticity, as it was often customary for masters to sign works actually
made by their students or employees.” Discovering that a painting thought to
be the work of an old master is actually that of one of his students will most
certainly result in a significant drop in value of the asset.
4.9.2 Condition
From the discussion on different alternative investments it should be evident
that the condition of the asset tends to be one of the major determinants of
value for numerous alternative investments.
Under normal circumstances an asset in perfect original condition will
command the highest possible price, however, investors should keep in mind
that in certain instances, such as antique furniture, the result of normal wear
and tear may increase the value of the asset as it increases the premium
placed on the patina of the asset.
According to Kamprint.com (2003) “[d]efects provide opportunity for
investment profit if the cost of the item plus the cost of competent restoration
is much less than the current market value of the item in fine condition.”
4.9.3 Rarity
Many alternative investments, especially those resorting under the category of
collectables, derive their value from the fact that supply of the specific asset is
limited and the demand for the specific asset is substantial.
Supply may be limited in an “artificial” manner via the introduction of limited
edition or limited production of a specified asset, or supply may become
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limited as a result of the natural consumption of an asset. The latter form of
supply “manipulation” necessitates a medium to long-term investment horizon
for alternative assets. Kamprint.com (2003) points out that “the investment
opportunity consists of buying when [assets] are plentiful and holding them
until they become rare.”
As was seen in the discussion on investing in cars it became apparent that
the fact that producers/manufacturers limited availability/supply resulted in the
possibility of realizing short-term profits.
4.9.4 Provenance
Provenance basically refers to the ownership history of a particular asset.
Collectors/investors are normally willing to pay a premium for an asset that
has been owned by a prominent figure such as a celebrity.
4.9.5 Familiarity
As a general rule people are attracted to those assets with which they are
familiar, mass media and rise to prominence of the Internet has led to an
increase in investor education as far as their knowledge of investments are
concerned.
Names such as Van Goch, Bordeaux and Ferrari are household names and
as such the investor base as well as research base on these and other
familiar assets are automatically increased.
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4.9.6 Importance of the asset
Importance of an asset refers to its historical significance, specifically the
influence that the asset, or development thereof, might have had on
subsequent asset and technical innovations brought about by the asset.
4.9.7 Technique/workmanship
It is evident that quality of an asset, together with supply/demand, is one of
the key value determinants of alternative investments. The quality of a
manufactured product/asset can be directly related to the skill of the creator or
the techniques used in the manufacturing process.
Investors/collectors are, under normal circumstances, willing to pay a
premium for assets of superior quality.
According to kamprint.com (2003) “technical wizardry in the absence of
aesthetic appeal does not bring a high price.”
4.9.7 Buying what you like
Investors/collectors are generally advised to purchase only those hard assets
in which they have an interest or those they particularly fancy. The reasons for
this are multiple.
•
Firstly, hard assets do not provide the investor with a periodic income
stream such as dividends or coupon payments, instead they provide
“periodic income” in the form of emotional dividends and as such the
investor should buy those assets which will afford him/her with the best
emotional dividends.
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•
Secondly, should the value of the asset decrease dramatically the
investor will still have an asset which he/she fancies.
4.10. ADVANTAGES AND DISADVANTAGES OF INVESTING IN
ALTERNATIVE INVESTMENTS
On his website www.goodbyedebthellowealth.com (2003) Karl Green
identifies the following advantages and disadvantages of investing in hard
assets.
4.10.1 Advantages
•
Hard assets are often considered inflation hedges as well as hedges
against bear markets. From a South African point of view various hard
assets act as Rand hedges as the majority of demand for hard assets
comes from the UK and US markets.
•
Various hard assets have “inherent appeal beyond their monetary
value, which can result in a sales premium.” (Green:2003) As a general
rule creating or preserving wealth via the use of hard assets/alternative
investments is done via capital appreciation, only in exceptional cases
do these investments provide periodic incomes such as dividends or
rent, however, in most cases they provide “emotional dividends” to the
owner for which investors would be willing to pay a premium. These
emotional dividends take various forms such as the enjoyment of a fine
wine and the status of owning a prized piece of art.
•
They have potential for appreciation. It is, however, important that the
investor should consider those factors that will have a bearing on the
value of the asset.
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•
Some are liquid. Many hard assets are traded via dealers, auctions or
even exchanges (precious metals) and as such they offer investors
some form of liquidity. The lack of liquidity in some of the assets may
be attributed to the low level of supply, current owners may be reluctant
to sell their prized possessions. The increased use of the Internet to
transact has created a market and also market liquidity for various
collectables, antiques and hard assets. Many professional collectors
believe that prices quoted on sites such as eBay.com give a true
reflection of the value of an asset. According to Harry Rinker “If you
want to see what something is really worth, go on eBay, check some
sales. That’s what your stuff is really worth.” The Internet has increased
the supply side of the value determination equation resulting in prices
dropping by some margin to reflect their “true” value. The researcher is
of the opinion that in the long run this added liquidity will be beneficial
as investors will be able to purchase and sell assets at fair values.
4.10.2 Disadvantages
•
Hard assets do not generate current income. As mentioned earlier
return on these assets takes the form of capital appreciation and
emotional dividends in most instances.
•
Value is based on subjective criteria and qualified experts are required
for valuation.
•
Vital information used in the determination of the value of most
alternative investments is limited. This may be attributed to the fact that
these investments are traded in various markets ranging from
exchange traded market and OTC-markets (precious metals) to fairs
(antiques fairs).
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•
They may be subject to significant decreases in value. Current market
moods and fads may leave the investor with an undesirable specimen,
this characteristic does, however, extend to more traditional markets as
well, one only needs to consider the bursting of the Information
Technology bubble in the late 90’s. Again the importance of taking into
consideration future expectations as well as value determinants are of
the utmost importance for successful investments.
•
It may be difficult to ascertain the authenticity of hard assets.
Authenticity is most definitely one of the major determinants of value
for most hard/alternative assets.
•
The nature of the market is such that investors often purchase the
assets in the retail market, and sell them in the wholesale market. This
might lead to investors not realizing the true potential of their
investments. Another factor to be considered is the fact that dealers
charge high commissions. This is not always the case but depends on
the asset chosen.
•
Investors have to contend with the fact that a large volume of these
assets is sold via auction and therefore they will be bidding for
specimens against industry professionals. This is, however, not always
the case. Purchasing assets via an auction might result in acquiring
valuable assets at discounted prices especially if the private investor
visits smaller auctions.
•
Another constraint of investing in art is that of theft, which brings in its
wake the additional cost of insuring the assets.
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4.11 SUMMARY
This chapter served as a review of the numerous assets that may be
considered alternative investments. The term alternative investment may be
used to describe various types of unusual investments ranging from hedge
funds to antiques. This chapter identifies an alternative asset as being a hard
asset, i.e. an asset with physical features.
This chapter aimed to provide a definition for the term alternative asset (as
used in the context of this study). The definition provided in this chapter is a
modified rendition of the basic definition used to define investments in their
broadest sense.
Apart from reviewing various asset types, the chapter subdivides the assets
into one of four groups, each with its own unique characteristics. These
groups include:
•
Antiques;
•
Collectibles;
•
Art; and
•
General.
Following the discussion on each of the asset types the chapter aimed to
identify a set of factors which influence the value, and hence the performance
of these assets in general. This set of factors included factors such as
authenticity, provenance and quality of materials used.
Lastly the chapter identified various advantages and disadvantages of
investing in alternative assets, coming to the conclusion that the major
drawbacks of these assets are their illiquid nature, and the fact that investors
need in-depth knowledge with regards to a specific asset or asset type.
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CHAPTER 5: EFFICIENT MARKETS AND ALTERNATIVE
INVESTMENTS
5.1. INTRODUCTION
The study necessitates a discussion pertaining to the markets in which
alternative assets are traded. It is assumed that ‘traditional investments’ such
as stocks and bonds are traded on organized, ‘efficient’ and developed
markets, but this doesn’t necessarily apply to alternative investments.
The first section of this chapter will define the term market, identify those
characteristics that may be associated with a good market, and review and
discuss the efficient market hypothesis (EMH). The second section of this
chapter will identify the common characteristics of the alternative investment
markets, compare the identified characteristics to those of a good market and
lastly discuss the efficiency of alternative markets with reference to the EMH.
5.2. DEFINING A MARKET
Reilly and Brown (2000:107) define a market as the means through which
buyers and sellers are brought together to aid in the transfer of goods and/or
services. They go on to identify certain key elements of this definition, namely:
•
The existence of a market isn’t dependent on the existence of a
physical location;
•
The market doesn’t necessarily own the goods and services being
transferred; and
•
A market’s operations aren’t limited to one specific product or service.
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In the South African setting one is able to identify various ‘official’ markets,
these include:
The money market –
“[t]he money market is defined as that part of the
financial market which deals in instruments with
maturities ranging from one day to one year…”
(Goodspeed 2003:41)
The equity market –
“[t]he equity market is part of the capital market.
Capital markets are markets in which institutions,
corporations, companies and governments raise
long-term funds to finance capital investments and
expansion projects.” (Goodspeed 2003:47)
The FX market –
“[t]he foreign exchange market [FX] is the financial
market where currencies are bought and sold.”
(Goodspeed 2003:36)
Bond market –
the bond market falls under the capital market.
Derivative market –
the derivative market refers to a market where
instruments, which derive their value from the
“prices”
(Goodspeed
2003:53)
of
underlying
assets, are traded.
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5.3. CHARACTERISTICS OF GOOD MARKETS
In their discussion of the organization and functioning of security markets,
Reilly and Brown (2000:107) identify the following factors that characterise a
good market:
•
Availability of information. Investors entering the market aim to do so at
a price justified by prevailing supply and demand. This requires
information which is timely and accurate, information on past
transactions and current factors such as outstanding bids and offers.
