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SEW mfigw fig mam m3 3 mmmmk. mm “$8 mgwmgfi “gong. “mm” %&§ 3 “Em A “gamma mmwmofiflgfi Exam mmw mw ENE? «mam mmm :gxom 3 $3 wow .35 wwmmfimfi m3.me mmugm cmwgfi gig ugfimmm $333 mmfimmwmfiww aw?“ $3? .nmmfinuw 3?me Ma “mmmgwmm Egfimwmg é Em? “mkmwgw may“ m3 mbmm mg? 3 wawmymg fix; .cmfifima mwfim m QM mmfi®fi> 538 Q mfifimmx $3» 3.3% $5ka wEmfiw fifimmfi 5&5wa Q QEWEE Exam mfl me “gm NEE.” Mg“ mama Emma “Ens, Ham E g5” mmEmwo gab Em ummmfiwv “8mm mg dawfifimfifiw we mwgmwmm mg mmmmmfi “anew “Mam, 1%?» 3w Egan 9&3 $8 mmuflm rat: tau tantra. Deals & Deal Makers: Venture Capital, While Risky Investment, Can Be an Effective Tool to Hedge Market Wall Street Journal; New York; Mar 23, 2000; By Paul M. Sherer; Edition: Eastern edition Start Page: C26 ISSN: 00999660 Subject Terms: Investments Venture capital Deals & deal makers (wsj) Abstract: Venture capital is probably one of the last things most investors would think of. But a new study argues that the performance of venture capital has almost no correlation to the stock market, making venture capital an effective hedging tool. Money is pouring into venture capital to chase the hot performance of new technology-stock ofi‘erings. Over the years, venture-capital funds have been strong performers, but extraordinarily risky ones. But Ibbotson found the venture fiends to befar riskier investments than the other asset classes. The venture funds’ 45% average return had a standard deviation (a measure of volatility) of115.6%, compared with a standard deviation of 15.65% for the S &P 500, says Peng Chen, senior research consultant at Ibbotson and co-author of the study. Full Text: Copyright Dow Jones & Company Inc Mar 23, 2000 Too much stock-market exposure? Try venture capital to diversify portfolio risks. Venture capital is probably one of the last things most investors would think of. But a new study argues that the performance of venture capital has almost no correlation to the stock market, making venture capital an effective hedging tool. Money is pouring into venture capital to chase the hot performance of newtechnology—stock offerings. Over the years, venture-capital funds have been strong performers, but extraordinarily risky ones. From 1960 to 1999', venture—capital funds tracked by Ibbotson Associates, a Chicago asset allocation and consulting firm, had an average annual return of 45%, according to a new study by the firm. That compares with 13.34% for the Standard & Poor’s SOD—stock index, 17.16% for small stocks and 7.57% for long—term Treasury bonds during the period. But Ibbotson found the venture funds to be far riskier investments than the other asset classes. The venture funds’ 45% average return had a standard deviation (a measure of volatility) of 115.6%, compared with a standard deviation of 15.65% for the S&P 500, says Peng Chen, senior research consultant at Ibbotson and co-author of the study. Translated into English: For the S&P 500, there is a 95% chance in any given year that returns will range from a 45 % profit to a 18% loss, Mr. Chen says. For venture-capital funds, there is a 95% chance that the performance will vary from a 276% profit to a total loss. Despite the risks, the Ibbotson study found that venture-capital values don’t move in line with the stock market and therefore are a good alternative investment. While small stocks have a 67% correlation with the S&P 500 and international stocks a 48% correlation, venture-capital funds have only a 0.4% correlation, Ibbotson says. I "Venture-capital investments are typically relying on one idea or one product," Mr. Chen says. "If that idea or product takes off, [the valuation is] going to take off. If it doesn’t, your investment would be worth nothing. The success of the idea doesn’t have a whole lot to do with what the general stock market is doing.” For diversification, the study recommends allocating 2% to 10% of an equity portfolio into venture capital. Though the Ibbotson study relied on fund performance from 1960 to 1999, recently the strong stock market has proved a windfall for venture-capital firms -— and may skew the data toward a higher correlation between the public and private markets. "I think what you would see on more recent data is greater correlation [with public stocks], because the IPO market is so good for venture—capital companies," says Mario Giannini of Hamilton Lane Advisors LLC, which is the alternative investment consultants for California Public Employees Retirement System. Still, he says, "we certainly believe that venture capital is not significantly correlated with the public markets, but I think that will vary depending when you’re taking your data." Venture-capital—fund returns should get hurt if the market for technology stocks crashes, "both because valuations won’t be strong, and because they’ll be holding their money longer,” Mr. Giannini says. But the funds have the flexibility of not having to sell in any given quarter, he adds. A series of