Editor's Letter

As a career hedge fund academic and practitioner, I remain surprised when questions are raised as to the fundamental basis for a wide range of alternative investments and their place in the modern investor's portfolio. Often one reads or hears that many alternative investments, such as hedge funds, commodity investments, and private equity, are simply “too risky” or “too complicated” for either the individual or institutional investor. The purpose of The Journal of Alternative Investments is to offer readers a means to understand better alternative investments and their place in the modern portfolio.

The lead section presents an article on Economic Value Added (EVA) analysis. In the first article, “Active Investing in Strategic Acquirers Using an EVA Style Analysis,” James Grant and Emery Trahan examine whether active investors such as hedge funds can develop an alpha-generating strategy by classifying acquisitions based on the pre-acquisition style quadrant of the acquirers. The evidence suggests that acquisitions across all EVA style quadrants generate negative risk-adjusted returns, wherein the potential for economic gains from shorting acquirers is greater for pre-classified wealth destroyers than it is for wealth creators. They also find evidence of continuing negative returns following the acquisition announcement for wealth destroyers, while for wealth creators the post-acquisition announcement effects are mixed. These results support the view that investment strategies involving acquisitions should be linked to the fundamentals of wealth creation.

The next section presents articles on options strategies. In the second article, “Collaring the Cube: Protection Options for a QQQ ETF Portfolio,” Edward Szado and Hossein Kazemi assess the effectiveness of a long collar as a protective strategy. They examine the risk/return characteristics of a passive collar strategy on the Powershares QQQ trust exchange traded fund and find that a 6-month put/1-month call collar provides far superior returns to the buy and hold QQQ strategy with significantly less volatility over the period of their study. Since returns from protective strategies are not normally distributed, both Leland alpha and the Stutzer index are used to measure risk-adjusted performance. In addition a number of implementations of a long collar strategy are considered where for each strategy the impact of bid/ask spreads on the strategy's performance are taken into account. To examine the collar's performance in different market environments, the time period is further segmented into two sub-periods, an early period which is generally favorable to the collar and a later period which is unfavorable to a collar strategy. The magnitude of the risk reduction of the collar is significant.

The put-write strategy of selling cash-secured S&P 500 Index put options has the potential to appeal to investors who wish to add income and attempt to boost risk-adjusted returns, in return for risking underperformance during bull markets. An investor who engages in a cash-secured (or collateralized) put sale strategy sells (or “writes”) a put option contract and at the same time deposits the full cash amount necessary for a possible purchase of underlying shares in his brokerage account. The first major benchmark index for the cash-secured put strategy is the CBOE S&P 500 PutWrite Index (PUT), which was introduced in 2007. In the third article, “The Cash-secured PutWrite Strategy and Performance of Related Benchmark Indexes,” Jason Ungar and Matthew Moran analyze the performance and volatility of the CBOE S&P 500 PutWrite Index. Over the period studied, the PUT Index outperformed the S&P 500 Index with significantly lower volatility. A key factor in the superior performance of the PUT Index was the fact that the S&P 500 options were richly priced - the implied volatility for the S&P 500 options usually was higher than the subsequent realized volatility of the S&P 500 Index.

The third section features an article on valuation of hard-to-value securities. When the adopting release for FAS 157 was published back in 2006 it was inconceivable to many how controversial the standards would become. It has since been deemed responsible for everything from bank failures to the sharp downturn in structured credit markets. And all this for a new accounting standard that did not require a single new fair value measurement. Nor were most of its principles a major departure from pre-157 valuation practices. In the fourth article, “Fair Value of Illiquid Securities – Are We There Yet?”, Espen Robak provides a detailed analysis of FAS 157 with emphasis on valuation hierarchy, exit price concept and illiquidity discounts as they relate to auction-rate securities, restricted securities, LP interests, warrants and convertible securities.

The final section presents perspectives on volatility and performance measurement. In the fifth article, “Volatility Exposure of CTA Programs and Other Hedge Fund Strategies,” Marc Malek and Sergei Dobrovolsky examine the dependence of trend-following CTA performance on underlying market volatility, both quantitatively and conceptually. While it is generally believed that CTAs have a long volatility exposure, tests conducted by the authors indicate that it is not quite true. The perception that CTA strategies are long volatility came from academic research and became widespread among traders. The notion of volatility exposure is sometimes confused with a dependence on volatility levels. If a CTA makes money in periods of high volatility and loses in periods of low volatility, its performance depends on the level of volatility. Volatility exposure, on the other hand, means that the CTA makes money when volatility rises and loses money when volatility falls. Both effects have comparable strength, are directly related and thus are quite easy to confuse. The authors note that volatility exposure, i.e. dependence on volatility changes, should not be confused with dependence on volatility levels. In the final article, “Real Estate and Private Equity: A Review of the Diversification Benefits and Some Recent Developments,” Urbi Garay and Enrique ter Horst discuss the recent literature on the benefits of including real estate and private equity investments in an investor's portfolio, and examine certain topics that have attracted academic and practitioners' interests in these two areas.

As markets evolve, alternative investments must evolve with it. The Journal of Alternative Investments looks forward to analyzing these changes and how they impact financial markets as well as individual and institutional investment portfolios. Remember we are all in this together.

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