•
Liquidity. This refers to the ability to buy and sell assets quickly and at
a known price.
•
Low transaction costs. Lower transaction costs make markets more
efficient.
•
External or informational efficiency. Refers to the market’s ability to
accurately reflect all the information with regards to supply and demand
factors in the asset price.
The availability of information, as a characteristic of a good market, implies
that there are various sources of information available, that there is an interest
in the ‘business’ of the asset and that a sufficient number of investors follow
the performance of the asset thereby creating a need for information.
As was stated earlier the requirement of liquidity refers to the ability of
investors to realize their assets quickly and at a known price. According to
Radcliffe (1982:6) the ability to sell an asset quickly is also referred to as
marketability, and even though it is a necessary condition for liquidity, it is, in
itself, not a sufficient condition. The second premise for liquidity of assets is
that of price continuity, i.e. the assurance that prices wouldn’t change much
from one transaction to another, unless substantial information has been
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made available. Price continuity is affected by market depth which refers to
the number of market participants who are willing to buy and sell the asset at
prices above or below the current market price.
5.4. EFFICIENT MARKETS
The following section will consider the Efficient Market Hypothesis (EMH). In
order to assist the reader in the understanding of the EMH, this section will
consider the assumptions which are made with regard to efficient markets.
These are (Stevenson and Jennings 1976:303):
•
A large number of competing, profit-maximizing participants analyze
and value securities independently;
•
New information regarding securities comes to the market in a random
fashion;
•
Competing investors attempt to adjust security prices rapidly to reflect
the effect of new information; and
•
The expected returns implicit in the current price of the security should
reflect its risk.
5.5. THE EFFICIENT MARKET HYPOTHESIS (EMH)
According to Dobbins, Witt and Fielding (1994:16) “[t]he EMH suggests that
share prices fully reflect all available information, any new or shock
information being immediately incorporated into the share price.” This
definition of the EMH may be adapted to encompass all assets (not just
shares) which are traded in efficient markets.
The EMH evolved from Eugene Fama’s PhD dissertation (1960) in which he
argued that in an active market with informed participants, assets will be
priced in a manner which reflects available information on the asset.
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"An 'efficient' market is defined as a market where there are large numbers of
rational profit-maximizers actively competing, with each trying to predict future
market values of individual securities, and where important current information
is almost freely available to all participants. In an efficient market, competition
among the many intelligent participants leads to a situation where, at any
point in time, actual prices of individual securities already reflect the effects of
information based both on events that have already occurred and on events
which, as of now, the market expects to take place in the future. In other
words, in an efficient market at any point in time the actual price of a security
will be a good estimate of its intrinsic value." (Fama 1965)
The EMH may take on one of three forms namely:
•
Weak;
•
Semi-strong; and
•
Strong.
5.5.1 Weak form EMH
“Weak form tests of the EMH are concerned with the extent to which share
prices can be used to predict future prices, and a great deal of evidence
suggests that the historic series of prices cannot predict future prices.”
(Dobbins et al 1994:17) “Successive price changes are independent. Any
implications from historic events for future share prices are reflected in today’s
price.” (Dobbins et al 1994:69)
From this it follows that this form of the EMH implies that the study of past
information in the evaluation of investment opportunities will not have any
relationship with future price movements, and as such investors who rely on
historic information to perform asset analyses won’t experience superior
returns.
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The fact, however, remains that past information may be used to a certain
extent in order to determine the perceived risk/return characteristics of an
asset.
5.5.2 Semi-strong form EMH
Semi-strong form tests attempt to measure the extent to which share prices
fully react to publicly available information relating to stock splits, earnings
announcements, forecasts and large block trades. (Dobbins et al 1994:17)
Prices adjust instantaneously to such new information as is contained in
earnings announcements, stock splits, dividend announcements and large
block trades. It is therefore not possible to use such public information to
make excess returns. (Dobbins et al 1994:70)
This form of the EMH encompasses the weak form of the EMH. According to
Fischer and Jordan (1983:454) the hypothesis implies that investors who base
their decisions on important new information after it is public should not derive
above-average profits from their transactions because the security price will
already reflect all such public information.
5.5.3 Strong-form EMH
Dobbins et al (1994:17) states that “strong form EMH tests are designed to
discover whether share prices reflect all information, even information which is
not available to the public.”
This form of the EMH encompasses both the weak and the semi-strong form
of the hypothesis. It argues that no investor should be able to outperform the
market even if he/she has access to ‘privileged’ information.
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Implied in this form of the EMH is the fact that investors will not be
compensated for risk in excess of the market risk, underlining the importance
of effective portfolio management and diversification.
5.5.4 Implications of the EMH
The EMH has various implications for individual and professional investors, on
various fronts of their investment activity, ranging from implications on
technical analysis to fundamental analysis.
The main focus of this study is the area of portfolio management and
therefore the focus of this section will be on the implication of the EMH on
portfolio management.
One of the most significant implications of the EMH on portfolio management
is the premise that the market rewards only unavoidable risks. This implies
that investors and portfolio managers should not expect to earn returns for
taking risks which may be diversified away.
According to Stevenson and Jennings (1976:312) the EMH implies that
investors should follow a passive portfolio management strategy. Money
managers struggle to out-perform the general market on a consistent basis,
they reason that these money managers employ superior and inferior
analysts, whose “recommendation-performance” often neutralizes each other.
Reilly et al. (2000:250) suggest that money managers who have access to
analysts with superior analytical abilities and unique insights should follow
these analysts’ recommendations. More importantly they recommend that
money managers who do not have access to superior analysts should
construct their portfolios to comply with their clients’ risk preferences, diversify
their portfolio completely and minimize transaction costs. This implies that the
average individual investor should also construct his/ her portfolio based on
these guidelines.
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5.6. EXISTING MARKETS
This section will discuss existing markets such as the equity and bond market
with reference to the characteristics of a good and efficient market as
discussed above. The section will sub-divide existing markets into ‘traditional
markets’ and ‘semi-traditional markets’ the difference will become apparent
upon further discussion. In the last part of this section the efficiency of
alternative markets will be considered.
5.6.1 Bond and equity markets
Both equity markets and bond markets may be classified under the term
traditional markets. The following are some of the identifiable characteristics
of these markets:
•
These markets are highly competitive, that is, there are numerous
institutional and individual investors who participate in the market, each
investor believing that he/she will be able to outperform the overall
market.
•
“They have access to a great deal of information, such as economic
forecasts, stockbrokers’ reports, newspaper articles, investment
advisory services and company reports, and they have the current
market price of all quoted securities and have access to past price
movements.” (Dobbins et al 1994:17)
•
According to Dobbins et al. (1994:16) investors can expect that “[i]n
such highly competitive and well-informed markets” prices will fully
reflect all available information and that prices will adjust quickly to new
or shock information.
If these characteristics of ‘traditional’ markets were compared to the
requirements of an efficient market, one would be able to conclude that these
traditional markets are highly efficient. Therefore at the very least the semi-
98
strong form of the EMH applies to equity and bond markets. According to
Dobbins et al (1994:17) there is a host of evidence that supports the belief
that equity and bond markets subscribe to the strong form of the EMH.
5.6.2 Real estate markets
The real estate market may be classified as a ‘semi-traditional’ market,
because even though it is a very active market, it isn’t quite as developed as
the ‘traditional markets’. Some of the prominent characteristics of this market
and the assets traded in the market, are listed below (Viruly 2000:1-3):
•
Large individual values. Direct property investments require large
capital investments, which tends to concentrate the ownership of
property investments in the hands of high net-worth individuals and
institutions.
•
Not a standardized investment. No two properties are exactly the same
and as such their value will not be determined on exactly the same set
of factors.
•
Can be improved by active management. The investor has the ability to
improve the performance of the property by taking certain actions, this
isn’t the case for assets traded in the ‘traditional’ markets.
•
Information tends to be poor. Property market information tends to be
imperfect, and “[t]he price at which transactions take place is not
always made public.”
•
No organized market. There is no centralized market which handles
transactions in this market.
Developments in the property market such as the introduction of property unit
trusts (PUT’s) and property loan stock companies (PLS’) have introduced
some liquidity and formality into the market. The direct property market,
however, remains to a large extent ‘unorganised’.
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Upon comparing the characteristics of the property market to the
requirements of efficient markets it becomes evident that this market
subscribes, at most, to the semi-strong form of the EMH. Even though there
might be numerous competing investors who participate in the market, Viruly
(2000:1) states that information and the flow of information within the market
tends to be poor. From this one is able to deduce that investors with superior
sources of information should be able to make superior investments based on
that information, one might go as far as saying that, if the flow of public
information regarding a specific property investment is sufficiently inefficient,
investors who have timely access to information in the public realm might be
able to use public information to make superior investment decisions. One
would still expect prices to change and react to information, but the reaction
might be delayed.
5.7. ALTERNATIVE INVESTMENT MARKETS
5.7.1 Defining alternative investment markets
Alternative investment markets refer to those markets where alternative
investments (as identified in the second chapter of the paper) are traded
between buyers and sellers.
5.7.2 Are alternative markets good markets?
In order to successfully answer the question as to whether or not alternative
markets are good markets one needs to discuss the characteristics of these
alternative markets with reference to the characteristics of good markets as
identified earlier.
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5.7.2.1 Availability of information
One of the characteristics of a good market is the availability of information
regarding the assets traded in that market. As was seen previously this
necessitates that various sources of information be available and that there is
sufficient interest in the asset. The investigations of this study into the
alternative investment arena make it apparent that information isn’t readily
available in the public sphere; even historical performance figures are very
difficult to obtain.