mammoth gains by venture-capital firms launching Internet companies has lured huge new investments into the market. Venture—capital investments last year hit a record $48.3 billion, up 151.6% from 1998, according the National Venture Capital Association and research firm Venture Economics. Calpers, for example, now has $10.5 billion of its $171 billion portfolio in alternative investments, which include private equity funds and some direct investments, spokesman Brad Pacheco says. That includes about $1 billion in venture capital. Last year, the pension fund committed $350 million to establish a dedicated venture-capital fund. Salomon Smith Barney believes that private equity in general is less risky than small—capitalization public stocks, because of the weak liquidity of small-cap stocks and the control available to private equity owners, says Michael S. Klein, Salomon vice chairman and head of the Financial Entrepreneurs Group. "Because venture capitalists and private equity firms retain control over the businesses in which they invest, they have the ability to exit their investment through several different alternatives other than selling stock," he says, such as a sale or a recapitalization. "This more than offsets the illiquidity of private—equity investing." The challenge in measuring the performance of venture capital and other private-equity funds is that the day-to—day value of their assets is typically unknown. Unlike public stocks, the value of investment in a private company is known only when the investment is sold. To obtain accurate results despite this problem, Ibbotson developed a model that measures assets of the funds at their openings and when they were liquidated. It used data on 148 venture funds provided by Venture Economics. Venture Capital: High Reward, High Risk CORRELATION AVERAGE STANDARD WITH S&P 500 ANNUAL RETURN DEVIATION* PERFORMANCE** S&P 500 13.34% 15.65% 100.0% U.S. Small Stocks 17.16 24.96 67.0 U.S. Long—Term Govt Bonds 7.57 11.41 35.0 U.S. 30 Day Treasury Bills 6.02 2.68 — 4.0 U.S. Inflation 4.51 3.16 -29.0 International Stocks*** 15.16 21.60 48.0 Venture Capital 45.00 115.60 0.4 *How much a result is likely to vary from the average. For each asset class, there is a 95% chance one year’s return will fall in the range of the average annual return plus or minus twice the standard deviation. **How closely the instrument’s performance duplicates that of the S&P 500 . ***Based on Morgan Stanley Capital International’s Europe Australasia and the Far East benchmark index Note: Performance since 1960, except for international stocks since 1970. Source: Ibbotson Associates Credit: Staff Reporter of The Wall Street Journal , Reproduced with permission of the copyright owner. Further reproduction or distribution is prohibited without permission. Playing Your Career Against the Market By ALEXANDRA ALGER people regard balance and diversi- fication as a matter of choosing the right mix of stocks, bonds and mutual fluids to match their goals. But a grow- ing number of economists say invest- ors are overlooking one of the most important elements of their financial portfolios: their jobs. Workers, these scholars argue, need to assemble portfolios that reflect their professions and the reliability of their earnings. Those with union contracts in stable industries should not allocate their investments in the same way as entrepreneurs who do not know what they will earn from one year to the next, or managers who receive much of their compensation in stock. New financial tools to help investors limit those risks are in the works, al- though their success is not assured gr! choosing their investments. most Robert J. Shilier, the Yale University :5 I, ' economist known for his well-timed criticism of the excesses of the stock market, hopes to introduce securities that would let workers hedge against downmms in the nation’s economy or their own professions. For those on the highest rungs — execu— tives and company founders who receive huge chunks of stock as part of their annual compensation —- a form of such hedging is already available. investment banks allow them to use their restricted stock — shares they cannot promptly sell —— as collateral for loans, so they can diversify their hold- logs. Employees should be as careful as top' executives to hedge their job risks, accord- ing to Deborah Lucas, chief economist at the Congressional Budget Office and a finance professor on leave from Northwestern Unis versity‘s Kellogg Graduate School of Mam agement “Jobs are assets, but risky assets," Ms. Lucas said. “People need to understand that risk." Here is away to start: Think of your job as part of your investmen , and look at how risky or sale, how stable or undependable, your income from it may be. As Geert Bekaert, a finance professor at Columbia Business School, put it, "A job generates income, just as a stock generata dividends and bonds generate interest" in broad terms, the stability of their cam- ings can be a gauge of how aggressive