University of Cape Town

Introduction to Actuarial Science (BUS1003H)

Asset categories

A significant part of your future actuarial training will have to do with liabilities,
i.e. the (usually uncertain) financial obligations owed by financial institutions to their
members or clients, and their valuation. These may be the liabilities of a life insurer,
a short-term insurer, a medical scheme, a pension fund or any of the other entities
in whose financial operation and stability actuaries are involved and interested. This
section of the course deals with the other side of the balance sheet, i.e. the assets in
which these entities may invest in order to meet their liabilities. It is good advice for
this section to keep the liability side of the balance sheet in mind when considering the
various asset classes and their properties. Of course, it is also equally good advice for
future studies on actuarial liabilities to give some background thought to the appropriate assets. Actuarial practice is often about solving a joint asset-liability puzzle.
A common starting point for deciding on investment strategy is to look to match
assets and liabilities as far as possible. The theoretical definition of ideal matching is
a situation in which all liability cash outflows are exactly offset by asset cash inflows,
removing all risk from the equation. For example, if you have a certain commitment
to pay out R100 to somebody in 12 months time, this constitutes a liability to you,
which you could match with the purchase of a zero-coupon bond (a definition of which
you will find a little later) providing a capital repayment of exactly R100 in 12 months.
In practice, actuarial liabilities are probabilistic in nature, and thus it is impossible
to predict cash outflows with complete accuracy. Short-term, fairly certain nominal
liabilities are the easiest to predict, while forecasts of long-term highly uncertain real
liabilities are by nature subject to significant error in estimation. (Nominal in this
context refers to liabilities which are fixed in Rand terms, and real to liabilities
which are linked to inflationary growth). Similarly, while it is possible to predict cash
inflows from assets with close to complete accuracy for some asset classes (such as
money market instruments and conventional government bonds), it is certainly not so
for others, such as cashflows from equities and property thirty years into the future.
Exact matching is therefore an ideal not attainable in practice, but its approximation
remains a useful framework and a reminder to consider the nature of the liabilities
when thinking about the appropriate composition of assets.

Overview

The investment market may be divided into the following sub-markets:

Money market instruments, comprising short term instruments such as cash, bank
deposits, Treasury bills, bills of exchange and commercial paper
Fixed interest stocks, often referred to as conventional bonds, including Governmentissued bonds as well as those issued by corporates, parastatals and local government
Index-linked bonds
Equities, i.e. shares in companies
Property, also commonly referred to as real estate
Derivatives, such as futures and options, which derive their value from that of
another underlying security
Alternative investments, such as hedge funds, private equity, private debt and
securitisations

1.1

Domestic vs. international investment

Note that for many of these asset classes, investors may consider investing either domestically or internationally. The primary reasons for choosing some level of exposure to
international bonds or equities, say, would be foreign currency-denominated liabilities,
or diversification, which will be discussed later in the course.

1.2

Direct vs. indirect investments

Investors may also choose to invest in these assets either directly, or indirectly via
collective investment vehicles such as unit trusts (detailed understanding of which
is beyond the scope of this course). Typically the decision is related to size: large
pension funds and life insurance companies, for example, would tend to invest direct,
often employing professional fund managers to manage the investments on their behalf.
This approach is justified by the large transaction sizes. For smaller investors, however,
transaction costs may make direct investment unviable, and hence they look to benefit
from the economies of scale offered by collective investment vehicles.

1.3

Private vs. institutional investors

We should distinguish between private and institutional investors. The former category,
as the name suggests, refers to individuals who invest for their own accounts. Actuaries
will often be concerned though with the investment needs of institutional investors, i.e.
institutions such as life offices, general insurers, pension funds, medical schemes and
so on.

