The Business Activities Study

This case study is related to the business activities of a hedge fund which performs a macro investment strategy. Its investment manager Troy Dexter seeks for profits which arise from shifts in the real economy. As he considers an end of the Australian housing market boom as likely, he anticipates that Australia's overall economic growth will slow down, whereas the prices for energy will go up. In reaction to those expectations he decides to purchase treasury bonds and stocks of energy companies Against this background Case Study 1 is aimed at classifying Troy Dexter's two investment decisions as either direct or indirect investments. Such a classification provides different results depending on the party from whose perspective it is assessed. Thus, it is the purpose of the following section of this work to distinguish between the terms direct and indirect investment based on the corresponding point of view using practical illustrations whenever possible. This is to be done after clarifying key terms associated therewith first. Term definition A hedge fund is an alternative investment vehicle which excessively uses financial instruments such as derivatives and leverage and in which an aggressive management strategy is usually applied (Fung & Hsieh, 2004). As Capocci and Hà ¼bner (2004) state, a hedge fund's major purpose is to generate active return (called alpha) for its typically wealthy investor base. As hedge funds are less exposed to capital market regulation than other fund types, they are able to generate – on average – higher returns, but associated with higher levels of risk as well (Lederman, 2012). Troy's decision to purchase energy stocks is related to his expectation of rising oil prices. Given his expectation turns out to be correct, the share price of oil producing companies will increase. The term â€Å"energy stock market†, however, comprises not only oil producing companies, but all other kinds of energy producing firms, as well as energy infrastructure and energy service providers, too (Henriques & Sadorsky, 2008). As Henriques and Sadorsky (2008) note, a rise in the oil price will not only increase the share price of oil and gas producers, but also the market value of those firms which offer substitutes (e.g. solar and wind energy) will increase. This holds as their products become more competitive in such an environment and their turnover is likely to increase. Stockholders who have purchased such stocks directly for their own stock portfolio before a rise in the oil price has taken place, will profit. Their profits, on the one hand, consist of the 4 chance to sell those shares at a higher price at the stock market and, on the other hand, of (increased) dividend payments (Bodie, 2013). Treasury bonds purchased in the debt market are usually characterized by less risk than any kind of stock market investment (Sharpe et al., 1999). Given Troy's expectation about the future economic environment of Australia, his decision to purchase such long-term fixed interest debt instruments is reasonable. This holds as they are issued by the Australian government which is very unlikely to default (Chaudhuri ; Smiles, 2004). On the contrary, as the Australian government has several tools at hand which allows it to make interest payments as promised (e.g. increase taxes), a treasury bond is considered as one of the safest investment forms available in the market (Hull et al., 2005). Investors who have decided to hold treasury bonds in their stock portfolio (direct security investment) can expect a fixed interest on their investment. The historic development of the Australian 10-year treasury bond is illustrated below.   Source: Reserve Bank of Australia, 2017. From this graph it can be derived that the long term trend of Australian treasury bonds is downward sloping. Starting from a level of more than 10.0% in 1995, the interest rate went down to about 3.0% in 2013. Interest rates in the short run are stagnating on a relatively low level of about 3.0%. Based on the fact that Troy Dexter has founded the hedge fund in 2009, it can be stated that his decision was right in the short run: Interest rates, indeed, went up from 4.0% to 6.0% between January 2009 and January 2010. However, it has to be noted that in the subsequent years his expectation turned out to be incorrect: Starting from January 2011, interest rates on the Australian 10-year treasury bond went down to about 3.0% in January 2013. This implies for Troy Dexter as the fund manager that his hedge fund may have generated losses from 2011 onwards as the interest rate of Australian treasury bonds have lacked his expectations. The figure adds value to the topic of this work as it illustrates that the fund manager's decision to invest in treasury bonds could not have been a smart decision in the long run: Fund investors are indirectly suffering from this decision as they have decided to provide Troy Dexter with parts of their funds which are now invested in a non-optimal security. 1. Direct vs. indirect securities – Northwest Capital Management perspective In order to classify Northwest Capital Management's investments in treasury bonds and energy stocks from the firm's perspective, one has to understand the business concept of capital management firms first. Firms such as Troy Dexter's hedge fund business aim at professionally managing private investor's funds. They do so by investing customers' money in a broad range of asset classes, restricted by particular investment goals (Fung ; Hsieh, 2001). However, as Brav et al. (2010) notice, the service such firms provide is not just related to the optimum asset allocation, but financial statement analysis as well as the monitoring of existing investments plays an important role, too. Hedge funds – in contrast to more conservative capital management firms – invest a relatively high percentage of its assets in risky asset classes such as the stock market of even emerging market economies (Jansen et al., 1998). The portfolio composition of an exemplary hedge fund is illustrated in the graph below. Source: Blair, 2001. The figure above already reveals that it is the hedge fund manager Troy Dexter who is responsible for the investment decisions of his fund and who chooses between the above asset classes (asset allocation). It is important to understand that the private investor is not involved in the daily investment process of the hedge fund, but hands over any responsibility for the invested amount of money to Troy Dexter. 