investors should be in choosing asset alloca~ tions. The more predictable the wages, the riskier other investments can be. A tenured professor, whose earnings are as consistent as the income from a high-grade band, can afiord to be largely in growth smells. But an hivestment banker may have compensation (mostly as bonuses) that depends heavily on the health of the stock market and may be even more volatile. People on Wall Street are often so exposed to the stock market's risks that they should hedge with bonds, lately! stocks or perhaps real estate, Ms. Lucas said. . OS!" workers. however, do not have such extreme risks. But economists say that many people may not real- ize the extent of their stock-market-expo— sire. Steven J. Davis, a labor economist at the University of Chicago Graduate School or Business. says wages ct collegeeducated workers in general correlate to some degree with movements in the Standard 8: Poor's film-stock index. Wages of less educated workers do not. Mr. Davis suspects that the wages of me best educated are more closely tied to the success of their employers, as reflected in the 5.8: P. The earnings of entrepreneurs track the stock market especially closely, according to Lucas. who done research or. the topic. To her, that provides strong evidence that entrepreneurs are not well diversified. “anesting in your own business is to some extent investing in your own human capital," Ms. Lucas said, using the econom- ics term to describe the value of a person’s training and skills. “it the value of your business and the value of the stock market move together, then they go down together. That’s a lack of diversification." she also found that entrepreneurs tended to have large stock portfolios. “That’s a double risk." she said Also underdiversified, she said, are those high-technology managers who. at least un‘ til recently, were receiving most if not all of their compensation in the form of stock options. if they do not shift into other assets, she said, they could be “billionaires one day and have nothing left the next" Recent years have provided few incen- tives for investors to diversify beyond stocks, Ms. Lucas acknowledged. “Our story is more cautionary than the history of the last 10 years," she said. But investors can diversify while remain- ing in stocks, she added. by finding a part of the market that moves in a diiierem direc- ‘ tion than their own company’s stock “Ii it’s ahigh-tech firm, the right thing to do — even if it's boring — is to invest in oldeconomy stocks," she said. Many financial advisers already consider the earnings outlooks of clients in planning their investment strategies. "The stability of your future income stream — it impacts everything, from what mortgage you take out to how you finance your children‘s edu- cation," said Robert Doyle, a certified pub- lic accountant and financial planner at Spoor Doyle 8: Associates in SL Petexsburg. Fla; But persuading some clients to accept even common-sense advice about not hold- ing too much stock in their own companies — unless they are sure they are part of the next Microsoft — can be difficult Roger Gibson, an invesmient adviser whose firm, Gibson Capital Management, is based in Pittsburgh. cited the example of a client inbis 20's who was once worth several million dollars based on stock he owned in his high-technology employer. Mr. Gibson advised him to sell much of it. But no. "He overstayed the party and got crunch ” Mr. Gibson said. The client, having left the company, has since cashed out most of his remaining half- million dollars worth of company stock, to diversify into other Stocks and hands. He has moved on to other jobs, meanwhile, where he has acquired stock options. Esra- cially because the client is still under 30 and receives large salaries in his jobs, Mr. Gib- son now considers him sufficiently diversi- tied. F portfolio strategy can help balance career risks, Mr. Shiller. the author of "Irran'onal Exuberance" (Princeton University Press), wants to introduce ways to hedge such risks mare directly. He and Allan Weiss, his business partner (and a former Yale student whom Mr. Shiller ad- vised) , are designing what they call “macro securities” to hedge fluctuations in profes- sional earnings. One security might be tied to a broad economic indicator, like the gross domestic product. People whose incomes varied with the health of the economy could use these securities to guard against slowdowns or recessions. Mr. Shiner also proposes a secu- rity that would be tied to home prices, so that investors could hedge against a fall in the value of their homes — the largest asset that many people have, aside from their jobs. Mr. Shiller, who has been Working on these ideas for years, recognizes how novel such securities would be. “There have been no big motivations in financial markets, unlike in Silicon Valley,” he said. “I'd love to see these things get going. it would be revolutionary." He and Mr. Weiss, having patented the structure of the macro securities, are try- ing to rally interest among investment banks that could underwrite them and among brokerages that could sell them to consnmers. They would not identify any of the firms with which they have held discus- sions. [nonetheybopemcomeup with similar nastrumems that track the earnings power of different professions, from law— yers or doctors to computer programmers. “There’s lots or data out there on wages for different professions; it’s just a question of finding it" said Mr. Weiss. 