1.4

Primary vs. secondary markets

The major asset classes which will be discussed in this section of the course owe their
existence to the need for corporate and government entities to raise capital in order to
carry out their planned activities. For example, a government may wish to build a new
road, or a company may wish to expand its business into a new market. Governments
can of course raise tax revenue, but must be aware of the effects that income tax rates
have on productivity and entrepreneurship; an alternative may therefore be for them
to borrow money by issuing bonds or money market instruments, as discussed below.
Companies can also issue bonds (or borrow money from banks), but may alternatively
look to raise capital by issuing new shares which entitle the holders to part-ownership
of the company. A distinction may be made here between primary markets, where the
newly issued bonds and shares are first brought to the investor market, and secondary
markets, where they are subsequently traded between investors. The existence of these
secondary markets is what makes it possible for the assets to be used to meet actuarial
liabilities, as they make the assets liquid and marketable.

1.5

Income vs. capital gains

A distinction should also be drawn between the two forms of returns obtained from
investment in assets: income and capital gains. Income refers to regular cashflows
paid to holders of the asset, such as dividends on shares or coupons on bonds (both
explained later). Capital gains, on the other hand, refer to the difference between the
capital value received when an asset is sold or matures and the price paid to obtain
it originally. Since it is possible on many assets for the final capital value to be less
than the original purchase price, a capital gain may in fact be a capital loss! In most
countries, both income and capital gains are taxed, often at different rates. In South
Africa, for example, capital gains are taxed at a lower rate than income, in an effort
to promote long-term savings and investment.

1.6

The SYSTEM T framework

A mnemonic which has served generations of actuarial students, and which you may
find useful in thinking about the properties of asset classes now and in your future
studies, is SYSTEM T, standing for the following characteristics:
Security (i.e. risk of default)
Yield (i.e. the return on an investment)
Spread (i.e. volatility or uncertainty of market values)
Term (i.e. short, medium or long duration)
Expenses (i.e. transaction costs), or Exchange rate/currency risk for offshore
assets
Marketability (i.e. the ease with which the asset can be bought or sold)
Tax

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Dont worry if the importance of these characteristics eludes you now, but refer back to
this mnemonic once youve been exposed to the various asset categories, as it provides
a very useful framework for the evaluation of asset properties.

Money market instruments

In general, money market instruments, often simply referred to collectively as cash,

are regarded as the best match for very short-term liabilities, for example endowment
assurance policies due to mature in two months time. (An endowment assurance policy
is an insurance contract which pays a stated sum after the expiry of a certain term, or
on earlier death).

2.1

Cash and bank deposits

Deposits held in banks typically earn interest at a predefined rate, which is likely to
vary with the prevailing level of the most important short-term interest rate in the
economy, the repo rate (set by the South African Reserve Bank). This interest rate is
significantly lower than the rates charged by the bank to borrowers, creating an interest
rate spread (i.e. differential) which is a significant source of bank profits. The various
types of accounts include call deposits, where money is available to the investor on
demand, notice deposits, where the investor has to give specified notice (e.g. 32 days)
of the intention to withdraw, and fixed-term deposits, where no withdrawal of funds is
allowed prior to expiry of the term.

2.2

Treasury bills

Treasury bills are short-term (usually 3-month) debt obligations of the central government. The investor who purchases a Treasury bill is in effect lending money to the
government for a short period of time, in exchange for a guaranteed return. Instead
of this return being quoted as an interest rate, it is expressed in discount rate form,
whereby the government borrows a little less than the face value of the bill it agrees
to pay back. With d as the discount rate, the amount P that the market is prepared
to lend for a repayment of R100 after n days (typically 91) is determined as follows:
n
)
P = 100(1 d. 365

For example, if d is 10% and n is 91, then:

P = 100(1 0.1

91
)
365

= 97.51

Note that this corresponds to an effective annualised rate of interest i where:

n
i = (1 d. 365
)

2.3

365
n

Other short-term instruments

Other instruments, generally of less importance for institutional investors, include

Bankers Acceptances (BAs), bills of exchange and Negotiable Certificates of Deposit

5
(NCDs). Investigation into these is left as a homework assignment for interested students.

