Understanding the Investment Landscape
Other than Investment Banks, there are other financial institutions in the market that play a big role. Below is a possible representation of Investors, Investment Intermediaries and Financial Markets as the Investment Landscape. It’s not perfect but a good way of looking at how the value chain typically operates. The purpose of this illustration is to provide a high level understanding and the awareness of different kinds of players in the markets, how they mostly interact with each other and how they are similar or different from each other. Please also note that it is not a theoretical or text-book representation of the investment landscape, it’s more of a representation I am choosing to make things most comprehensive.
Firstly on the extreme left we have a bucket of end-investors, which includes Retail investors (like individuals, small businesses, etc.), Companies, Governments (who manage the countries financial assets and liabilities), and then some High Net Worth Individuals (who are classified differently from Retail Investors as they are very rich as the name suggests). The qualification of High Net Worth Individuals varies in different places, but thumb rule could be used as individuals with higher than $1m of net worth. Their investments and investment intermediaries are less regulated by regulators as latter put more emphasis on surveillance of retail individuals’ investments and investment intermediaries. A typical example is that HNWIs can invest in Hedge Funds as Investment Intermediaries who are not regulated by the Regulators, whereas Retail Investors typically cannot directly invest in Hedge Funds (except in certain jurisdictions like Australia where Retail Investors could hold Hedge Fund investments like Retail Investors in other countries would hold Mutual Funds). Now there is obviously an overlap and linkage between these end-investors as all Retail Investors would typically have tax contributions to the Government, would work for some Companies and might be involved indirectly in the company’s investments etc. Hence this is not a list of investors that don’t have any dealings with each other. Most End investors as shown in the diagram can invest and interact with the financial markets (Investable assets) directly or through Investment Intermediaries.
Investment Intermediaries typically act as an interface between Investors and Financial markets. They typically use their skills and expertise to generate better returns for the investors, and try to make some profits for themselves. Some of these intermediaries can technically operate only with End Investors and do not need to interface with Financial Markets at all, for example a Commercial Bank could deal with only Retail and Companies Savings and Loans and make profits from that. Some of these Intermediaries have been explained hereby.
Private Equity firms typically invest and manage companies which are not typically publically traded i.e. do not have shares listed in the stock market. Private Equity firms came into existence after Second World War. Typically investors including Banks and Institutional Investors provide financing to Private Equity firms, which they use to invest in certain companies, structure the investment in an efficient way and monitor the growth of the investment. They typically try to arrange an IPO for the company after few years, or try to sell it to other companies interested in it. Private Equity Investments have gone up significantly in the last few years, and was expected to be around $1 trillion in 2008. The diagram below shows the rough size of different investment intermediaries in 2008 (various sources on internet, including wikipedia).
Hedge Funds are private investment funds in which typical investors include HNWIs, Institutional Investors (like Pension Funds, Insurance firms, etc.). Hedge funds are typically unregulated / less regulated and they invest in varied ranges of investments. Hedge Funds have existed since Alfred Jones created the first one in 1949. It outperformed all other Investment Funds for years because of the specific technique used by the Fund called Short Selling (i.e. selling an asset when you don’t possess it, if its value goes down you can buy it back at a lower price and make profit). The Hedge Fund industry has grown dramatically in the past decade or so. Hedge funds managed around $2 trillion of assets in early 2008. On top of these assets, they typically have leverage too, which on average turned out to be around 3. Hence they were expected to be trading with over $6 trillion assets. Many institutional investors (like pensions funds, mutual funds etc.) gain exposure to hedge funds through Fund of Hedge Funds, which help in reducing risk and diversifying the exposure to different asset classes (like Equities, Derivatives, FX, etc.). As shown below, Fund of Hedge Fund could invest 25% each into 4 Hedge Funds with different strategies focussed on Equities, Derivatives, FX, and all of these. The institutional investors could invest in this Fund of Hedge Fund to gain exposure to Hedge Fund strategies, but not being exposed to one Hedge Fund or one financial market. This is a very common investment structure for investing into Hedge Funds.
Hedge Funds are typically run by experienced professionals from Finance and Investment Banking background. Their aim is to make money when financial markets go up or down. For example, if the stock of a company is expected to go up, they will buy the stock and make profit by selling it later. When the stock is expected to go down, they will sell it (by borrowing it first). Later they will buy it back when its value has gone down (and return it to the institution from whom they had borrowed it) and make profit. This is what is attractive to most investors, their low correlation with the financial markets as demonstrated below. S&P500 represents the Equity market returns in US, and Hedge Fund Index represents the Hedge Fund returns. As you can see, even when the equity market returns are negative, Hedge Funds still manage to make positive returns for most times (except in 2008 during the Credit Crisis)
Sovereign Wealth Funds
Sovereign wealth funds are state owned investment funds which invest in different financial assets to generate returns. The funds arise from State savings as well as management of assets by Central Banks. SWFs are Government / Central Banks owned funds that have become tremendously important in recent years due to growth in assets owned and managed by certain Central banks. That includes Middle Eastern countries’ SWFs (grown with huge Oil exports, also known as Petro-dollars), Asian countries’ SWFs (grown with significant exports), etc. SWFs are believed to have investments of around $3.3trillion in 2008. They have invested in Investment Banks in 2008 following the credit crisis and the recapitalization requirements by those banks. Cash rich SWFs were being treated with open arms by financial institutions during the crisis. SWFs’ primary objective seemed to be gaining more muscle, secondary being the returns on investment. Such investments by SWFs during the credit crisis did prove to be profitable.
Insurance firms offer hedging against risks. We are familiar with life insurance, car insurance, home insurance etc., which are part of our day-to-day life. The premium we pay for our insurances provides capital for insurance firms that they invest in financial markets. Insurance firms had around $20 trillion assets under management in 2008.
Mutual Funds are investment funds with pools of money from different investors, typically including retail investors and investing into stocks, bonds and different financial securities. The key difference between a Mutual Fund and Hedge Fund is that Mutual funds are highly regulated whereas Hedge Funds are not. Also Mutual Funds do not take that much risk (for example 10 times leverage or short selling etc.) that Hedge Funds might be taking. Mutual Fund Industry was managing around $20 trillion of Assets in early 2008.
Pension Fund is also pool of assets brought together by pension contributions of different companies’ employees or other individuals. Since most public and private companies have Pension plans, as well as independently run and managed Pension plans, the assets held and managed by Pension Funds are significant, around $22 trillion in early 2008. This makes them an important institutional investor. Since the contributions come from individuals pensions (which they expect to receive and live off after retirement), Pension Funds are highly regulated by the Government.
Financial Intermediaries Investing in Each Other
These Investment Intermediaries do not only act as intermediaries between end-investors and financial markets, they also invest into each other. For example, Pension Funds and Mutual Funds are key institutional investors that have asset allocation into Private Equity firms, Hedge Funds (typically not directly, but through Fund of Funds) etc. The interaction between different players is much more complex than shown in the diagram. The diagram is kept simpler for the sake of illustration.
Financial Markets / Investable Assets
The overall financial markets’ assets by the end of 2007 were estimated to be over $150 trillion. Different investors have their asset allocation process in which they follow certain procedures to decide how to allocate between equities, bonds, credit, FX, commodities, derivatives, housing and other asset classes. The procedure varies for different investors, for example Hedge Funds would typically look for high returns, tolerating high (calculated) risk, with some leverage, and short term investments. On the other hand, Mutual Fund would typically look for medium to long term investment, low risk and low leverage.