Praise for Stephen Todd Walker’s Understanding Alternative Investments “Few finance books today capture the true essence of tactical allocation and why it is crucial to make adjustments to a portfolio like Understanding Alternative Investments does By understanding that risk premiums change with market conditions, it can be possible to employ tactical asset allocation strategies to improve investment returns.” —Neil Peplinski, CFA, Managing Partner, Good Harbor Financial, LLC “One of the best finance books ever written on venture capital Venture capital moves in waves and riding the next wave is not always easy, which is why every investor, venture capital partner, and entrepreneur should study this book.” —Gary Rubinoff, Managing Partner, SummerHill Venture Partners “His latest book is an excellent read for financial services professionals who want to deepen their knowledge of alternative investments Todd has remarkable insights on how alternative investments can be integrated into variable annuities and 401(k) plans.” —David Nanigian, PhD, Assistant Professor of Investments, The Richard D Irwin Graduate School “Anyone who starts a business is a venture capitalist, an exercise highly valued by our society This book will acquaint the reader with the amazing depth and span of venture capital markets and the opportunities they present to the investor.” —Dr William C Dunkelberg, Chief Economist, National Federation of Independent Business and former Dean of the Fox School of Business and Management, Temple University “This book is a refreshing view of finance Wave theory can also be applied to private equity, which has no boundaries.” —Rupert Harrington, Managing Director, Advent Private Capital “Wave theory is timeless and should be learned by every business student One can learn a lot from Understanding Alternative Investments It should be mandatory reading.” —Brad Leve, Assistant Director, Farrell Corporate Innovation and Entrepreneurship Center, Smeal College of Business, The Pennsylvania State University “Walker’s new book, Understanding Alternative Investments, thoughtfully extends the application of his wave theory to real estate (as well as additional alternative investments) and provides valuable insights to investors and managers alike.” —Robert L Cooney Jr., Cofounder and Managing Principal, Steel Castle Capital, LLC “The nature of risk—and the appetite for it —have changed greatly since the onset of the Great Recession, and so has the landscape for alternative investments In Understanding Alternative Investments, Walker has taken a thoughtful, building-blocks approach It is a useful navigation tool for anyone interested in hedge funds or other alternative investments.” —Gregory J Nowak, Esq., Partner, Pepper Hamilton LLP, and author and lecturer on alternative investments and structures “Weathering today’s investment market is more challenging than ever Walker’s book provides investors with the critical tools needed when allocating real estate as part of a diversified portfolio Understanding Alternative Investments illustrates how alternative investments, such as real estate, can provide attractive risk-adjusted returns in an economic cycle.” —Jake E Hannah, Commercial Real Estate Professional “Crowdfunding is the next wave Extremely helpful book for anyone raising capital or investing in early stage companies.” —Bill Marvin, CEO and Cofounder of InstaMed “One needs to watch the waves when investing in or raising venture capital especially with technology.” —Bami Bastani, President and Chief Executive Officer, Meru Networks “Pension plan sponsors, endowments and foundations as well as pension consultants have all warmed up to managed futures in a significant way over the past decade This book clearly shows the merits of managed futures and how they can be used to further diversify a portfolio The attractive long-term, risk-adjusted (and noncorrelated) returns are one important way institutions can generate much-needed alpha in an era where much more horsepower is required beyond the traditional paradigm of stocks and bonds.” —David Lerman, Senior Director, Asset Managers, Products and Services, CME Group “Understanding Alternative Investments is an essential tool to prepare for finance interviews It offers comprehensive yet accessible insight into portfolio diversification with alternative investments that I used to impress my interviewers and receive job offers from bulge bracket, private equity, and real estate firms.” —Tony Murphy, Student at the Wharton School of the University of Pennsylvania “Perceptive work Anyone truly interested in helping improve the cardiovascular problems of today should read this book whether they are passionate about seeing a deadly disease get eradicated or as an investor in this space Todd has sparked a new movement with Cardio Companies as he calls them Investors have the potential to make money as well as help those inflicted with the number one killer of women and men worldwide, cardiovascular disease.” —Roger Schwab, Sports/Medicine Director, Main Line Health and Fitness “Venture capital has changed with the emergence of crowdfunding and P2P financing This evolution makes a working understanding of alternative investments critical