Fixed interest stocks (bonds)

Bonds are loans by investors to the bond issuer in exchange for a given schedule of
repayments. They are thus similar in nature to Treasury bills, but for much longer
maturities, up to around 30 years in South Africa, although in international markets
bonds with maturities up to 100 years have been issued.
Bonds are commonly regarded as the best match for medium- to long-term liabilities
which are reasonably predictable, e.g. payments on a life annuity benefit with fixed
escalations. An annuity benefit, as you probably already know, is a series of regular
(typically monthly) payments to an individual for as long as he or she remains alive.
Students are often confused about how a loan can be considered an investment, as this
is not quite as intuitive a concept as it is for cash, shares or property. The answer is
that from the perspective of the lender, the loan provides an entitlement to a regular
schedule of repayments of interest and capital, which is an asset. Their usefulness
as investments is further enhanced through trading, i.e. being bought and sold in a
market. Take the example of Investor A, who by purchasing a bond newly issued by
the government (on the primary market) is in effect lending a sum of money to the
government in exchange for a series of fixed repayments. A has the choice of holding
on to the contract to maturity or alternatively selling it on to B (on the secondary
market) for the price prevailing on the market on which the bond is traded. Note that
the bond is an asset because it entitles the holder to the series of repayments on the
original loan. Once sold, A no longer has anything to do with the contract, and B
inherits all rights to the income stream and capital repayment at maturity.

3.1

Government bonds

The investor effectively lends the government (as the issuer) a sum of money for a fixed
period (known as the term) in return for regular (usually half-yearly) payments of
interest (referred to as coupon payments) over the term of the loan and a lump sum
payment which is usually equal to the initial loan value (known as the par value)
at the end of the term. It is important to understand that all of these cashflows are
known at the outset, so it is possible to predict nominal cashflows emerging from the
bond with close to complete accuracy. The only potential source of uncertainty arises
from the possibility that the government may default on its repayments, but this risk
is customarily treated as negligible, and government bonds are accordingly regarded
as risk-free.
Consider a bond with a par value of R100 and coupons of C per annum for n years,
payable in two half-yearly instalments of 12 C. Bond yields are by custom quoted as
nominal rates compounded half yearly. Assuming that the market expects a yield of
2i on this investment, the price P of the bond at issue is given by:

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P = 21 Ca2n + 100v 2n , at a rate of i per period (half-year)
Note: i is a nominal rate in two senses:
1. It is a nominal rate compounded half yearly. The effective rate of return on the
investment is (1 + i)2 1.
2. It is not a real rate of return in that the effect of inflation has not been removed.
Broadly the real rate of return is approximately equal to the nominal rate of
return less the expected future inflation rate.
One very important feature of the above equation is that if i rises, P will fall. It is
important to understand clearly this inverse relationship between interest rates and
bond prices. In simple conceptual terms, we know that the future cashflows are fixed,
therefore the only way that an investor can earn a higher yield is by paying a lower
price for the investment.
Bonds may trade at prices above or below their par values, depending on their characteristics and prevailing market yields. A bond selling for a price above par value is
said to trade at a premium to par, while one trading below is at a discount to par.
Zero-coupon bonds, as the name suggests, are a special category which provide no
coupons, but only a capital payment at maturity. Consequently, they always trade at
a discount to par.

3.2

Local government and corporate bonds

The central government is not the only entity empowered to issue bonds to raise debt
capital. Lower levels of government (provincial, local and municipal) may also issue
bonds, as may parastatals and corporates in the private sector. The fundamental structure of such bonds is identical to that presented above; the main distinction lies in the
yield which investors expect on such instruments.
As discussed above, government bonds can be treated as default-free. Governments
are aware that defaulting on bond commitments would lead to immediate loss of confidence in the economy, with potentially devastating effects, and in addition have almost
limitless ability to raise capital to meet their debt commitments, either through issuing
new bonds or from tax revenue. For a corporate, on the other hand, debt repayments
must be serviced out of earnings; if these are insufficient, it may become impossible
for corporates to meet the repayments. There is therefore some risk of default with
bonds not issued by the central government. In addition, corporate bonds are often less
marketable than government bonds. Investors require some compensation for bearing
these risks, which comes in the form of higher yields on corporate bonds compared to
government bonds.
Corporate bonds may either be debentures, which are secured against company assets,
or unsecured loan stock. The latter category is clearly riskier and would command a
higher yield.

