Often one hears the comment, “Here is the ’good news’ and here is the ’bad news.’” Of course, it is the same news. For instance, the common aphorism that “Change is Good,” also meets up with the necessity to change. Change in the financial markets is the life’s blood of The Journal of Alternative Investments. The research published in The Journal of Alternative Investments aims to review past ideas and introduce new concepts. But change is not easy. One need but remind ourselves of Alice’s series of statements in Lewis Carroll’s book Alice in Wonderland that when faced with changes around her she exclaimed that “How queer everything is today! And yesterday things went on just as usual. I wonder if I’ve been changed in the night? Let me think: was I the same when I got up this morning? I almost think I can remember feeling a little different. But if I’m not the same, the next question is, Who in the world am I? Ah, that’s the great puzzle!”
Certainly, investors and researchers in the alternative investment space have every reason for waking up in today’s markets feeling a little bit different and questioning who in the world are they. The first article in this issue, “The Different Faces of Volatility Exposure in Portfolio Management,” offers a potential solution to individuals’ concerns over the uncertainty in financial markets. The following two articles, “Managed Futures Research: A Composite CTA Performance Review” and “Venture Capital in Crisis: The Impact of the Economic Downturn in Company’s Time to Exit,” raise questions (in other words, increase uncertainty) about how performance issues were previously addressed in managed futures and private equity research. A perfect example of how the rapidly changing market environment can impact how we view current research is illustrated in the last three articles in this issue: “Risk Assessment for a Structured Product Specific to the CO2 Emission Permits Market,” “Financial Turmoil in Carbon Markets,” and “Voluntary Environmental Regulation and Firm Performance: The Chicago Climate Exchange.” When these articles, which deal primarily on the carbon emission markets, were submitted, the markets had gone from “hot to not.” Within recent months, however, with new regulatory impetus in several states, as well as potential action at the federal level in the U.S., what may have been once regarded as somewhat backward-looking articles have a renewed importance in where the area may be going in the future.
RISK MANAGEMENT
In “The Different Faces of Volatility Exposure in Portfolio Management,” Joanne Hill analyzes the different forms and features of equity volatility exposure and reviews the merits of incorporating equity volatility exposure in portfolio management. The main goal is to show the diversification power of tradable equity volatility-based products, such as VIX futures and products based on VIX futures indexes, and to compare their value in a risk-management context with other strategies traditionally used for modifying investment risk. Features examined include correlation and tail-risk properties, betas to the VIX and S&P 500, and the impact of rolling futures positions on returns. Different investment applications of short-term and mid-term VIX futures and VIX futures indexes are reviewed and the risk–return characteristics of these forms of volatility exposure are compared to those of other risk-modification strategies. The analysis shows that for investors with longer term investment horizons, mid-term VIX futures and futures indexes have the most attractive features for managing risk and are more capital efficient than fixed-income. However, the main significance of the analysis from a portfolio management perspective is that volatility exposure is a viable and attractive alternative to adding cash-equivalent and fixed-income exposure for reducing risk.
PERFORMANCE ISSUES IN ALTERNATIVE INVESTMENTS
The data and time dependency of empirically based financial research is a common concern to both academics and practitioners. Changes in regulatory, trading, and investor environments may result in dramatic changes in the underlying viability of any investment vehicle and/or trading process. This is especially true for managed futures programs for which a single, commonly used database does not exist and that are often dynamic in nature and are impacted by changes in trading instruments and underlying markets. As a result, empirical analysis of the potential benefits of managed futures (e.g., commodity trading advisors (CTAs)) may be impacted by the period of analysis and the strategy composition of the database or index used to represent the managed futures investment.
Thomas Schneeweis, Richard Spurgin, and Ed Szado conduct a series of empirical tests on CTA indices that are designed to represent the overall return to the reporting universe of CTAs (e.g., composite CTA index) in “Managed Futures Research: A Composite CTA Performance Review.” These tests are similar to those previously conducted on a series of “composite” hedge fund indices. Using major composite CTA indices as a surrogate for CTA portfolios, these tests include cross-sectional and time series analysis of 1) distributional characteristics (e.g., rolling return and standard deviation), 2) measures of relative performance (e.g., break-even analysis) and 3) significance of various trading and momentum factors (e.g., momentum factors, dynamic look-back options) in multivariate regression. Results reflect the common wisdom that performance results may be dominated by the period of analysis as well as the index and multi-factor regression model used in the analysis.