3 co-iounder with Mr. Shiller of Case Skillet- Weiss, 2. Cambridge, Mass. firm that puts together home price indexes for banks and corporate credit rating agencies. Could such securities catch on? “It would- n't surprise me at all.” said Christopher Jones. vice president for strategy at Finan- cial Engines, an calico investment advisory - service in Palo Alto, Calif. "You see this today at the corporate level. investment banks create complex derivative contracts for their clients to hedge all lands of risk. Over time. i think you'll see that happening at the individual level." 13 {£111}: :28 8:... .8. a 2.3 88.... E. ..E: .28 2.8.2:... 8.... £88.. .88....8 5.3 8...... 2... 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GETTING GOING 4> By Jonathan Clements 15 Stocks JustAren’t‘Enough year, you’re probably blaming imploding technology IF YOUR PORTFOLIOJHAS been murdered over the past stocks. But don’t overlook the innocent-looking accomplice. According to a Wall Street ruleof thumb, “all you need to build a diversified portfolioxare 15 or 20 stocks.” Sound harm- less enough? In truth, it’s extraordinarily dangerous advice. Emboidened by that popular adage, many investors aban— doned mutual funds during'the“ late 19905 and loaded up on individual stocks, only tube ammered by "the posite Index’s 62% plunge I . . . ~ . I I: ' ‘-What; went wrong?‘,It turnsbut that you nee a lot more than 15 or 20 stockstoireti’uce‘ Here’s why: t VOIaiilltY Risingi'fi'le market’s overall ~gyrat’ionsri V increase between 1962, andw,1997, according to a study in the February 2001‘Journal‘ot Finance by JohnCampbeli, Martin Lettau, Burton. Malkiel and Yexiao Xu. But over the same stretch, the volatility of individual stocks more than doubled. “Investors that have a portfolio that is highly concentrated in just a few securi- - ties are taking on a lot more risk than they were 20 or 30 years ago," says Mr. Malkiel, an econom- ics professor at Princ- eton University. Not all the news is bad. While individual- stock volatility has been rising, Mr. Malk- iel and his co—authors also found that stocks were less likely to move in iockstep with one another. Because some stocks zig while others zag, you can re- duce a portfolio’s overall volatility by spreading your money across more stocks. “The benefits of diversification are even greater,” Mr. Malkiel says. “But you need somewhat more securities to get that benefit. Because of the enormous specific risk of individ- ual stocks, the old rule that says ‘get 20 well—diversified stocks’ should probably be replaced by a rule saying ‘get 40 well-diversified stocks.’ ” Losing Track: A 40-stock portfolio shouldn’t perform much more erratically than the broad stock market. But unfortu- nately, volatility isn’t your only worry. With a limited number of stocks, “you can end up with a portfolio that has very low risk,” says William Bernstein, an investment adviser in North Bend, Ore. “But you can also have a very low return. The risk of having a volatile portfolio is completely different from the risk of having a low return.” At issue is the notion of “tracking error.” In a Winter 2000 Journal of Investing article, Ronald Surz and Mitchell Price calculated returns for portfolios of 15 randomly selected Wait 9m»? “Swami she/0i stocks over the 13% years through June 1999. y » The authors found that among such randomly selected- 15-stock baskets, the typical portfolio strayed as much as 8.1 percentage points a year from the market’s 'return.vThus,' if ' the market was up 11% in a given year, the typical portfolio might gain as much as 19.1%—or as little as 2.9%. . y 4 ’ What if you are careful to pick a group of 15 well-div'ersi-' fied Stocks? The typical tracking error was 5.4’percentage‘ points. .Some 15-stock portfolios strayed far more than this amount, while others would track the market more closely. Even if you held 60'stocks and even if you were careful to di- versify, the typical tracking error was still 3.5 percentage pointsayear. ' a , . “Fifteen names aren’t enough,”'argues Mr. Surz, presid- dent of PPCA, an investment-software firm in San Clemente, ' Calif. To get decent diversification, “the number is probably north of 60.” ‘ « Future Shock: Purchasing 60 or more stocks is no longer a crazy idea for small investors, thanks to the emergence of "to lios," those portfolios g of individual stocks that can be bought through Web sites like www.foliofn.com and www.metfoliocom. But you may, in fact, want a lot more than 60 stocks. “At the level of 300 