Inflation-linked bonds

In the South African market, inflation-linked bonds are issued mainly by the government. These operate similarly to conventional fixed interest bonds, except that interest
(coupon) payments and the capital repayment grow with inflation. It is thus the real
value of coupons and capital that is guaranteed at the outset, not the nominal value
as with conventional bonds.
Assume that the market anticipates future inflation at a rate of j per annum. Then
the amount P the market will lend to receive 12 C per half-year and a capital repayment
of R100, both growing with inflation, is given by:
P = 12 C

P2n

t=1 (1

+ j) 2 v t + 100(1 + j)n v 2n , at i per half-year

P = 21 Ca2n + 100v 2n , at i0 where i0 =

(1 + i)
1

(1 + j) 2

Equity

Equities refer to investments in a companys shares. Each share in a company entitles the owner to a proportionate share of the profits. In practice, equity investors
receive their returns through dividend payments, which are a share of profits which
the directors agree to pay out to shareholders each year based on the companys performance, and from capital gains achieved when the share is sold.
Equity investments could consist of holdings in private companies (see the discussion of
private equity below), but most commonly when we talk of equities from the perspective of the institutional investor, we will be referring to shares in companies which are
listed on stock exchanges, which act as the markets for trading in those shares. These
are known as listed shares or public companies. In South Africa, listed shares are
quoted on the JSE Securities Exchange (note for interest that some large South African
companies have their primary listings overseas, many on the London Stock Exchange).
The returns on equity investments are driven, in the long run, entirely by the financial
performance of the company. In the short run, however, returns are driven by price
movements on the stock exchange, which reflect supply of and demand for the share;
such price movements are heavily influenced by market sentiment, or investors views
on the companys prospects, as well as views on the prospects of equities in general
relative to other asset classes.
Equity investments are therefore by their nature inherently riskier than the other asset
classes we have dealt with so far. Investors require some compensation for bearing
this risk, with the result that equity returns have significantly outperformed those of
bonds and cash over any suitably long period in history (a feature which we will have
a look at in the next section of this course). Equities have also tended to outperform
inflation consistently over the medium- to long-term. They are thus regarded as an
appropriate investment for long-term real liabilities. A suitable example would be retirement benefits for a young fund member: this liability is long-term in the sense that

8
cash outflows may only be expected in 40 years time, and real in the sense that it is
linked to salary increases, which in turn are expected to be linked to inflation, over the
members working career.
The above discussion refers to ordinary shares. An additional class of share investment,
known as preference shares, is also available to investors, but detailed knowledge of this
is beyond the scope of this course.

Property

Property, like equity, is a real asset and therefore considered by actuaries as an inflation
hedge. An investment in property gives the investor legal rights to the use of the land
and/or buildings.
Direct property investments may be made in offices, shops, factories and industrial
units, warehouses, shopping centres, retail warehouses, agricultural and residential
property. The return on property is usually obtained from rental income as well as
anticipated capital gains on resale.
Because of its real nature, property is often considered as an alternative to equity
investment. Probably the most pronounced difference between the two asset classes
lies in the much reduced marketability of property, because of the following three
characteristics:
Large unit size which makes direct investment in parts of a property generally
unfeasible, as opposed to the easy divisibility of a company into shares
Uniqueness of properties, as opposed to identical shares of a company
Valuation is much more difficult since properties are infrequently traded and
there is no market quoting prices for them between trades, unlike listed equities
Some of these difficulties can be minimised through indirect investment in property
companies and trusts, which purchase and manage properties through the legal structure of a company or collective investment vehicle, shares or units of which are sold
to investors. This enables smaller investors to obtain exposure to the property market
without being limited by large unit size, and allows diversification of property holdings
(an important concept in investment strategy which is discussed later in the course). It
also allows investors to obtain access to property expertise, without having to acquire
this themselves.