Alternative markets tend to comply with this requirement of a good market in
varying degrees. For example the development of wine exchanges such as
Uvine is an indication of the rapid development of that market. Wine and wine
investments are widely followed by various investors/collectors. On the other
hand various alternative investments are less popular for investors/collectors.
It would be safe to assume that the importance of familiarity of the asset
should not be underestimated, the conclusion may be made that the more
specialized the asset becomes, the less the following of that asset will
become.
The second premise of availability of information is that of the existence of a
number of sources of information. Again alternative markets comply with this
requirement in varying degrees, as indicated by the investigations of this
study. It should be said that the existence and development of the Internet
has placed a wide selection of information at the fingertips of investors,
resulting in the increased flow of information in these markets. The
assumption that the more specialized the asset becomes the less information
and sources of information are available seems to hold true.
5.7.2.2 Liquidity
The requirement of liquidity has two facets, namely marketability and price
continuity.
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Marketability is the ability to sell/buy an asset quickly and at a known price. In
popular markets the ability to sell/buy an asset should not pose a problem to
the investor/collector and the further development of exchanges for alternative
investments should only improve the situation.
One of the most prominent problems for most alternative investments is the
lack of price continuity. This lack of price continuity may be attributed to
various factors including the fact that some of the value of alternative
investments is determined by unquantifiable elements such as emotions and
the allure of status. Another contributor to this characteristic of alternative
investments is the fact that a large number of assets are sold via auction and
therefore various factors, other than the perceived value of the asset, may
influence the price, such factors include, for example, the number of people in
attendance during the auction and the publication of advertisements prior to
the commencement of the auction.
The researcher is of the opinion that the lack of liquidity in the alternative
markets isn’t necessarily determined by the demand side of the market, but
may also be influenced by the supply side, i.e. holders of alternative assets
are reluctant to sell them even if a large demand exists. This statement should
help in explaining the price premium commanded due to the rarity of a specific
asset.
5.7.2.3 Transaction costs
A good market is characterized by, amongst others, the ability of its
participants to transact at low costs. Unfortunately assets transacted in the
alternative markets are subject to high transaction costs, in many instances as
much as “30%” (Fiske and Freeman 2001).
The fact that transaction costs are high should not discourage the investor to
consider these assets as alternative investment opportunities, but it should
102
lead the investors to consider alternative investments as being medium to
long-term investments.
As the markets for these alternative investments start to develop and the
popularity for investors increase, transaction costs will start to decline,
increasing the allure of these investments.
5.7.2.4 Informational efficiency
Informational efficiency refers to the market’s ability to accurately reflect all
information with regard to the current demand and supply of an asset.
Essentially alternative markets are ‘unexplored’ territory for investors
(especially institutional investors). The flow of information is insufficient (at the
best of times) and in many instances non-existent. From this one should be
able to deduce that investors with timely access to information regarding
alternative assets should be in a position to make investments that will yield
superior returns.
5.7.3 Are alternative markets efficient markets?
To what form of the EMH does alternative investments subscribe and what is
the implication thereof?
From the discussion on the characteristics of alternative markets various
aspects such as the flow and availability of information in alternative markets
suggests that most alternative markets subscribe to the weak form of the
EMH even though there are certain exclusions to this, such as the wine
market which, in the opinion of the researcher, subscribes to the semi-strong
form of the EMH.
The implication of this statement is far reaching and may in itself explain the
allure that alternative investments hold for investors. The major implication for
103
investors is that they would be able to derive superior returns on the back of
timely public information in those markets which subscribe to the weak form of
the EMH and superior returns on the back of privileged or insider information
in those markets which subscribe to the semi-strong form of the EMH.
5.8. CONCLUSION
The discussion in this section reinforces the importance of proper portfolio
diversification. The researcher is of the opinion that the inclusion of alternative
investments into a portfolio may result in a greater degree of diversification.
From this section and previous sections it follows that the drivers of value
differ between ‘traditional’ and alternative assets. This may result in low
positive or even negative correlations between the returns on alternative
assets and the returns on traditional assets. If this proves to be true then the
inclusion of alternative assets into existing diversified portfolios may prove to
be beneficial.
5.9 SUMMARY
This chapter briefly considers the concept of a market, identifying some of the
characteristics of good or efficient markets. Following this the chapter
considers the Efficient Market Hypothesis (EMH) in each of its three forms,
that being the weak, semi-strong and strong form.
The chapter also considers some of the characteristics of markets that are
generally perceived to be ‘traditional’ and efficient markets, including the stock
market and the bond market.
Lastly the chapter considers the markets for alternative assets in the context
of the characteristics of good markets, and the EMH. From this consideration
it followed that in general these alternative assets were being traded in
104
inefficient markets, but that the degree of inefficiency may vary between
different assets. In particular more recognizable assets such as wine and gold
coins tend to trade in semi-efficient markets not unlike the direct property
market.
105
CHAPTER 6: APPLICATION OF PORTFOLIO THEORY
6.1 INTRODUCTION
This chapter will aim to apply basic portfolio theory to different data sets. The
objective of the exercise is to generate empirical evidence of the
diversification benefits (or lack thereof) associated with the incorporation of
alternative assets into an existing portfolio.
The construction of the portfolios is subject to some assumptions each of
which will be discussed at the relevant time.
In the following sections each of the alternative assets, as well as the more
traditional assets will be discussed and evaluated at the hand of the theory as
discussed in Chapter 2.
The assets to be analyzed in this section include:
•
Gold coins (Kruger Rands);
•
Wine investments; and
•
Art.
These assets represent some of the more popular alternative investment
choices and therefore provided the data necessary to complete the study.
Please note that a conscious decision was made not to include property
investments in this analysis. The author is of the opinion that various studies
have investigated and proven the benefits associated with property
investments.
The results of the statistical analysis performed in the chapter is based on
historical data gathered from various data sources which include iNet Bridge,
Oanda.com, Decanter.com and the JSE Securities Exchange.
106
6.2 INCLUSION OF KRUGER RANDS
6.2.1 Introduction
In this section the study will analyze historical data in order to determine the
possible diversification benefits that may be associated with the inclusion of
Kruger Rand investments into a fully diversified risky portfolio.
The section will firstly consider the construction of a fully diversified portfolio,
consisting of debt and equity investments. Secondly Kruger Rands will be
included in the diversified portfolio in order to determine their diversification
benefits as an alternative investment choice.
The study was conducted on the following basis:
•
Weekly data ranging between 1 Jan 1990 and 31 Dec 2003 was used
to calculate the relevant figures. This resulted in a sample of 730
observations.
•
The period reflects a balance between a significant amount of historical
data and applicability of the study given the prevailing economic
climate.
•
The period also includes the reaction of the market to a shock event, in
this instance the effect of the 9/11 attacks on the US. Weekly data was
used as opposed to monthly or annual data as it allowed for more
observation and therefore it should result in more accurate inferences.
•
Any assumptions made with regard to a specific asset will be
discussed at the relevant time.
107
6.2.2 Assets used in the construction of the portfolios
The purpose of this study is to identify the effect that the inclusion of an
alternative investment will have on a diversified portfolio. In order to fulfill this
purpose the study will construct a diversified portfolio (given the frequency of
the data used) for each of the alternative investments, prior to the inclusion of
the alternative investment.
Each initial diversified portfolio will be constructed via the use of debt
instruments, equity investments and cash. After constructing the initial
diversified portfolio, an alternative investment will be included in the asset mix
in order to determine the effects that it might have on the existing portfolio.
6.2.2.1 Debt instruments
6.2.2.1.1 Definition
According to Bodie et al. (2003:296) a debt security may be defined as a
security, such as a bond that pays a specified cash flow over a specific
period.
6.2.2.1.2 Assumptions
The following assumptions were made with regard to the debt investment:
•
A typical investor would include a debt instrument as part of a
diversified portfolio. This assumption is reasonable in as far as debt
instruments are generally considered to be one of the primary
investment vehicles.
•
The South African All Bond Index (ALBI) represents a fully diversified
bond portfolio.
108
•
It was assumed that an investment product, which replicates, exactly,
the performance of the ALBI index is available to investors. It was
furthermore assumed that there were no transaction costs involved in
the purchase or sale of any of the assets.
•
Assets are infinitely divisible and as such investors are able to buy and
sell fractions of an asset.
6.2.2.2 Equity investments
6.2.2.2.1 Definition
Bodie et al. (2003:6) defines equity as an ownership share in a corporation.
Therefore equity investments include ordinary shares as well as preference
shares.
6.2.2.2.2 Assumptions
The following assumptions were made with regard to debt investments:
•
It may reasonably be assumed that a typical investor would include
equity investments into an efficient and diversified portfolio.
•
Similar to the assumption made for debt investments, it is assumed
that the JSE All Share Index (ALSI) represents a fully diversified equity
portfolio.
•
The assumption is made that an investment product, which replicates,
exactly, the performance of the ALSI may be acquired or disposed of
by an investor, free of any transaction costs.
•
Assets are infinitely divisible and as such investors are able to buy and
sell fractions of an asset.
109
6.2.2.3 Cash
Most investors, institutional or individual, include cash or cash equivalents in
their diversified portfolios. Cash serves various purposes including:
•
Provision for emergencies;
•
Provision for liquidity; and
•
Ensuring that investors are able to exploit future investment
opportunities.
The inclusion of cash in a diversified portfolio is therefore important for the
purposes of this study. Accordingly the following assumptions relate to the
cash portion of the portfolio:
•
The yield on the 90-Day South African Banker’s Acceptance (BA) rate
was used as a proxy for the return that investors were able to realize
on the cash investment.