0.50% 0.50% 31% 19% 15% 14% 7% 6% 3% 2% 2% Strategy composition of a hedge fund Short selling Other Equity long/short Macro Relative value arbitrage Event driven Fixed income Convertible arbitrage Distressed securities/high yield Equity markets neutral Emerging markets 6 Derived from this line of reasoning it can be stated that Troy Dexter's intended purchase of treasury bonds and energy stocks can be considered as a direct securities investment from the firm's point of view. This holds, because there is no third party involved in Troy's securities acquisition process (Bodie, 2013). In contrast, it is likely to be assumed that Troy himself owns a trading platform which he can use to exercise any stock market transactions personally and immediately. Even if Troy does not own such a trading platform, the consultation of a stock broker can still be considered as a direct securities investment from Northwest Capital Management's point of view. This holds because a stock broker can simply be considered as an entity which executes buy and sell orders on behalf of someone else for a particular fee or commission (Pollock et al., 2004). As Pollock et al. (2014) note, brokers are not allowed to alter the order, but execute the transaction only. 2. Direct vs. indirect securities – Investor perspective Taking the viewpoint of an investor in Troy Dexter's hedge fund, Troy's investment decisions can clearly be considered as indirect investments. As stated above, the fund manager decides about the allocation across available asset classes. The investor knows about the financial risks tied to Troy's investment decisions from the prospectus and may have expectations about a desired return, but cannot alter Troy's daily sell and buy orders. However, this would be a vitally important characteristic of a direct securities investment. As soon as customers have decided to invest in the fund, they have to sign a declaration of consent in which they transfer the responsibility for managing their funds to the portfolio management team (in our case to Troy Dexter) (Philpot ; Jonson, 2007). Not the investors themselves engage a broker who carries out financial market transactions, but Troy Dexter does that on behalf of them using his financial market knowledge. In this context it is important to note that – although restrictions are less strict in a hedge fund – fund managers have to stick to the proposed fund objective and are not allowed to invest in anything which is not related to the praised goal of the fund, although it may be a lucrative investment (Philpot ; Jonson, 2007). This assignment of any kind of right to alter the investment decision related to maximizing investors' own monetary wealth underpins the indirect nature of a fund investment from an investor's point of view. The incentives for customers of Northwest Capital Management to provide Troy Dexter with the rights to manage their savings on behalf of them (indirect investment) is related to Troy Dexter's expertise about financial markets (Capon et al., 1996). Additionally, as Capon et al. (1996) state, the pooling of large amounts of money in the hedge fund provides customers with a lot more market power than they would have when investing on their own. This shows that although private investors cannot actively decide about each investment decision on their own, the indirect securities investment through Troy Dexter's Northwest Capital Management is utterly worthwhile for its investor base. It can be summarized that investing in a hedge fund implies no direct securities investment from the private investors' perspective. This is compounded by the fact that private investors of a hedge fund do not own any securities themselves (Droms & Walker, 1996). Instead, those securities are entirely controlled by the fund managers who either own a trading platform themselves or contact brokers to carry out deals which are likely to benefit the fund's investor base. Shareholders are not able to access the fund's existing investments on a daily basis, but have to rely on the fund managers' expertise (Droms ; Walker, 1996). This trust, however, may be the basis for higher returns compared to investing individually on any kind of capital market. 7 Furthermore, the indirect securities investment from the investor's point of view implies that each single investor gains or loses proportionally to his or her investment in Troy Dexter's hedge fund. This fact stands in sharp contrast to a direct securities investment in which an investor is on his own and has a claim on any gains and losses related to this investment (Bodie, 2013). Instead of having the chance to convert profits right away in a direct securities investment, an indirect investment via a fund prohibits an investor from this right and makes him dependent on the decisions of the fund manager. Recommendations: A common way of how to classify securities is to divide them into either direct or indirect securities. In this context it is of particular importance to distinguish between either an investment manager's or a private investor's perspective (Davis, 2004). Conclusion: The statements above have shown that the classification of any kind of investment as being either direct or indirect depends on the party from whose perspective such a classification is made. 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