for entrepreneurs and those hoping to reshape the world of finance.” —Justin W Askins, Esq., Attorney, Investor, Venture Capitalist “This book provides any entrepreneur as well as investors valuable insight regarding crowdfunding.” —Steve Graham, CEO of Scitt Kits, LLC and Serial Entrepreneur UNDERSTANDING ALTERNATIVE INVESTMENTS CREATING DIVERSIFIED PORTFOLIOS THAT RIDE THE WAVE OF INVESTMENT SUCCESS STEPHEN TODD WALKER UNDERSTANDING ALTERNATIVE INVESTM ENTS Copyright © Stephen Todd Walker, 2014 All rights reserved First published in 2014 by PALGRAVE MACMILLAN® in the United States—a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN: 978–1–137–37018–1 Library of Congress Cataloging-in-Publication Data Walker, Stephen (Stephen Todd) Understanding alternative investments : creating diversified portfolios that ride the wave of investment success / Stephen Todd Walker pages cm ISBN 978–1–137–37018–1 (hardback) Portfolio management Investment analysis I Title HG4529.5.W355 2014 332.6—dc23 2013047212 A catalogue record of the book is available from the British Library Design by Newgen Knowledge Works (P) Ltd., Chennai, India First edition: July 2014 10 Printed in the United States of America DISCLAIMERS AND DISCLOSURES This book is designed to provide accurate and authoritative information in regard to the subject matter covered, and the information, analysis, and data contained herein are based on sources believed to be reliable The author and Stratosphere, LLC not, however, guarantee the timeliness, accuracy, or completeness of the information provided The author has been associated with a number of leading investment banking firms in his career but the opinions in this book are his alone All information and opinions herein are subject to change without notice and are not intended to be the primary basis for any investment decision The strategies described not address individual financial objectives and may not be suitable in every situation The appropriateness of a particular investment or strategy depends on an investor’s particular circumstances and objectives The author and Stratosphere, LLC not intend to render individual financial, investment, tax, legal, accounting, or other professional advice or services in this book If personal advice or services are required, the reader should engage a competent professional Nothing in this book should be construed as a recommendation about the advisability of purchasing or selling any particular security The charts and graphs are for illustrative purposes only, and past performance of any security described in this book is not necessarily indicative of and does not guarantee comparable future results All investments are made at the reader’s own risk, and the publisher, the author, or Stratosphere, LLC shall not be liable or cannot be held responsible for any losses or damages, including without limitation special, incidental, consequential, or other damages, incurred as a result of actions taken or not taken on the basis of the information, opinions, or strategies set forth or described herein The author, the author’s clients, and/or Stratosphere, LLC may invest in securities mentioned in this book Alternative investments are speculative and include a high degree of risk They are typically highly illiquid, because, among other things, they often involve (i) securities that are not registered under the Securities Act of 1933 and/or (ii) securities that are subject to legal or contractual restrictions or requirements relating to their purchase, holding, or sale, or the exercise of rights and performance of obligations with respect to them Most alternative investments are also very volatile Investors could lose all of, or in some cases more than the original amount of, their investment For these reasons, they are suitable only for experienced and sophisticated investors who are capable of understanding and assuming the risks involved and who are willing to forego liquidity and put capital at risk for an indefinite period of time Some of the other risks involved in and factors affecting the price of the types of alternative investments discussed in this book are set forth below:Gold: Risks of investments in actual gold or securities backed by actual gold include but are not limited to forgery, fraud, theft, and loss Prices of all types of investments in gold can be affected by, among other things, (i) speculation; (ii) hedging; (iii) expectations regarding inflation; (iv) supply and demand; (v) currency exchange rates; (vi) interest rates; (vii) global or regional instability; or (viii) political, financial, economic, and regulatory conditions or events.Commodities: Risks include but are not limited to geopolitical risk, leverage, speculation, and fraud Prices can be affected by, among other things, (i) changes in supply and demand relationships; (ii) governmental programs and policies; (iii) national and international political and economic events, armed conflict, and terrorist activity; (iv) changes in interest and exchange rates; (v) trading activities in commodities and related contracts; (vi) technological change, climate change, and weather conditions; and (vii) the price volatility of a specific commodity.Hedge funds: Risks