•
The BA-rate is believed to be more representative of actual interest
rate movements than the repo-rate, as it has shorter reset periods.
•
The BA and thus the cash investment is not a substitute for the riskfree asset as its returns (as will be seen later) are volatile.
6.2.2.4 Kruger Rands
6.2.2.4.1 Definition
Chapter three contains a detailed discussion of Kruger Rands and therefore it
would be sufficient to define these assets for the purpose of this section as a
South African bullion coin traded worldwide.
110
6.2.2.4.2 Assumptions
Price data and return data for Kruger Rands aren’t readily available, as there
existed no formal exchange for the product at the time of this investigation. In
order to generate price data, historical information pertaining to the Rand gold
price was used as a proxy for the performance of the Kruger Rand. This is a
reasonable assumption as, according to Investgold Ltd, Kruger Rand market
makers determine the price of the asset based on the Dollar gold price
multiplied with the prevailing Rand-Dollar exchange rate and a bid spread of
approximately –3% and an ask spread of approximately +6%. For the purpose
of this study the spreads weren’t taken into account in order to simplify the
statistical calculations.
6.2.3 Analysis of the assets used to construct the diversified portfolios
In this section a comparative analysis is performed on the assets identified in
the previous section. The purpose is to indicate the performances of the
individual assets and their risk characteristics, but also to evaluate the comovements of the assets.
6.2.3.1 Performance analysis
Figure 6.1 represents the weekly movements of the ALBI index over the 730week observation period.
111
Figure 6.1
Weekly All Bond Index (ALBI) movements 1990 - 2003
Index Level
200
150
100
50
2002/12/31
2001/12/31
2000/12/31
1999/12/31
1998/12/31
1997/12/31
1996/12/31
1995/12/31
1994/12/31
1993/12/31
1992/12/31
1991/12/31
1990/12/31
1989/12/31
0
Date
Source: Inet
Figure 6.1 indicates that the index has increased over the observation period.
Figure 6.2 represents the weekly movements of the All Share Index (ALSI)
over the same holding period.
Figure 6.2
Weekly All Share Index (ALSI) movements 1990 - 2003
14000
Index Level
12000
10000
8000
6000
4000
2000
2002/12/31
2001/12/31
2000/12/31
1999/12/31
1998/12/31
1997/12/31
1996/12/31
1995/12/31
1994/12/31
1993/12/31
1992/12/31
1991/12/31
1990/12/31
1989/12/31
0
Date
Source: Inet
112
Again the index increased over the holding period.
Figure 6.3 represents the weekly movements of the 90-day BA-rate over the
holding period (1990 – 2003).
Figure 6.3
Weekly 90-Day BA yield-rate (BA) movements 1990 - 2003
Source: Inet
In contrast to the other assets the yield on the 90-BA has declined over the
holding period.
Lastly figure 6.4 indicates the price movement of the Kruger Rand asset over
the same holding period.
113
Figure 6.4
2002/12/31
2001/12/31
2000/12/31
1999/12/31
1998/12/31
1997/12/31
1996/12/31
1995/12/31
1994/12/31
1993/12/31
1992/12/31
1991/12/31
1990/12/31
4000
3500
3000
2500
2000
1500
1000
500
0
1989/12/31
Price Movement
Weekly price movements of the Kruger Rand
Date
Source: Inet
Figure 6.4 indicates that the Kruger Rand’s price increased over the
observation period. The steepness of the trend line in figure 6.4 would lead
one to suspect that the price increase experienced by the asset was greater
than that of all the other assets considered.
Direct comparisons between the returns on these assets are not possible from
the charts cited above. Only general inferences, such as the ones made with
regards to a general increase or decrease in the price of the asset or index
level are possible. In order to directly compare the performances of the assets
over the holding period, asset returns had to be standardized. This was done
by calculating the holding period yield (HPY) for each asset. Note that in this
case a week represented an individual holding period.
114
The following equation represents the calculation of HPY:
HPY = HPR − 1
Where:
[6.1]
HPR represents the holding period return (calculated by dividing
the end value of the asset by its initial value, for a specific
holding period).
Figure 6.5
Weekly HPY for the ALBI (1990 – 2003)
Source: Inet
Figure 6.5 represents the holding period yields for the ALBI (debt investment)
during the period Jan 1990 to Dec 2003. Of this figure it may be said that
most of the observations lie in the band between –2.00% and +2.00%,
however, there are some outliers as indicated by points A and B on the figure.
Only when it is compared to similar figures for the equity asset and the cash
component of the diversified portfolio can the debt instrument be properly
analyzed. Figures 6.6 and 6.7 represent the holding period yield for the equity
asset and the cash component of the diversified portfolio respectively.
115
Figure 6.6
Weekly HPY for the ALSI (1990 – 2003)
Source: Inet
Figure 6.7
Weekly HPY for the BA (1990 – 2003)
Source: Inet
Figure 6.6 indicates that even though there were some outliers (as indicated
by A and B), most of the observations (HPY) for the ALSI were concentrated
in a band between –5.00% and +5.00%. In the case of the BA (as indicated in
116
figure 6.7) the returns are represented on an annualised basis and as such
the cash investment never produced a negative return.
Figure 6.8
Weekly HPY for the Kruger Rand (1990 – 2003)
Source: Inet
Figure 6.8 indicates the weekly HPY for the Kruger Rand asset during the
period ranging from 1990 to 2003. The chart indicates that on average the
Kruger Rands provided investors with a weekly return ranging between –5%
and +5%.
In order to directly compare the returns on the various investments, it is
essential to annualise the return figures. These figures should be annualised
using equation 6.2:
Annual HPY = [πHPR]
1
n
−1
[6.2]
Applying this equation to the returns of the different assets produced the
following set of results.
117
Table 6.1
Table of comparative performance measures
Asset
Simple Average HPY
Annualized HPY
Debt
0.06%
2.98%
Equity
0.22%
10.09%
Cash
13.93%
13.93%
Kruger Rands
0.16%
7.40%
Source: Inet
Table 6.1 indicates that the debt investment proved to be the worst performer
of all the assets considered, in terms of return. On the other hand cash
investment seems to have outperformed all the other assets based solely on
return.
From the discussion on portfolio theory it was apparent that securities and
portfolios should not be assessed based solely on returns, but that the risk of
each asset should also be considered. The following section will briefly
consider the relevant risk measures for each of the assets.
6.2.3.2 Risk analysis
The initial chapters of this study identified the measures of variance and
standard deviation as the most widely used and recognized measures of
investment risks.
From that discussion it transpired that the higher the level of standard
deviation, the higher the risk associated with the asset. Also the discussion on
the capital market theory indicated that investors would expect a direct
relationship between risk and return. Thus if risk increases so too should
return.
118
This section of the study uses probability distributions of asset returns to
illustrate the degree of standard deviation for each of the assets. Figure 6.9
illustrates the probability distributions for each of the assets mentioned in the
previous section, starting with debt instruments, moving to equity investments
cash and ending with the Kruger Rand.
Figure 6.9
Probability distributions of assets
Source: Inet
Figure 6.9 (note that each of the figures is based on the same scale) indicates
that the cash investment proved to be the most risky asset of the assets being
analysed. This conclusion may be made by considering the extent to which
the returns of the asset tends to deviate from the mean. The wider the
dispersion around the mean the higher the risk associated with the asset. The
kurtosis (level of peakedness) of the distribution of the debt instrument
indicates that this asset is represented by a leptokurtic distribution, which
indicates that this asset tends to have a high concentration of returns situated
around the mean. When compared to the more platykurtic distributions of the
equity, cash and Kruger Rand investments, it may be said that the debt
instrument has lower levels of risk than the equity, cash and Kruger Rand
119
investments. When considering these risk measures in conjunction with the
return analysis it may be said that the results are in line with the belief that
return should increase as risk increases.
Table 6.2 lists the percentage annual volatility for each of the assets. This
measure is an annualised standard deviation figure for each of the
investments and as such these figures were calculated by applying the
following formulae:
σ
2
i
[R
=∑
n
t =1
Where :
i
− Ri
n
]
2
σ i2 represents the variance of the asset
[6.3]
R i represents the realized return on asset i
R i represents the mean return on asset i
and
σ i = σ i2
[6.4]
Where : σ i represents the standard deviation of asset i
In order to derive the percentage annual volatility the calculated standard
deviation is annualised.
Table 6.2
Percentage Annual Volatility of assets
Percentage
Annual Volatility
Debt
8.86%
Equity
19.48%
Cash
22.77%
Kruger Rands
15.50%
Source: Inet
120
Table 6.2 confirms the results indicated by the probability distribution curves
cited in figure 6.9. In addition to this it allows investors to rank the assets in
order of riskiness. For this section cash investments represent the most risky
of the assets, whilst debt instruments represent the lowest risk.
6.2.4 Portfolio construction
Following the analysis of the individual assets, investors have to consider
whether or not they would benefit from combining these assets in portfolios.
Ultimately the investors would like to add investments to a portfolio that would
lead to the highest level of diversification, therefore if an investment increases
the degree of diversification of a diversified portfolio, investors should
consider these assets for investment purposes.
The aim of this section is to prove that a well-diversified portfolio, consisting of
equities, bonds and cash, may be diversified even more through the inclusion
of the Kruger Rand asset.
In order to prove the above-mentioned hypothesis, the study will aim to
construct a well-diversified portfolio consisting of a mixture between cash,
equities and fixed-income investments. After considering the unique
characteristics of this particular portfolio, the study will investigate the effects
that the inclusion of the Kruger Rand in the portfolio will have on it in terms of
risk and return.
