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Facebook IPO: Hyped up or Undervalued?

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The scale of what Facebook has achieved since its inception in 2004 is difficult to fathom. Used as a verb it has become something that is unmissable. Hate it, love it or be indifferent to it, it is simply impossible to not acknowledge its presence in our lives. A website set in shades of blue. You generate the content. Yet once you are hooked and have access to the internet, it is impossible not to check for updates and notifications. It was a key player in the Arab Spring movement. It helps citizens communicate under fundamentalist or totalitarian regimes. It helps you see old classmates age and enjoy news of their children. My 7 year old came with the sooner rather than later request of wanting to be on Facebook.

Country wise and reach numbers are staggering. Facebook reaches more than 901 million active users, with 80% outside the US of A. No one really understands this phenomenon that Mr. Zuckerberg has set rolling. This is reflected in its IPO as well. It probably does not estimate the true potential that is Facebook. The markets seem to be in a quandary on how to estimate the value of such experiential sites. Non-product technology companies are not easy to value.

There are reports that the company’s shares need to stand at about $24 rather than $38. The share price is hovering around $38, the high being at $45. Naysayers have been saying that Facebook has not performed well-some even comparing it to a starlet tripping on the red carpet. Its slowing growth rate is cited as another factor for its poor showing. At 900 million plus Facebook is not going to have accelerating growth rates.

The recent exit by General Motors from Facebook for poor engagement and purchases seems to indicate more advertisers may move out. Yet Facebook keeps its customers engaged, with users returning time after time. It does have the brand image of something you do on your down time. But then again it is during down time, we feel free to discuss with friends thoughts on different subjects. As we go along, we learn their preferences in an organic manner. Rarely has a company’s IPO generated such interest in groups outside of investors. If one could put a value on those who wish they could own Facebook stocks, the numbers would go beyond $38.

Facebook post its IPO decided to buy Karma a mobile social gifting app. Mobiles where Facebook’s young customers increasingly use FB has not been its strongest. By acquiring Tagtile, Karma and Instagram it looks like Facebook is looking at aggressively closing those holes.

There has been speculation Facebook’s price was not allowed to dip below $38 by its group of bankers. This if true can last only a short time, unless investors see real value. At 104 billion, Facebook is geared to go further. How does one value a social behemoth? With data from around the world, you need appropriate tools to capture and monetize it. That seems to be the way forward for Facebook.

Its 28 year old, casual dressing CEO and chairman has changed the rules of the game totally. He sought to make several early backers and partners rich by going public. But it can’t be just that. He is and does everything that spells sure business failure. And yet it has been just the opposite. Millions relate to his product still, and it was business as usual for him as he rung the NASDAQ bell remotely. It didn’t seem too big a deal for him. Yet this upstart has made a formal entry in the time honored route in the market. The lack of fluctuations seems to indicate Facebook is here to stay.

Mechanics of Monetary and Fiscal Policy

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Monetary and Fiscal policies are the two economic policies employed by the government in an economy to control the aggregate demand.

Using the fiscal policy, the government controls their own expenditure and revenue collection in order to control the economy.

Using the monetary policy, the central bank of the country influences the money supply and interest rates in the economy to stimulate demand, control inflation, and stabilize currency.

The following video by Khan Academy explains the basic mechanics of monetary and fiscal policy.

Biases in Hedge Funds Performance Data and Risk Measures

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The hedge fund industry does not have a very evolved performance measurement framework. This makes it difficult for investors to depend on the historical records while allocating their funds.

The performance data provided by the hedge fund databases and indexes has several biases. Let’s discuss some of these biases.

Self-selection: The inclusion in a hedge fund database is voluntary and the hedge fund managers can choose to include themselves or not to. In general, if a fund has poor track record it may not want to expose its performance and will decide not to be included in a database.

Backfilling: This means that when a new hedge fund is added to an index, the past performance of the fund is back-filled in the index. For example, if the hedge fund is 3 years old, it’s record for the past three years will be added to the index, and the index values will be adjusted accordingly. The successful funds are more likely to be added to an index than an unsuccessful one, which creates a bias in the index. Studies suggest that backfill bias adds about 4% or more to hedge fund returns

Survivorship Bias: This is the situation where unsuccessful funds are removed from the index, and the past index values are adjusted to remove the data of the dropped fund. Since a fund is more likely to be dropped from an index because of poor performance, such actions create bias in the index. Studies suggest that survivorship bias adds about 3% or more to hedge fund returns.

Impact on Risk Measures

Even the risk measures of the hedge funds have biases.

Smooth pricing of infrequently traded assets: Hedge funds invest in many infrequently traded and illiquid assets such as real estate, and OTC instruments. Since these assets are traded less, and don’t have regular price updates, they exhibit low volatility. This is called the smoothing effect, which creates a downward bias to the risk of the assets. Also, the low correlation of these alternative assets with regular asset classes such as equity, and fixed income can make the bias even larger.