Derivatives

Derivatives are so named because they are derived from other assets. Emphasis in
this course is given to forwards/futures and options, although there is some limited
discussion of swaps below. In derivative terminology, the purchaser of a derivative
contract is said to be long the derivative, or to be the long party, while the seller is

9
called the short party.
Since derivatives have only been thrust into the mainstream public eye in recent times,
there is a widespread assumption that they are a recent innovation. In fact, historians have found reference to agreements remarkably similar to forward contracts in
manuscripts from several thousand years ago. It is well documented that farmers have
entered into such arrangements for at least several hundred years, to protect themselves
against declines in crop prices because of unfavourable weather patterns or overproduction. For example, the Yodoya rice market in Osaka, Japan offered something
substantively similar to modern futures contracts as far back as 1650.
The Chicago Board of Trade (CBOT), on which derivatives are still traded today, was
originally established in 1848. The original purpose was to provide farmers and traders
the ability to hedge their anticipated returns on commodity sales. In this context,
hedging means protection against variability by locking into a certain future price. The
nature of such contracts is that the counterparty must be either looking to hedge as well,
in which case they must have an opposite exposure to the first party, or alternatively
looking to speculate, i.e. to profit from price movements. It is important to realise
that derivative markets provide opportunities for both hedging and speculation.

7.1

Forwards and futures

A forward contract is an agreement by the long party to purchase an asset at a specified

future date for an agreed sum of money from the short party. This is an agreement
entered into by the two parties, which can therefore be structured to meet the specific
requirements of both parties but which also entails credit risk: there is a risk, to the
party for whom the forward contract expires with a positive value, that the other party
will default on its responsibility.
A futures contract works in exactly the same way as a forward, but is a standardised
contract traded over an exchange, with a clearinghouse which acts as a counterparty
to each and every trade, i.e. acts as a middleman between the short and long parties,
guaranteeing their positions and removing the credit risk.
Consider purchasing a six-month futures contract on an asset at R100 (the exercise
price or strike price). You have therefore entered into a contract to purchase the
asset for R100 in six months time. Ignoring taxes and transaction costs, if in six
months time the asset is worth more than R100 you will have made a profit equal
to the difference between the price at the time and R100. Conversely, if the asset is
worth less than R100 you will have made a corresponding loss. In practice, the asset
is usually not physically delivered, but the contract is rather settled in cash for the
difference between the asset price and the strike price.
Actuaries will most often consider futures contracts as part of a hedging strategy. For
example, say that a pension fund is expecting a significant cash inflow in nine months
time, which it plans to invest in the equity market. The fund runs the risk of significant increases in equity prices over the intervening period, and being forced to buy
into what may be a temporarily inflated market. This risk could be hedged by the

10
purchase of a nine month futures contract on an appropriate equity index, allowing
the fund to secure the price at which it will buy into the market in nine months time.
This strategy of course also removes the potential for profit that would arise from a
drop in the market over the nine-month period.
Returning to our six-month futures example, the profit profile (to the long party) of
the transaction in six months time is:

The profit profile to the short party, i.e. the seller of the futures contract, is obviously
the mirror image of that to the long party:

It is interesting to note that, ignoring interest and costs, these are the same profit
profiles that you would obtain by buying or selling the asset for R100 now. The essential
difference is that you dont need to purchase or own the asset in order to make the
profit or loss. Futures markets can thus be used to speculate as well as hedge: futures
contracts allow investors to take large positions in assets for very little money down,
which can lead to enormous profits as well as crippling losses. The much-publicised
collapse of Barings Bank several years ago, as well as the more recent losses sustained
by Societe Generale, both resulted from traders eluding their respective organisations
risk management protocols in order to take futures positions which they hoped would
translate into massive profits, but which turned against them badly.