6.2.4.1 Co-movements between the assets
As was indicated in the discussion on portfolio theory, Markowitz and other
theorists underlined the fact that diversification of a portfolio can be attained
by adding investments to the portfolio that have low positive or negative
correlations with those assets in the existing portfolio.
121
Figure 6.10
Scatter plot matrix of asset returns
Source: Inet
Figure 6.10 represents a scatter plot matrix in terms of which the returns of
two assets were plotted against one another. This process was completed for
all possible asset combinations. An upward sloping trendline indicates a
positive relationship between the returns of the individual assets, whilst a
downward sloping trendline indicates a negative relationship between the
asset returns. This exercise assists investors in detecting the existence of
positive or negative relationships between assets, prior to conducting various
measurement calculations.
Various measures of co-movement may be used to determine the
relationships between the assets used to construct a portfolio, one of these
122
measures is covariance, which Reilly and Brown (2000:262) defines as a
measure of the degree to which two variables move together relative to their
individual mean values. The formula used for the calculation of covariance is
cited below:
Cov AB =
∑ [R
A
][
− R A RB − RB
]
n
[6.5]
Where : R x represents the realized return on asset x
R x represents the mean rate of return on asset x
n represents the number of observatio ns
Applying the above-mentioned formula to the data gathered for each of the
different assets results in the following covariance matrix:
Table 6.3
Covariance matrix
Debt
Equity
Cash
Kruger
Rands
Debt
1
Equity
0.0000762
Cash
0.00000042 0.000064
1
Kruger Rands
-0.0000658
-0.0000541
1
0.000107
1
Source: Inet
Even though these figures indicate whether or not the relationships between
assets are positive or negative, they are difficult to interpret. In order to
address this problem, the resultant figures need to be standardized. The
correlation coefficient of assets provides investors with such a standardized
measure. Correlation coefficients range between –1 and +1. Where –1
indicates a perfect negative relationship between two variables and +1
indicates a perfect positive relationship between two variables. The correlation
coefficient indicates both the direction and magnitude of the relationship
between assets.
123
The following formula may be used to calculate the correlation coefficient for
each of the assets.
ρ xy =
Cov xy
[6.6]
σ xσ y
Table 6.4
Correlation coefficient matrix
Debt
Equity
Cash
Kruger
Rands
Debt
1
Equity
0.230
1
Cash
0.001
-0.075
1
Kruger Rands
-0.249
0.1843
-0.008
1
Source: Inet
Table 6.4 indicates that all of the assets have either a low positive correlation
with one or more of the other assets, or a negative correlation with the other
assets, a fact that indicates the possibility of diversification between the
different asset classes.
6.2.4.2 Initial diversified portfolio
This section aims to identify the portfolio that offers the investor the highest
level of return for a given level of risk, assuming that the investor invests in a
mix between cash, equities and fixed-income investments.
124
Figure 6.11
Efficient frontier
Source: Inet
For the purpose of this study it is assumed that investors aim to identify the
minimum variance portfolio, or the portfolio with the lowest level of risk. The
portfolio that satisfies this requirement may be found when the following asset
mix is attained:
Figure 6.12
Asset mix of a diversified portfolio
Cash
11.56%
ALSI
14.35%
ALBI
74.09%
Source: Inet
125
Given the above mentioned asset mix it is clear that the minimum variance
portfolio would have provided the holder of the portfolio with a annualised
return of 5.26%, and a standard deviation of 7.41%.
6.2.4.3 The alternative portfolio
In order to avoid confusion the diversified portfolio which includes the Kruger
Rand asset will be labeled the alternative portfolio.
Following the construction of the diversified portfolio the question remains as
to whether or not the inclusion of an alternative asset into that portfolio will
hold any additional benefits for the investor. In order to answer this question
one would need to construct an efficient frontier of the alternative portfolio and
identify the minimum variance portfolio. After this has been done a direct
comparison between the two portfolios is possible.
Figure 6.13
Efficient frontier of the alternative portfolio
Source: Inet
126
Figure 6.13 illustrates the efficient frontier of the alternative portfolio. On the
basis of visual inspection it would seem as though this portfolio holds a lower
level of risk than the diversified portfolio, this is evident in the lower levels of
standard deviation indicated by the figure.
As was the case for the diversified portfolio, the assumption is made that the
investor will target the minimum variance portfolio. In doing so the following
figure (figure 6.14) illustrates the asset mix of the alternative portfolio.
Figure 6.14
Asset mix of the alternative portfolio
Kruger Rand
18.84%
Cash
10.50%
ALSI
8.88%
ALBI
61.78%
Source: Inet
Figure 6.14 indicates that the alternative portfolio should be constructed in
such a manner that 18.84% of its total value is made up of the Kruger Rand
asset.
Given the above mentioned asset mix it is clear that the minimum variance
alternative portfolio would have provided the holder of the portfolio with an
annualised return of 5.59%, and a standard deviation of 6.86%.
127
This indicates that the alternative portfolio will enhance both return and risk.
Table 6.5 tabulates the risk and return figures for both the portfolios.
Table 6.5
Portfolio risk and return figures
Portfolio
Return
Risk
Diversified Portfolio
5.26%
7.61%
Alternative Portfolio
5.59%
6.86%
Source: Inet
From this we are able to conclude that investors who held diversified
portfolios, could have enhanced both risk and return on their portfolios if they
included Kruger Rands to their portfolios. Furthermore it may be said that
portfolios that weren’t effectively diversified would also have benefited from
the inclusion of the Kruger Rand. Lastly as all asset allocation decisions are
based on historical data it follows that rational investors should expect that the
inclusion of Kruger Rands in their portfolios should lead to increased
diversification.
6.3 INCLUSION OF WINE ASSETS
6.3.1 Introduction
This section of the study will aim to identify possible benefits associated with
the inclusion of wine as an alternative investment in diversified portfolios. This
section of the study will follow the same methodology used in the section on
Kruger Rands.
128
As there are numerous wines available for investors to choose from, an
analysis of all possible wine assets would be near impossible. This study will
focus on two specific wine assets namely:
•
A 1982 Mouton-Rothschild (First growth wine); and
•
A 1982 Montrose (Second growth wine).
Apart from the decision to include a first growth and a second growth wine in
the analysis, the wines were chosen at random. The 1982 vintage was
chosen at random, but to ensure the highest possible degree of comparability
it was decided that both wines should be from the same vintage. It should be
noted that the difference between a first growth wine and a second growth
wine relates to the quality of the wine, and more specifically it may be said
that the first growth wine is of a higher quality than the second growth wine.
It should be noted that the following general assumptions were made during
this analysis:
•
Monthly price data related to each asset was used for the period
August 1995 to December 2002. This was done in order to
accommodate the fact that price data related to the wine assets was
published on a monthly basis and was only available for the stated
period.
•
Wine prices were denominated in British Pounds and therefore they
were converted to Rand prices via the prevailing Pound/Rand
exchange rate. The effect of this was also considered during the study.
As was the case in the previous section of the study, any other assumptions
related to a specific asset will be discussed at the relevant time.
129
6.3.2 Assets used in the construction of the portfolios
This section will aim at identifying each of the assets that was used in the
construction of the relevant portfolios. As most of the assets were defined in
previous sections of this study, this section will only list the relevant assets
and highlight the assumptions pertaining to each of the assets.
The assets that were used included:
•
Debt instruments
o The study used the monthly price data for All Bond Index (ALBI)
as a proxy for a fully diversified fixed-income portfolio.
•
Equity investments
o This section of the study used the monthly price data for the All
Share Index (ALSI) as a proxy for a fully diversified equity
portfolio.
•
Cash
o Monthly data pertaining to the 90-day Banker’s Acceptance (BA)
rate (yield rate) was used as a proxy for the returns generated
by cash investments.
•
Mouton-Rothschild
o Assumptions for this asset are mentioned in a previous section.
•
Montrose
o Assumptions for this asset are mentioned in a previous section.
As was the case in the previous section, it is assumed that normally, rational
investors will hold diversified portfolios that are constructed in order to include
a mixture of debt instruments, equity investments and cash. Thus it is the aim
of this section to identify the possible benefits of including a wine asset into
such a diversified portfolio.
Lastly the assumption is made that investors are able to buy and sell fractions
of any given asset.
130
6.3.3 Analysis of the assets used in the construction of portfolios
This section aims at analysing each of the above-mentioned assets on an
individual basis. The analysis of the performance of each asset will be
followed by a risk analysis of each asset.
Following the individual analysis of each asset various comparisons will be
made. This section will also give consideration to the co-movements that the
assets experienced during the observation period.
Lastly it should be noted that even though both wine assets are analysed in
this section they will be used individually in the construction of new alternative
portfolios. This is done in order to reduce repetition and therefore isolate the
effect of differing qualities between the assets.
6.3.3.1 Performance analysis
Figure 6.15 graphically illustrates the monthly price movements of the ALBI
during the observation period ranging between Aug 1995 and Dec 2002.
Figure 6.15
Monthly price movements of the ALBI
Source: Inet
131
From figure 6.15 it is apparent that the index has shown an increase during
the period under observation. This is in line with the increase the index
showed based on weekly prices as indicated in a previous section.
Figure 6.16 shows the corresponding price movements of the ALSI during the
period Aug 1995 to Dec 2002.
Figure 6.16
Monthly price movements of the ALSI
Source: Inet
As was the case for the ALBI the ALSI showed an increase during the period.
Figure 6.17 illustrates the monthly movements of the 90-day BA-rate for the
period Aug 1995 to Dec 2002.
132
Figure 6.17
Monthly yield movements of the 90-day BA-rate
Source: Inet
Figure 6.17 indicates that the yield on the 90-day BA has declined during the
period under review. This is evident from the fact that the trendline depicted in
figure 6.17 is downward sloping.