The collapse of many IT-related companies shocked venture capital investors around the world in 2000–2001. Similarly, the 2008–2009 financial crisis found VC investors very vulnerable. In “Venture Capital in Crisis: The Impact of the Economic Downturn in Company’s Time to Exit,” Yannis Pierrakis compares the financial and dot-com crises to investigate their effect on the lifecycle of investments from the initial investments to exit. An empirical analysis of 807 venture-backed firms that were exited between 2000 and 2009 uses a detailed sample of 2,716 transactions. Results show that time to exit has considerably increased. Further analysis of disaggregate data reveals that it is not only the time to exit that has increased throughout the years, but also the uncertainty as to the time that an exit should be expected. The source of venture capital (public or private) and the amount that a company raised before exit has no effect on the time to exit.
SUSTAINABILITY IN ALTERNATIVE INVESTMENTS
The aim of “Risk Assessment for a Structured Product Specific to the CO2 Emission Permits Market” is to use a new modeling technique for CO2 emission prices to estimate the risk associated with a related, structured product. After a short discussion of the specificities of this market, Marius-Cristian Frunza and Dominique Guegan investigate several modeling methods for CO2 emission prices. They use the results for risk modeling of the swap between two CO2-related instruments: the European Union allowances and the certified emission reductions. They also estimate the counterparty risk for this kind of transaction and evaluate the impact of different models on the risk measure and the allocated capital.
The article “Financial Turmoil in Carbon Markets” assesses the impact of financial turmoil on carbon markets. The carbon trading behavior aligned with security trading is incorporated into a model of the price-volume relationship. The model indicates that correlation increases when stock prices plunge, which is referred to as contagion. Empirical studies to estimate the model parameters for EUA futures prices, FTSE 100, and DAX suggest that the correlations between EUA and stock indices decrease with the stock indices, which is consistent with the existence of contagion driven by financial markets. Takashi Kanamura shows that the high volatilities in both stock indices and carbon prices come from low stock prices, implying an absence of an inverse leverage effect not only in FTSE 100 and DAX but also in EUA futures prices. More importantly, high volatility in carbon prices driven by low stock prices may represent the impact of financial turmoil on carbon price volatility. In addition, the author shows that the positive relationship between EUA futures prices and FTSE 100 or DAX indices for phase II of the EU-ETS is more enhanced than phase I of the EU-ETS and investigates the differences of the correlations between carbon prices and stock indices regarding the type of carbon assets, that is, EUA and CER. It is found that, on average, EUA correlates with FTSE 100 and DAX more strongly than CER. Finally, almost the same empirical study results are obtained using the correlations between EUA and FTSE 100 or DAX and using the volatilities calculated from the Engle’s dynamic conditional correlation model.
In “Voluntary Environmental Regulation and Firm Performance: The Chicago Climate Exchange,” Catherine Boulatoff, Carol Boyer, and Stephen Ciccone examine stock return and financial performance of firms that voluntarily participated in the Chicago Climate Exchange’s emissions-reduction program. Findings reveal that the stock price of firms joining the program increased by a small, statistically significant amount during the announcement period. Stocks overperformed by about 8% during the first year after the announcement. Financial performance of participating firms also improved compared to a matched sample of non-participating firms. Results support the hypothesis that sustainable business practices provide quantifiable benefits to participating corporations and do no harm to the financial status of the firm, while potentially improving the environment.
Perhaps as one reads the articles in this issue, one can at least be comforted by Alice’s comments after meeting all the challenges she endured: “ ’That was a narrow escape!’ said Alice, a good deal frightened at the sudden change, but very glad to find herself still in existence.” Despite all the change about us we are still here, still in existence—We must be doing some good for someone.
We continue to thank our readers for their comments, their submissions, and their support in these changing times.
TOPIC: Real assets/alternative investments/private equity
Thomas Schneeweis
Editor
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