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7.2

Options

Whereas a futures contract creates an obligation to trade in an asset at a specified

future date for a specified amount, an option creates the right to do so without the
obligation. This means that if conditions are unfavourable at the maturity of the option, the holder can simply let the option expire without exercise, losing only the initial
option premium that was paid.
A dazzling variety of exotic options exists, but in this course we will focus only on
European call and put options. The European designation has nothing to do with
where they are traded, but simply refers to options which can only be exercised at
maturity (to be contrasted with, for example, American options, which can be exercised
at any time prior to maturity).
7.2.1

Call options

A call option gives the purchaser the right to buy an asset at a specified future date
for an agreed price. The entity selling the option is often referred to as the writer of
the option. Take the case of an option to buy an asset for R100 in six months time,
which costs R10 today. If the price of the asset in six months time is above R100,
the option holder would exercise and profit by the excess of the assets price over the
strike price of R100. We can see that, ignoring interest, tax and transaction costs, and
taking account of the option premium paid, the assets price would need to be above
R110 in order for the holder to make a net profit. On the other hand, if the assets
price ends up less than R100, the holder of the option can let it expire worthless and
will suffer a net loss of R10, the original option premium.
This profit profile is shown below:

12
The profit profile to the option writer is again the mirror image of the above:

Clearly writing options is significantly riskier than purchasing them. For a call option
writer, profit is limited to the option premium, but the potential loss is theoretically
infinite. The purchaser of the call option faces the reverse: a loss limited to the option
premium but an unlimited upside.
Consider how the pension fund referred to in the futures section above, which is expecting a large cash inflow in nine months time, could use call options in its hedging
strategy instead of futures. By buying a call on the equity index, the fund would be
able to buy into the equity market at the strike price, and would thus be protected
against unexpectedly sharp increases in equity prices. The important distinction from
futures hedging is that it would not lose out on the upside, as it can allow the option to
expire worthless and buy into the market at prevailing prices in the event of a market
fall. In effect, the fund is purchasing a sort of insurance against market movements,
the cost of which is the option premium.
7.2.2

Put options

A put option, by contrast, offers the holder the right to sell an asset at a future date
for a given price. Consider an option to sell an asset for R100 in six months time,
which costs R10 today. If the price of the asset is below R100 in six months time,
the option holder will exercise and receive the difference between R100 and the asset
price; clearly an asset price of less than R90 will be required for a net profit, ignoring
interest, costs etc. If the price ends above R100, the option will expire worthless.
The profit profiles to purchasers and writers of put options is shown below. Once again,
the option purchasers loss is limited to the option premium, as is the writers profit,
and the purchaser has the chance of a significant gain and the writer of an equally
significant loss, although in this case this is limited to the strike price.

13
The profit profile from the put option purchasers perspective looks as follows:

And from the writers perspective the picture is the reverse:

Interested students may wish to do some additional reading about more exotic option
structures: American, Bermudan, Asian, barrier, binary... the list is almost endless.

7.3

Swaps

A swap is a derivative contract in which two parties agree to swap streams of cash
flows. As with other derivatives, they can be used either to hedge (which is the context
in which actuaries will generally consider them) or to speculate.
The most common types of swaps are:
Currency swaps, in which the parties exchange cash flows denominated in different currencies, and
Interest rate swaps, in which the parties exchange cash flows based on different
interest rates. The most common form is a fixed-for-floating swap, in which one
party pays according to an agreed fixed interest rate, and the other according to a
rate which fluctuates in line with prevailing short-term interest rates. This floating rate is typically linked to the Johannesburg Interbank Agreed Rate (JIBAR)
or, on international markets, the London Interbank Offered Rate (LIBOR), which
are rates at which banks are prepared to lend money to one another.

14
You may also come across equity swaps and total return swaps. Knowledge of the swap
mechanism is beyond the scope of this course, but again would make for interesting
additional reading.

Alternative investments

Recent years have seen the emergence of various alternative asset classes which are
starting to receive the attention of institutional investors. Some of the more important
are briefly discussed below, although knowledge of these asset classes is beyond the
scope of the first-year course and an overview is provided merely as an introduction to
further reading if desired. As you will see, these are either special cases, combinations
or customised packages of asset classes to which you have already been introduced.