Figure 6.18 represents the price movements of the Mouton-Rothschild during
the review period.
Figure 6.18
Monthly price movements of the Mouton-Rothschild 1982
Source: Inet
133
It should be noted that figure 6.18 represents the price movements of the
Mouton-Rothschild in Rand terms. Thus even though the price of the asset
has increased during the review period, some of that increase may be
attributed to favourable exchange rate movements.
Lastly figure 6.19 represents the price movements of the Montrose wine asset
during the period being reviewed.
Figure 6.19
Monthly price movements of the Montrose
Source: Inet
Again this graph illustrates the monthly price movements in Rand terms and
therefore some of the performances indicated by the graph may be attributed
to favourable exchange rate movements.
Direct and meaningful inferences can’t be made from these figures, but they
allow the investor to make general inferences such as indicating positive or
negative price performance.
In order to compare the performances of the assets directly, these figures
need to be standardized. This is done by calculating the holding period yield
134
(HPY) on each of these assets. Figure 6.20 depicts each asset’s HPY for the
period under review.
Figure 6.20
Holding Period Yields on assets
Source: Inet
Figure 6.20 illustrates the returns on the assets on comparable terms. From
the figure it may be concluded that the Mouton-Rothschild should prove to be
the riskiest of the assets, this is because its HPY-movements have the largest
range (i.e. the largest difference between the lowest and the highest HPY).
The Montrose investment should (based on the same reasoning) prove to be
the second riskiest of the assets.
135
From the data used to construct the figures used above, one would be able to
derive the following table (table 6.6)
Table 6.6
Table of comparative performance measures
Asset
Simple Average
Annualized HPY
HPY
Debt
0.41%
4.37%
Equity
0.94%
8.92%
Cash
13.62%
13.62%
Mouton-Rothschild
2.84%
23.23%
Montrose
2.04%
19.34%
Source: Inet
From table 6.6 it is clear that on a pure return basis the Mouton-Rothschild
wine asset outperformed all the other assets during the review period. Debt
was the worst performing asset during the same period.
The fact that the Montrose provided similar performance to the MoutonRothschild may prove to be important, as it indicates that lower quality wines
may provide investors with high return levels at affordable prices, which is
similar to the performance of small-cap stocks in relation to large-cap stocks.
The full extent of this will only be evident upon completion of the risk analysis.
6.3.3.2 Risk analysis
From the earlier discussion of the study it was apparent that risk is the
uncertainty of realized returns being equal to expected returns. Given this
definition it may be said that dispersion around the mean provides the investor
with a measure of risk, specifically the wider the dispersion the higher the
level of risk.
136
Probability distributions of return provide the investor with a visual record of
the dispersion of returns around a central value.
Figure 6.21
Probability distributions of assets
Source: Inet
Figure 6.21 illustrates the probability distributions of the assets being
considered. From this graphical depiction it may be concluded that the
Montrose wine asset has the widest dispersion of returns around its mean
whilst the cash investment seems to have the lowest level of dispersion
around its mean. This leads to the conclusion that the Montrose wine asset is
the riskiest of the assets being considered, whilst cash bears the lowest level
of risk.
137
In order to facilitate further analysis of the risk characteristics the study
calculated the percentage annual volatility for each of these assets. The
resultant figures are tabulated in table 6.7.
Table 6.7
Percentage Annual Volatility
Percentage
Annual Volatility
ALBI
11.27%
ALSI
22.99%
BA
10.85%
Mouton-Rothschild
53.98%
Montrose
37.86%
Source: Inet
From table 6.7 it is apparent that the Mouton-Rothschild asset proved to be
the riskiest asset based on percentage annual volatility, whilst the cash
investment was the least risky based on the same measure. This accentuates
the importance of proving risk attributes by means other than visual
inspection.
6.3.4 Portfolio construction
Following the analysis of the individual assets the study focuses on
constructing portfolios which consist of combinations between the assets
mentioned above.
This section of the study may be broken down into three sections. Firstly a
portfolio consisting of a mixture between the more “traditional” assets will be
constructed, i.e. a portfolio consisting of a mixture between equities, debtinstruments and cash. In order to avoid confusion this “traditional asset”
portfolio will be labelled the “diversified portfolio”. Secondly the first growth
138
wine, namely the Mouton-Rothschild, will be added to this portfolio in order to
observe the benefits, if any, it holds as far as diversification is concerned. This
new portfolio will be labelled the “MR portfolio”. Lastly the second growth wine
will be added to the diversified portfolio in order to judge its effects on
diversification. This last portfolio will be labelled the “Montrose portfolio”.
6.3.4.1 Construction of the diversified portfolio
In order to construct a diversified portfolio, Markowitz indicated that the
relationship or co-movement of the asset returns were of vital importance.
Figure 6.22 depicts the scatter plot matrix of the returns on the debt
instruments, equity investments and cash investments used in the
construction of the diversified portfolio.
Figure 6.22
Scatter plot matrix of asset returns
Source: Inet
139
From figure 6.22 it appears that there is a positive relationship between the
ALBI and the ALSI whilst the relationship between the BA and the other two
assets (ALBI and ALSI) is negative.
From the data used to construct the scatter matrix the following correlation coefficient matrix may be derived.
Table 6.8
Correlation coefficient matrix of asset returns
Debt
Equity
Debt
1
Equity
0.4679
1
Cash
-0.0891
-0.17284
Cash
1
Source: Inet
Table 6.8 indicates a negative correlation between cash investments and
equity investments, this should bode well for diversification. The smaller
negative correlation between debt instruments and cash should also provide
an added degree of diversification.
Using the various findings of prior sections an efficient frontier may now be
derived for the diversified portfolio. Figure 6.23 illustrates this efficient frontier.
140
Figure 6.23
Efficient frontier for the diversified portfolio
Source:Inet
As mentioned in the section on the Kruger Rand the assumption is made that
the investors will target the minimum variance portfolio presented by the
efficient frontier. This results in the following asset mix:
141
Figure 6.24
Asset mix of the diversified portfolio
Source: Inet
If an investor held a portfolio constructed in the fashion denoted by the
optimal asset mix he/she would have realized an annualised return of 9.26%
whilst facing a standard deviation of 7.41%.
6.3.4.2 Construction of the Mouton-Rothschild (MR) portfolio
Following the construction of the diversified portfolio, the effects of the
inclusion of the Mouton-Rothschild wine asset on that portfolio will be
examined in this section. As was the case in the previous section it is
important to establish the relationship between the Mouton-Rothschild and the
other individual assets. Figure 6.25 represents the scatter plot matrix of the
returns of the different assets against one another.
142
Figure 6.25
Scatter plot matrix of the returns on the assets used in the MR portfolio
Source: Inet
From figure 6.25 it may be concluded that the relationship between the
returns on the assets used in the construction of the diversified portfolio
remain the same. Furthermore from the figure it seems that there is a
negative relationship between the return on the Mouton-Rothschild asset and
the ALBI, a positive relationship between the returns on the BA and the
Mouton-Rothschild. The returns of the ALSI and that of the Mouton-Rothschild
are slightly positively related. These conclusions may be made by considering
the slope of the trend line, where a positive slope would indicate a positive
relationship and vice versa. The steeper the slope the stronger the
relationship, thus it may be said that the positive relationship between the
ALBI and the ALSI is much stronger than the relationship between the BA and
the Mouton-Rothschild.
143
The relationship of the Mouton-Rothschild to the other assets should be
conducive to diversification, as they are all small positive or negative
relationships.
The data used in the construction of the scatter plot matrix may be used to
calculate and derive the correlation matrix as shown in table 6.9 below.
Table 6.9
Correlation matrix
Debt
Equity
Cash
MoutonRothschild
Debt
1
Equity
0.4679
1
Cash
-0.0891
-0.17284
1
Mouton-Rothschild
-0.0899
0.00276
-0.0518
1
Source: Inet
The figures stated in table 6.9 confirm the conclusion made from the visual
inspection of the scatter plot matrix.
The assets may be used to construct the following efficient frontier.
Figure 6.26
Efficient frontier for the MR portfolio
Source: Inet
144
The efficient frontier in figure 6.26 was constructed by varying the weights of
the different assets used in the construction of the portfolio and then
calculating the standard deviation and return on the portfolio. This figure plots
the returns against the corresponding standard deviations.
As was the case for the previous portfolios the assumption is made that
investors will target the minimum variance portfolio. When compared to the
efficient frontier for the diversified portfolio it would seem as if the MR portfolio
provided the holder of the portfolio with higher returns and lower risk. This
deduction is based on visual inspection and should be confirmed or rejected
upon calculation of the relevant portfolio statistics.
From the dataset used it appears that the minimum variance portfolio would
have the following asset mix as indicated in figure 6.27.
Figure 6.27
Asset mix of the MR portfolio
Source: Inet
Based on the above-mentioned asset mix the relevant portfolio statistics may
be calculated. These statistics are presented in Table 6.10 below.
145
Table 6.10
Portfolio statistics of the diversified portfolio and the MR portfolio
Diversified portfolio
MR portfolio
Return
9.26%
9.71%
Standard Deviation
7.41%%.
7.27%
Source: Inet
From table 6.10 it appears that the return on the MR portfolio was higher than
that of the diversified portfolio during the period under review, and furthermore
the MR portfolio presented the investor with a lower level of risk, as measured
by standard deviation.
The conclusion to be drawn from this analysis is that the inclusion of the
Mouton-Rothschild in the portfolio enhanced its overall performance. Given
that the Mouton-Rothschild was chosen on a random basis it may be said that
there is a possibility that other randomly selected first-growth wines may
provide similar results.
