Thursday, January 13, 2011

Anson, Fabozzi, & Jones, The Handbook of Traditional and Alternative Investment Vehicles

This is not a book that you’d want to curl up with on a snowy afternoon. The Handbook of Traditional and Alternative Investment Vehicles: Investment Characteristics and Strategies by Mark J. Anson, Frank J. Fabozzi, and Frank J. Jones (Wiley, 2011) is a reference book. It’s a book you dip into to get up to speed on asset classes that you may have ignored in the past or about which you have less than expert knowledge.

I don’t normally list chapter titles in a book review, especially not when there are 22 of them, but in this case I think it’s necessary to convey the breadth of this volume. So here goes: Introduction, Investing in Common Stock, More on Common Stock, Bond Basics, U.S. Treasury and Federal Agency Securities, Municipal Securities, Corporate Fixed Income Securities, Agency Mortgage Passthrough Securities, Agency Collateralized Mortgage Obligations, Structured Credit Products, Investment-Oriented Life Insurance, Investment Companies, Exchange-Traded Funds, Investing in Real Estate, Investing in Real Estate Investment Trusts, Introduction to Hedge Funds, Considerations in Investing in Hedge Funds, Investing in Capture Venture Funds, Investing in Leveraged Buyouts, Investing in Mezzanine Debt, Investing in Distressed Debt, and Investing in Commodities.

To give a sense of the book, I’m going to confine myself to the last chapter. Since commodities are a hot topic right now, I assume most investors have some notion about what commodities are and how they trade. What more can we learn from this handbook?

First, there is a critical distinction between how stocks and bonds are valued and how commodities are valued. In the case of stocks and bonds, one important valuation metric is the present value of the expected cash flows. But, with the exception of precious metals which can be lent out at a market lease rate, commodities “do not provide a claim on an ongoing stream of revenues” and “interest rates have only a small impact on their value.” (p. 455)

We learn that there are six ways to obtain exposure to commodity assets: “through the commodity itself, shares in a commodity-related firm, futures contracts, commodity swaps/forward contracts, commodity-linked notes, or exchange-traded funds.” Each avenue is described briefly but not analyzed critically.

There are three reasons why commodity prices should be negatively correlated with the prices of stocks and bonds. (1) Inflation has a positive impact on commodity futures prices, a negative impact on the values of stocks and bonds. (2) Commodity futures are affected by short-term expectations, stocks and bonds by long-term expectations. (3) The three key inputs to economic production are capital, labor, and raw materials. “In the short to intermediate term, the cost of labor should remain stable. Therefore, for any given price level of production, an increase in the return to capital must mean a reduction in the return to raw materials, and vice versa. The result is a negative correlation between commodity prices and the prices of capital assets.” (p. 467) Actually, there’s a fourth reason, dealing with price shocks. Supply disruptions produce positive returns for commodities, negative returns for financial assets.

The chapter ends with a discussion of the various commodity indexes.

I suspect that some of my readers would take issue with the reasons put forward for a negative correlation between commodities and financial assets. But a survey of investment vehicles is, or at least should be, a place to begin one’s research, not conclude it. And this volume is a laudable jumping-off point.

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