or 400 stocks, you’re proba- bly down to one or two percentage points of tracking error," Mr. Bernstein says. “Do you want to take the risk of underper- forming the market by one or two percent- age points a year over the next 20 years? I don’t." Over time, trailing the market by a few percentage points a year can really bite. If you earned 9% a year for 20 years while the market gained 11%, for instance, you would amass 30% less than if you had earned the market‘s return. The only way to eliminate this tracking error is to own the entire market, preferably through a low-cost index fund that mimics the Wilshire 5000 or the Russell 3000. _ Of course, rather than trailing the market by two percent» age points a year, you might beat the index by that much. The problem is, the costs of failure are far greater than the bene- fits of success. If you hit the jackpot, your retirement might be somewhat more comfortable. But if you destroy your retire- ment nest egg, you might not be able to retire at all. “People are trading off the high likelihood that they will lag the market for the small chance of winning the lottery,” says Larry Swedroe, research director at Buckingham Asset Management in St. Louis. “You’re playing with the money you’re going to retire on. You shouldn’t be taking unnecessary risk. But that‘s What you do when you don’t diversify.” CELEBRATING ‘ As part of its anniversary celebration, BusinessWeek is presenting a series of weekly profiles of the ', greatest innovators of the past 75 years. Some made their mark in scienco or technology; others in management, finance, marketing, or government. This week, BusinessWeek publishes a special commemorative issue on Innovation. Basins» IO/\\ /O'~\ Three Wise Men of Finance IF YOU'VE EVER put money in an index mutual fund, you can thank three economists—Harry Markowitz, William Sharpe, and the late Merton Miller. Such funds are the best—known application of research they did in the 19505 and ’60s. Their work won them the Nobel prize for economics in 1990 andchanged the way investors and managers think about markets, money management, and securities design. Key concepts in investing and corporate finance that are today accepted as obvious can be traced back to their articles in scholarly journals—everything from the existence of a systematic trade-off between risk and return, to the concept that markets are efficient Markowitz, a self-described nerd whose father was a Chicago grocer, set the ball rolling. In 1952, the University of Chicago economist published a 14-page paper called “Portfolio Selection.” At its heart was what Peter Bernstein, dean of financial economists, called “the most famous insight in the history of modern finance” ——the idea of diversifying a portfolio of stocks in order to produce the maximum potential returns given the amount of risk an investor is prepared to take on. Of course, the notion of not putting all one’s eggs in the same basket had been a truism for centuries. (It’s mentioned in the Talmud and Shakespeare among other places.) Markowitz proved Why this is so by explaining the ' fundamental trade-offs between risk and return and between asset concentration and diversification. Money managers around the world still follow his precepts daily. Markowitz’ early work sparked a long period of intellectual MILLER ' Their insights ferment. In the process, Markowitz, Sharpe, and Miller demolished many cherished Wall Street ideas. One example: that it’s possible to beat the market consistently by savvy stock picking. Impossible, they said—beCause thousands of investors collectively have factored everything that is known about stocks into current prices. Sharpe, a charming if sometimes blunt computer whiz, devised the capital asset pricing model (CAPM), which quantified the idea that investors demand extra returns for taking on more risk. Souped-up versions of the CAPM are still used widely in business to guide investment decisions. Miller, a passionate defender of futures markets, developed, with Franco Modigliani, the MM Proposition. They showed that any companfs worth depends on its earning power rather than its book value. So, if there’s a tax break on interest payments, savvy companies should favor debt over equity. That insight was a real shocker to a Wall Street steeped in the cult of the equity. It provided the intellectual heft that led to the surge in the junk bond markets in the ’705. Leveraged buyout, anyone? There were some failures. A few techniques developed fi‘om their ideas by Wall Street rocket scientists proVed disastrous: So-called portfolio insurance 111110 file 111 lkS was partlykto blanlile for the 1987 UN , ‘ stock mar et cras . be een flSk Now, a new generation of financial economists is and remm challenging the work of Miller, Sharpe, and Markowitz, often - - improving on it. But it’s the mvestmg Nobel trio who helped turbocharge global capital forever market, . — —By Christopher Farrell SHARPE ...
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