6.3.4.3 Construction of the Montrose Portfolio
The final analysis to be performed in the section on wine investment is the
construction of the Montrose wine asset. This wine is, as was mentioned
earlier, a second growth wine. The difference between first and second
growth wines relates to their respective quality, where the first growth wine is
of a higher quality that the second growth wine. This section of the study aims
to investigate the question as to whether lower quality wines may also hold
diversification benefits for investors. As was seen in a previous section the
second growth wine proved to be more risky than the first growth wine, but
also had a higher mean historical return. Figure 6.28 represents the scatter
plot matrix of the returns of the different assets against one another.
146
Figure 6.28
Scatter plot matrix of the returns on the assets used in the MR portfolio
Source: Inet
The relationships between the returns on the assets used to construct the
diversified portfolio remain the same. Figure 6.28 indicates a low level of
positive correlation between the returns on the Montrose asset and those of
both the ALBI and the ALSI. Furthermore it may be said that the returns on
the Montrose asset and the BA seem to be positively correlated as well.
These characteristics may prove beneficial for the portfolio construction
process.
The data used in the construction of the scatter plot matrix may be used to
calculate and derive the correlation matrix as shown in table 6.9 below.
147
Table 6.11
Correlation matrix
Debt
Equity
Cash
Debt
1
Equity
0.4679
1
Cash
-0.0891
-0.17284
1
Montrose
0.1737
0.3375
0.0459
Montrose
1
Source: Inet
The figures stated in table 6.11 confirm the results of the visual inspection of
the scatter plot matrix.
The assets mentioned above may be used to construct the following efficient
frontier.
Figure 6.29
Efficient frontier for the Montrose portfolio
Source: Inet
148
Again the assumption is made that investors will target the minimum variance
portfolio. Based on visual inspection it would seem as if the Montrose portfolio
provided higher levels of return than the diversified portfolio. Furthermore it
may be said that the Montrose portfolio may have presented lower levels of
risk than the diversified portfolio. In a subsequent section the relevant
statistics that will either confirm or reject the conclusions of the visual
inspection process will be calculated.
From the dataset used it follows that the minimum variance portfolio would
have the following asset mix as indicated in figure 6.30.
Figure 6.30
Asset mix of the Montrose portfolio
Source: Inet
Based on the above-mentioned asset mix the relevant portfolio statistics may
be calculated. These statistics are presented in Table 6.12 below.
149
Table 6.12
Portfolio statistics of the diversified portfolio, MR portfolio and
Montrose portfolio
Diversified
MR portfolio
portfolio
Montrose
Portfolio
Return
9.26%
9.71%
9.23%
Standard Deviation
7.41%.
7.27%
7.38%
Source: Inet
From table 6.12 it appears that the return on the Montrose portfolio was lower
than that of both the diversified portfolio and the MR portfolio during the period
under review. The figures cited in table 6.12 also indicate that this level of
return was achieved at a lower risk level than was the case for the diversified
portfolio. Upon calculating the level of return produced per unit of risk taken it
becomes clear that the inclusion of the Montrose asset into the diversified
portfolio resulted in a slight diversification advantage for the investor.
The conclusion that may be drawn from this analysis is that second growth
wines may be included in portfolios in order to enhance their overall
performance. Furthermore these results indicate that the quality of the wine
isn’t necessarily a determining factor with regard to its diversification
capabilities. Even though the first growth wine did result in a higher level of
diversification the question has to be asked whether or not this warrants the
substantial cost differences between the two wine classes.
150
6.4 INCLUSION OF ART INVESTMENTS
6.4.1 Introduction and assumptions
This section of the study aims to analyse the effects that the inclusion of an
art investment into an existing diversified portfolio will have on the level of
diversification of such a portfolio.
As was the case in previous sections certain assumptions had to be made in
order to facilitate the analysis.
The following summarizes the assumptions and details surrounding the use
of the art investment:
•
The performance of the Fine Art Index will be used as a proxy for a
general art investment product.
•
The study was performed by making use of annual price data relating
to the FAI, dating back to 1989. This was due to informational
constraints.
•
The assumption is made that an investment product exists that will
afford investors the opportunity to invest in the Fine Art Index (FAI).
•
Fractions of an investment may be bought or sold.
•
All other assumptions will be made at the relevant time.
6.4.2 Assets used in the portfolio construction
As was the case in previous sections the assumption is made that the initial
diversified portfolio will be constructed via an asset mix between debt, equity
and cash. The following details pertain to each of these assets:
•
Debt instruments
151
o The annual index movements of the All Bond Index (ALBI) were
used as a proxy for the price movements of the debt portion of
the portfolio.
•
Equity investments
o The annual index movements of the All Share Index (ALSI) were
used as a proxy for the movements of the equity portion of the
portfolio.
•
Cash
o The annual rate changes of the 90-Day Banker’s Acceptance
rate (BA) were used as a proxy for the movement of the cash
portion of the portfolio.
In addition to these assets the art portfolio (which denotes that portfolio which
includes the art investment) will include a theoretical asset which replicates
(exactly) the changes in the FAI. The assumptions pertaining to this asset are
listed above.
6.4.3 Analysis of the assets used in the construction of the portfolios
This section will concentrate on performance analysis and risk analysis of the
individual assets, a later section will also consider the degree of co-movement
that exists between the various assets.
6.4.3.1 Performance analysis
Figure 6.31 illustrates the annual index movements of the ALBI during the
period ranging between 1989 and 2002.
152
Figure 6.31
All Bond Index Movements
Source: Inet
From figure 6.31 it appears that the index level increased over the holding
period, but it tended to fluctuate between a level of 115 and 165.
Figure 6.32 illustrates the index movements of the All Share Index over a
corresponding holding period.
Figure 6.32
All Share Index Movements
Source: Inet
153
Figure 6.32 indicates the ALSI index increase during the holding period from a
level of about 2800 to a level of about 9500.
Figure 6.33 plots the annual BA-rate over a holding period which is concurrent
with that of the previous two assets.
Figure 6.33
Annual BA-rates
Source: Inet
Figure 6.33 indicates that the 90day BA yield-rate has declined during the
holding period. This downward movement should not be seen in isolation and
should be considered on a portfolio wide basis.
Lastly figure 6.34 illustrates the annual movements of the Fine Art Index (FAI)
during the holding period.
154
Figure 6.34
Annual movements of the FAI
Source: Inet
From figure 6.34 it appears that the FAI has increased during the holding
period that ranges from 1989 to 2002.
Even though the figures listed above allow investors to make certain initial
conclusions, these conclusions are normally relatively limited. In order to be
able to directly compare the results indicated by these graphs the figures
need to be standardized. The following section will standardize these figures
via the use of the holding period yield calculation.
The holding period yield movements for the debt investments are illustrated in
figure 6.35.
155
Figure 6.35
HPY movements of the ALBI
Source: Inet
From figure 6.35 it appears that the HPY on the ALBI ranged between –0.2%
return per annum to +0.15% per annum. Also the figure indicates that at times
the HPY experienced swings between positive and negative returns.
Figure 6.36 illustrates the HPY movements for the equity investment (ALSI)
over the holding period.
Figure 6.36
HPY movements of the ALSI
Source: Inet
156
From figure 6.36 it appears that the HPY on the equity investment ranged
between -0.1% per annum and +0.65% per annum. This wider range of
movements should lead the investor to believe that the equity asset was more
risky than the debt investment. This is in line with the conclusions made in
previous sections of this study.
The HPY movements for the cash investment (BA) are plotted in figure 6.37.
Figure 6.37
HPY of the BA
Source: Inet
Lastly figure 6.38 graphically illustrates the HPY movements of the art
investment (FAI).
157
Figure 6.38
HPY of the FAI
Source: Inet
From the figure it appears that the HPY on the FAI ranged between the levels
of –0.35% and +0.32% per annum. This should lead one to believe that the art
investment was less risky than the equity investments.
From the data used to construct the figures used above, one would be able to
derive the following table (table 6.13)
Table 6.13
Table of comparative performance measures
Asset
Simple Average
Annualized HPY
HPY
Debt
3.27%
2.53%
Equity
12.29%
9.28%
Cash
14.08%
14.08%
Art Investment
3.19%
1.50%
Source: Inet
158
From table 6.13 it appears that the cash investment generated the highest
level of return during the holding period, whilst the art investment generated
the lowest overall return during the holding period.
6.4.3.2 Risk analysis
As was the case in the previous analyses, the assets should be analysed in
terms of both risk and return. This section will consider the risk characteristics
of the assets being analysed.
Again the probability distributions of the returns on the assets will be used to
provide a visual reflection of the dispersion of returns around a mean value. It
should be noted that higher levels of dispersion indicate higher levels of risk.
Figure 6.39
Probability distributions of assets
Source: Inet
Figure 6.39 illustrates the probability distributions of each of the assets (the
graphs were drawn on the same scale). From this it seems that the ALSI
proved to be the riskiest of all the assets, whilst cash was the least risky of the
159
assets. The FAI was more risky than the ALBI and cash, but less risky than
the ALSI.
The following table (table 6.14) tabulates the numerical values of the assets
percentage annual volatility.
Table 6.14
Percentage Annual Volatility
Percentage
Annual Volatility
ALBI
10.65%
ALSI
24.73%
Cash
3.13%
Art
17.88%
Source: Inet
Table 6.14 confirms the results of the visual inspection performed above.
From the table one would be able to deduce that the ALSI was in fact the
riskiest of the assets over the holding period and cash the least risky of the
assets.
6.4.4 Portfolio construction
Following the analysis of the individual assets the study focuses on
constructing portfolios which consist of combinations of the assets analysed
above.