8.1

Hedge funds

Hedge funds have been the subject of much discussion in recent years. Originally
conceived as an unregulated investment class for wealthy private investors, they have
moved into the mainstream over the past decade or so, and are beginning to form part
of institutional portfolios.
The concept of a hedge fund is notoriously difficult to define, and the term is not
particularly descriptive of how such funds operate. It has come to encompass all investment funds which make use of significant leverage and derivative strategies to achieve
outperformance. Leverage refers to the use of debt to fund investments in highergrowth asset classes, as well as the short-selling of assets, i.e. the sale of assets you do
not in fact own (this is a strategy about which you should not concern yourselves too
much at this stage).
As a simplified example of leverage, assume that you can borrow money for a year at
10% per annum, and that you can purchase a share for R100 which will, with equal
probability, either grow by 40% or shrink by 10% over the year. The expected return
on the share (a concept with which you will become familiar after starting your Statistics studies in the second semester) is 15%, i.e. the average of 40% and -10%, which is
greater than the cost of debt (if it were lower, it wouldnt be a particularly compelling
investment opportunity).
If you buy the share out of your own funds, you will have a cash outflow of R100 now,
and an asset worth either R140 or R90 in a years time. Your return will therefore be
90
1) or -10% ( 100
1). If on the other hand you borrow half of the cost
either 40% ( 140
100
of purchasing the share, your cash outflow now is only R50. In a years time, you again
have an asset worth R140 or R90, but in addition you need to repay R55 on the loan.
Your return is therefore either 70% ( 14055
1) or -30% ( 9055
1). Your potential gain
50
50
and potential loss have been intensifed by the use of debt, i.e. your return has been
levered. An investment manager who can consistently beat the market will improve
her return through the use of leverage, while one who consistently underperforms will
see her returns reduce.

15
Because of the specialised and often risky strategies that hedge funds employ, they
remain unregulated and cater mainly to sophisticated private investors. In the United
States, for example, there is a requirement that the majority of a funds investors
be accredited in the sense of minimum annual income, minimum net asset value and
a minimum stated degree of investment knowledge. The case for the inclusion of
some hedge fund exposure in institutional portfolios has been made relatively recently,
mainly in the last five years, on the basis that their low correlation with the returns
on traditional asset classes allows their inclusion to enhance expected return while
reducing the variance of return. Expected return, variance and correlation are all
concepts that will become familiar to you from your initial forays into Statistics, and
you shouldnt be too worried at this stage if you fail to understand this motivation for
exposing institutional portfolios to hedge fund returns.

8.2

Private equity and private debt

Equity and corporate bonds have been discussed above. Private equity consists of equity capital that is not listed on a public exchange. Very often, private equity funds
structure takeovers of companies, many of whom were previously listed, through Leveraged Buyouts (LBOs), which as you will have guessed from the discussion of leverage
above, involve the use of large amounts of debt to fund the purchase. The rationale
for such transactions is a belief that through better management, corporate financial
performance can be improved and returns to investors enhanced. Recent South African
examples of private equity takeovers of previously listed firms include Alexander Forbes
and Shoprite Checkers. Most private equity funds require a significant commitment of
capital for between two and five years before investors can realise returns.
Similarly, private debt consists of bonds or other corporate debt instruments which are
placed privately, and not traded on a public exchange.

8.3

Securitisations

Securitisation refers to the conversion of individual financial assets, for example mortgage loans, into tradeable financial securities through their pooling. This allows retail
investors to effectively lend money for mortgages and benefit from the interest paid
on them. The last twenty years have seen the creation of a multitude of securitised
structures, many with complex structures and all beyond the scope of this course, but
the interested student may wish to do some further investigation into Mortgage-Backed
Securities, Asset-Backed Securities, Collateralised Debt Obligations and Loan Participation Notes, to mention but a few of the most prominent varieties.