include but are not limited to (i) little or no regulation; (ii) leveraging, short selling, and other speculative investment practices; (iii) lack of transparency regarding underlying investments; (iv) unavailability of pricing or valuation information; (v) reduction of profits by high fees, some of which are not based on profitability; (vi) complex tax structures and delays in distributing important tax information; and (vii) the potential for regulatory changes Venture capital funds : Risks include but are not limited to (i) business risks involved in investing in smaller, less established companies; (ii) availability of future capital or other financing; (iii) lack of liquidity of underlying investments; and (iv) dilution of underlying investments.Leveraged buyout (LBO) funds: Risks include but are not limited to the following: (i) Investments in LBO funds are speculative and carry a high degree of risk (ii) LBO funds frequently have limited transparency and utilize different valuation methods (iii) Private equity does not have the same regulatory requirements such as mutual funds (iv) Investors in LBO funds might experience delays in receiving tax information Similarly, investing in LBO funds might not be tax efficient (v) Long lockups for funds are a risk (vi) Economic and political developments can adversely affect LBO investments (vii) Market risk exists (viii) Managers can utilize leverage, which might increase their exposure to certain variables such as rising interest rates (ix.) There is no guarantee of future results based on past leveraged buyout activities Typically, there is no market for Limited Partnership Investments (x) Investors in LBO funds rely on the General Partner as well as the investment advisor (xi) There is no assurance that the funds’ objectives will be achieved (xii) Failure to make payments in a private equity fund might lead to a forced sale of its investments in the fund or preclusion from further investment (xiii) LBO funds can have high fees for management, placement, and performance.Managed futures: Risks include but are not limited to (i) illiquidity; (ii) leveraging and other speculative investment practices; (iii) they are not required to provide periodic pricing or valuation information to investors; (iv) high fees; (v) may involve complex tax structures; (vi) delays in distributing important tax information; (vii) manager risk; (viii) market risk; (ix) reliance on certain strategies such as trend following, which might not work in certain environments; and (x) government and political risk.Real estate: Risks include but are not limited to (i) falling property values due to increasing vacancies or declining rents resulting from economic, legal, or technological developments; (ii) non-diversification (certain real estate funds can be classified as “non-diversified” under the 1940 Act and can invest a greater portion of its assets in obligations of a single issuer than a “diversified” fund); (iii) reliance on an investment adviser and subadviser; (iv) tax risks; (v) investment and market risk; (vi) competition can reduce the number of attractive portfolio investment opportunities available to a real estate fund); (vii) interest rate risk is the risk that debt securities in a fund’s portfolio might decline in value because of increases in market interest rates; (viii) if a real estate fund holds mortgage backed or other such securities, there is credit risk where securities in the fund’s portfolio might decline in price or the issuer thereof will fail to pay interest or principal when due; (ix) leverage risk (real estate funds can use leverage, which will magnify investment, market, and certain other risks); and (x) past performance is no guarantee of future results * * * Trademarks and service marks used in this book are the property of their respective owners “All truly great thoughts are conceived by walking.” —Friedrich Nietzsche CONTENTS List of Illustrations INTRODUCTION That Was Then, This Is Now CHAPTER Does the Universe Move in Waves? CHAPTER Not All Financial Advisors Are Created Equal CHAPTER Access to Alternative Investments and Competitive Advantages CHAPTER The Changing Financial Landscape CHAPTER I Hate To Say It, But I Told You So CHAPTER The “Smart Money” Is Global CHAPTER Hedge Funds: Evil or Angels in Disguise? CHAPTER The Fools’ Gold or the Real Deal? CHAPTER Venture Capital CHAPTER 10 Asset Allocation and Alternative Investments CHAPTER 11 Modern Portfolio Allocation CHAPTER 12 Devising Portfolios with Alternative Investments (Active vs Passive) CHAPTER 13 The Asset Allocation Process and Sample Portfolios Notes Index ... investor that included alternative investments While my previous book is about patterns, trends, and cycles that alternative investments exhibit and defining alternative investments, Understanding Alternative. .. Liquidity of Alternative Investments Growth of Alternative Investments Traditional Portfolio vs Diversified Portfolio with Alternative Investments Large Pension Plans and Alternative Investments. .. and Serial Entrepreneur UNDERSTANDING ALTERNATIVE INVESTMENTS CREATING DIVERSIFIED PORTFOLIOS THAT RIDE THE WAVE OF INVESTMENT SUCCESS STEPHEN TODD WALKER UNDERSTANDING ALTERNATIVE INVESTM ENTS