This section will consider the relationships between the assets that are to be
included in the subsequent portfolios. Secondly the section will aim to
construct a diversified portfolio consisting out of a mixture of debt, equity and
cash. Lastly the section will aim to consider the effects of the inclusion of the
160
art investment in the diversified portfolio. It should be noted that this new
portfolio will be labelled the “art portfolio”.
6.4.4.1 Construction of the diversified portfolio
Prior to the actual construction of the portfolio consideration should be given
to the relationships that exist between the price movements of the different
assets. Figure 6.40 illustrates a scatter plot matrix of the relationships
between the different asset returns.
Figure 6.40
Scatter plot matrix of asset returns
Source: Inet
From figure 6.40 it would seem as if there is a positive relationship between
the returns on the ALBI and the ALSI, as well as between the returns on the
ALBI and the FAI. The relationships between the ALSI and cash and the ALBI
161
and cash are decidedly negative. There seems to be a negative relationship
between the returns on the ALSI and the FAI, whilst there is a small negative
relationship between the returns on cash and the FAI.
From the data used to construct the scatter matrix the following correlation coefficient matrix may be derived.
Table 6.15
Correlation coefficient matrix of asset returns
Debt
Equity
Cash
Debt
1
Equity
0.2292
1
Cash
-0.4115
-0.5063
1
Art
0.1836
-0.2233
-0.0268
Art
1
Source: Inet
From table 6.15 it seems that the negative relationships that exist between the
returns of the cash asset and the debt instrument, the equity investment and
the cash asset as well as the equity investment and the art investment hold
the promise of enhanced diversification of portfolios.
Using the various findings of prior sections an efficient frontier may now be
derived for the diversified portfolio. Figure 6.41 illustrates this efficient frontier.
162
Figure 6.41
Efficient frontier for the diversified portfolio
Source:Inet
As was the case in the previous sections the assumption is made that an
investor will target the minimum variance portfolio, i.e. that portfolio with the
lowest level of risk. Following the selection process the asset mix for the
minimum variance portfolio is illustrated in figure 6.42.
Figure 6.42
Asset mix of the diversified portfolio
Source: Inet
163
This asset mix would have presented the investor with a return of 7.28% and
a level of risk equal to 7.87% as measured by standard deviation.
6.4.4.2 Construction of the art portfolio
This section will aim to analyse the benefits, or lack thereof, of including the
art investment in the diversified portfolio. From the previous calculations the
following efficient frontier (as illustrated in figure 6.43) may be constructed for
the art portfolio.
Figure 6.43
Efficient frontier for the art portfolio
Source:Inet
From figure 6.43 it would seem as if the inclusion of the art investment in the
diversified portfolio would have had an effect on the risk and return of the
diversified portfolio.
Again the assumption is made that investors will target the minimum variance
portfolio. This strategy would have resulted in an asset mix as indicated in
figure 6.44.
164
Figure 6.44
Asset mix of the art portfolio
Source: Inet
Based on the above-mentioned asset mix the relevant portfolio statistics may
be calculated. These statistics are presented in Table 6.16 below.
Table 6.16
Portfolio statistics of the diversified portfolio and the art portfolio
Diversified
Art portfolio
portfolio
Return
Standard Deviation
7.28%%
11.70%
7.87%.
2.37%
Source: Inet
From table 6.16 it appears that the inclusion of the art investment in the
diversified portfolio resulted in an increase in the level of return, as well as a
decrease in the level of risk of the portfolio, as measured by standard
deviation.
165
The conclusion that may be drawn from this analysis is that the inclusion of
the art investment in the diversified portfolio would have benefited the holder
of the portfolio during the holding period, reviewed in this study.
6.5 SUMMARY
This chapter applied the theoretical principals of portfolio construction to three
alternative assets, that being wine, art and gold coins.
The experiments started off by establishing a ‘traditional’ diversified portfolio
consisting of a mixture of cash, bond and stocks. This portfolio then served as
a proxy for a completely diversified portfolio (the market portfolio as identified
in the discussion on modern portfolio theories). Following the construction of
this proxy portfolio, the effects of including a single alternative asset to the
existing asset-mix was considered.
The alternative assets used for the purposes of this chapter included Kruger
Rands (gold coins), 1982 Mouton Rothschild and 1982 Montrose (wine), and
a art investment based on an art index. These assets were chosen on the
basis of the availability of historic price information.
Each of the experiments performed during this chapter indicated that these
assets had a positive impact on both the risk and return characteristics of the
proxy portfolio. In most instances return increased, whilst overall risk
decreased. These results stem mainly from the low positive and negative
correlations that these assets had with the assets used in the proxy portfolio.
Upon considering the results obtained from these experiments it followed that
investors may benefit from considering some of these alternative investments
when constructing diversified portfolios. It should however be noted that
investors are urged to take a medium to long-term view on these assets.
166
CHAPTER 7: CONCLUSION
This section will discuss the various conclusions that may be made following
the completion of the study.
•
At the outset of the study the aim was to determine whether or not
alternative/hard assets might be used to diversify existing portfolios
even further. The study commenced with a brief overview of various
modern portfolio theories and their respective origins, then the study
moved on to discuss in detail the subjects of risk and return, including
their respective methods of measurements. From there the focus of the
study moved to the identification of various alternative assets. The next
section of the study gave consideration to the theories surrounding
efficient markets and the efficient market hypothesis. This formed the
theoretical basis for the study.
•
The last section of the study concentrated on producing and
investigating empirical evidence which would confirm or reject any
initial assumptions made during the early stages of the study.
The following section will briefly consider some of the most prominent findings
of each of the chapters and the study as a whole.
After considering the various portfolio theories, including the Markowitz
portfolio theory and the Capital Market Theory, the conclusion was reached
that the methods used, within these theories to construct diversified portfolios,
would be directly applicable to this study. More specifically this decision was
made to use the Markowitz Portfolio Theory as the basis for this study in light
of the fact that the Capital Market Theory is an extension of the Markowitz
Portfolio Theory and as such the findings of the study should not be
significantly different if the portfolios were constructed by using the CMT.
From this initial study followed the close examination of various concepts
related to portfolio management in general.
167
The study investigated more closely, the most important features of the
different portfolio theories. This included an in depth look at the definitions and
measurement of both risk and return. The section identified standard
deviation, as used in the Markowitz portfolio theory, as the relevant measure
for risk. In keeping with this it was decided to construct consequent portfolios
along the guidelines set out by the Markowitz portfolio theory.
The study concentrated on the identification and discussion of various
alternative investments/assets. These assets included assets such as
furniture, art, investment cars, containers and ceramics. Each asset or asset
class was briefly reviewed. The main contribution of this study, apart from
identifying various assets, was the identification of those factors which may be
regarded as universal value drivers of these assets. Among these factors
were authenticity, quality and provenance. Upon completion of the
investigation into the various assets it became apparent that even though
there were various alternative assets available for inclusion into portfolios,
some assets were more prominent than others. The most significant assets as
identified by the study included Gold, Wine and Art. The study also provides a
framework for the classification of assets into one of four groups, those
groups being antiques, collectibles, art and general alternative investments.
The identification of the more prominent alternative assets, as mentioned
above, led to the investigation of the effects that these assets would have on
existing portfolios. It should be noted that these assets were identified based
on the availability of price data and information relating to the assets.
Even though the main aim of the study was not to investigate the efficiency of
the alternative asset markets, as the study progressed it became apparent
that a brief discussion of this subject was warranted. The study gave
consideration to the various characteristics of good markets as well as to the
different forms of the efficient market hypothesis (EMH). Upon conclusion of
the initial examination various markets were tested in broad terms, against the
characteristics identified. These markets included equity markets, bond
markets, property markets and the alternative investments markets. The
168
findings of this section of the study are considered to be significant as it would
appear that most alternative markets subscribed to the weak-form of the
EMH. This would lead investors to believe that they should be able to derive
above average risk-adjusted returns, based on superior information, or access
to information regarding the asset. The study indicated that one of the major
disadvantages of alternative asset markets were their informational
inefficiency. This section was also identified as one that holds promise for
further investigation on the subject matter of alternative investments.
The findings of this empirical seemed to be important given the goal of the
study. During the course of this section of the study, the researcher performed
an analysis of those alternative assets which were perceived to be the
prominent groups/assets.
What is important, and this warrants the study as a whole, is the fact that the
inclusion of an alternative asset into an existing portfolio (assumed to be a
fully diversified portfolio, given various assumptions) gave rise to a greater or
lesser extent, to improved diversification and return. The results of the study
reject the hypothesis that these investments do not hold any benefits in terms
of further diversification of diversified portfolios.
Throughout the study it becomes apparent that alternative investments/hard
assets hold untapped potential for improving the risk/return characteristics of
existing investment portfolios. The study identified various benefits and
constraints associated with investing in these assets. It should be noted that
no asset class is without constraint or disadvantage and therefore investors
should not exclude the possibility of including an alternative asset into their
existing portfolios (taking note of constraints and giving it the necessary
consideration).
169
7.1 FURTHER RESEARCH POSSIBILITIES
As the study progressed it became apparent that very little research has been
done in this particular field, especially from an investment management
perspective. However two areas for further research appeared to be most
prominent.
The first of these areas pertain to the effectiveness of the markets in which
these alternative investments are traded. It would seem as if most assets are
bought and sold on an auction basis or privately which would lead one to
believe that price formulation is highly subjective.
The second area that offers the possibility of further research would be to
research the possibility of introducing ‘artificial’ liquidity and tradability into
these markets. This may be done in much the same way as has been done in
the property market, i.e. by unitising larger asset holdings. This type of
development should increase the efficiency of the alternative investment
markets, but may also alter some of its unique characteristics.
170
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