Option-like investment strategies: Hedge funds have very non-linear investment strategies such as arbitrage strategies. These strategies make their returns highly skewed, and the funds exhibit high kurtosis (fat tails), and negative skewness. The traditional measures such as standard deviation and VaR will underestimate the risk of losses for these funds. Even Sharpe ratio is inappropriate for measuring performance.

Fee Structure: Hedge funds have a high fee structure, which also exhibits option-like features. There a 1-2% fixed fee plus an incentive fee of upto 20% if the returns are positive. This creates incentives for fund managers to take higher risks to maintain high performance.

To conclude, investors should study these funds carefully and account for these biases and risks before investing.

Hedge Fund Indexes

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The information about hedge funds is not publicly available or listed on any exchange. Investors have to obtain this information directly from the hedge funds or data provider specializing in collecting hedge fund data.

Many such hedge fund data providers also publish indexes. These indexes allow easy tracking of the performance of hedge funds and also comparison across different funds. These indexes track both hedge funds and fund of funds.

Many institutions publish hedge fund indexes. Some of them are listed below:

  • Specialized firms
    • Hedge Fund Research
    • Van Hedge
    • Hennessee
    • Greenwich
  • Banks
    • Crédit Suisse/Tremont indexes (Based on the TASS database managed by Tremont/Owned by Lipper)
    • ABN AMRO EurekaHedge
  • Index providers
    • MSCI
    • S&P
    • FTSE
  • Educational institutes
    • CISDM
    • EDHEC

Hedge fund indexes can be equal-weighted or asset-weighted (weighted by assets under management for each fund.)

Asset-weighted indexes provide a better representation of the funds performance, however, some indexes still use equal-weights because they do not want to disclose the size of the funds.

There are no guiding principles on how individual hedge funds are included in an index. Most indexes are constructed by selecting funds from their database. So, if an index has volunteered to be included in a database, it can become a part of the index. Due to information asymmetry, the performance reported by various hedge fund indexes can vary significantly.

Another category of indexes, called investable indexes, includes only those funds that an investor can actually buy and sell. Such funds are called open funds. A hedge fund needs to have certain characteristics to become eligible for inclusion in such an index, for example, readily accept new investments, no lock-up periods, among others.

Mock Exams for CFA Level 1 and 2

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With just a few days left for the real exam, Finance Train’s CFA Level 1 and 2 Mock Exams can help you assess your exam preparation and your readiness for the exam.

The objective of our mock exam is to simulate the real exam experience so that you are fully equipped and ready to go in the exam room.

The mock exams follow the 2012 syllabus, and questions are selected from all 18 study sessions based on the weights suggested by the CFA Institute.

What’s the Exam Format?

Each mock exam is available as an instantly downloadable PDF, after payment. You can choose to print the PDF (recommended) and take it as a pen and pencil exam just like the real exam.

How much does it cost?

Finance Train’s CFA Level 1 mock exam costs just $20 and the Level 2 exam costs $40.

For a limited period, we are offering a 20% discount on both the exams.

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Leverage and Unique Risks of Hedge Funds

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There are two important points that need special mention while discussing hedge funds. One, hedge funds make extensive use of leverage. Some people believe that leverage is the major source of risk for hedge funds, while others argue that using leverage combined with risk management enhances hedge fund returns. Second, hedge funds face certain unique risks that make them more risky.

Let’s discuss these two aspects in more detail:

Leverage

Most hedge funds (but not all) use leverage in their trading strategies. In certain strategies such as arbitrage, leverage is essential because of the small profit margins in these arbitrage trades. Just like leverage enhances your profits, it also magnifies your losses. With a leverage of 10:1, you stand to lose as much as 10 times compared to a trade with just your own funds.

Hedge funds normally have a leverage of 2:1 to 10:1. However, some hedge funds have run leverage as high as 100:1. Within a hedge fund, there will usually be specified maximum limits for leverage, and the fund manager will be legally bound by that limit.

Hedge funds can create leverage in many forms such as:

  1. Borrowing external funds
  2. Buying on margin
  3. Using derivatives and other financial instruments

Unique Risks

Apart from market risk and other trading related risks, hedge funds face the following risks that are unique to them:

  • Liquidity risk: Hedge funds that trade in illiquid or thin markets can cause extreme lack of liquidity for them.
  • Pricing risk: Hedge funds invest in very complex financial instruments and many of them are traded over-the-counter. Such products are difficult to price, which can easily go wrong.
  • Counterparty credit risk: Hedge funds face significant counterparty risk, which can arise from many sources such as margin trading, and mortgage trading.

Funds of Hedge Funds

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Even though hedge funds are very popular, they are not accessible to small investors because of the higher amount of investment required. An alternative is a fund of hedge funds that allows all kinds of investors easy access to the hedge funds. Unlike a hedge fund that invests in stocks, bonds and other securities, a fund of funds invests in a selection of hedge funds. As an FOFs client base grows, it can invest larger amounts of money in hedge funds.

Benefits

Funds of Funds provide several benefits to investors:

  • Retail investors: Using FOFs, even retail investors get access to huge funds.
  • Access: Sometimes a hedge fund may not be accessible to investors because it has reached maximum number of investors or any other factor. An FOF may be able to provide investment in such hedge funds.
  • Diversification: Instead of investing in a single hedge fund, an investor can diversify its portfolio.
  • Expertise: Individual investors may not have the skill and expertise to find good hedge funds. Funds of funds provide the expertise of the managers who have experience and skill in selecting hedge funds.
  • Due Diligence Process: While selecting a hedge fund, even institutional investors have to perform due diligence which is a specialized process and is also time consuming. An FOF may be more suited for this job.

Drawbacks

Funds of Funds also have some drawbacks:

  • Fees: The total fee can be very high because the investors also have to pay the manager’s fees apart from the fee charged by each hedge fund.
  • Performance: It’s not necessary that an FOF will perform better or provide consistent performance.
  • Diversification is not always good: Mixing high performing hedge funds with other funds to lower the risk may defeat the overall purpose of investing in hedge funds.

Types of Hedge Funds

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The market for hedge funds has grown significantly and there are many types of hedge funds around the globe. These hedge funds can be classified based on their size, global reach, and investment strategies among others. However, these classifications are not exclusive and there is some degree of overlap. Presented below is one type of classification of hedge funds:

Long/Short Funds

These are the most common form of hedge funds that take long and short bets in stocks. The long and short exposures will be based on forecasts. If the stock prices are expected to rise the fund will take  a long position, and if the prices are expected to fall, they will take short positions. The funds will make heavy use to leverage in their positions. The funds will generally not be market neutral and will maintain a positive or negative market exposure.

Market-neutral Funds

These are a type of long/short funds that take long and short positions so that their net exposure is zero. The total value of all long positions will equal the total value of all short positions.  Such a portfolio will be dollar neutral and beta neutral. These funds also use leverage. Market-neutral funds use various strategies such as long/short equity, fixed-income arbitrage, pairs trading, warrant arbitrage, mortgage arbitrage, convertible bond arbitrage, closed-end fund arbitrage, and statistical arbitrage, among others.

Note that even though we see terms such as arbitrage and market-neutral, these funds are not actually risk-free.

Global Macro Funds

These funds place directional bets on stocks, currency, interest rates, commodities, and macroeconomic variables. These funds are highly leveraged and use derivatives extensively. Within global macro funds there are specialized funds, such as futures funds, and emerging market funds.

Event-driven Funds

Event-driven funds place bets on events affecting companies or securities. For example, if a company is in financial difficulty and is undergoing restructuring, the fund may buy its securities at a deep discount (distressed securities), and stands to earn well if the company is successful. Another example is mergers and acquisition related events. When a company announces its merger or acquisition, its stock will sell at a discount before the effective date of the acquisition. The hedge fund may indulge in risk arbitrage by buying stocks of company being acquired and at the same time selling stocks of the acquiring company.

Measuring the Performance of Venture Capital Investments

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Once a venture capital investor invests in a new venture, he will evaluate the performance of his investment at the time of liquidation, and also during the life of the investment.

The performance is generally measured by calculating the internal rate of return (IRR) on:

  • Cash flows since the beginning of the investment
  • Unliquidated remaining holdings

Many associations such as European Private Equity and Venture Capital Association (www.evca.com) have published detailed guidelines for performance evaluation. Another such organization is the British Private Equity and Venture Capital Association (www.bvca.co.uk). The guidelines can be downloaded from their websites.

EVCA’s IRR Measure of Performance

The EVCA advocates that the performance be measured at three levels:

1. The Gross Return on Realized Investments

This return takes account of the cash outflows (investments) and inflows (divestments, including realization values, dividend and interest payments, repayments of the principal of loans, etc.), which take place between the Fund and its realized investments.

2. The Gross Return on all Investments

This return takes account of all of the following:

  • The cash outflows (investments) and inflows which take place between the Fund and:
    • Its wholly realized investments
    • Its partially realized investments
    • Its wholly unrealized investments
  • The valuation of the unrealized portfolio (consisting of wholly unrealized investments and the unrealized portions of partially realized investments but excluding cash and other assets held in the portfolio).

3. The Net Return to the Funder

This measures the return earned by the Funders in the Fund, and takes account of:

  • The cash flows which take place between the Fund and the Funders, net, by definition, of all of the following:
    • The Venture Capital Company’s carried interest;
    • The management fees paid to the Private Equity/Venture Capital Company by the Funders;
    • All other applicable professional and ancillary charges which are paid out by the Venture Capital Company in the course of investing, managing and divesting from its investment portfolio.
  • The valuation of the unrealized portfolio (consisting of the unrealized portions of partially realized investments, wholly unrealized investments and also including cash and other assets), after deducting the implied carried interest.

When the portfolio is fully realized/fully distributed, the Net Return is the ‘cash-on-cash’ return to the Funders.

Challenges

There are several challenges in measuring the performance of venture capital projects:

  1. It is difficult to arrive at detailed valuations, as they have very limited information.
  2. There is no meaningful benchmark against which the performance can be measured.
  3. Any reliable performance feedback is of long-term nature.