Alternative Investments

Instruments, Performance, Benchmarks, and Strategies

H. Kent Baker, Greg Filbeck

• Publisher: Wiley
• Year: 2013
• Print ISBN: 9781118241127
• eBook ISBN: 9781118282588
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

A comprehensive guide to alternative investments that reveals today's latest research and strategies

Historically low interest rates and bear markets in world stock markets have generated intense interest in alternative investments. With returns in traditional investment vehicles relatively low, many professional investors view alternative investments as a means of meeting their return objectives. Alternative Investments: Instruments, Performance, Benchmarks, and Strategies, can put you in a better position to achieve this difficult goal.

Part of the Robert W. Kolb Series in Finance, Alternative Investments provides an in-depth discussion of the historic performance, benchmarks, and strategies of every major alternative investment market. With contributions from professionals and academics around the world, it offers valuable insights on the latest trends, research, and thinking in each major area. Empirical evidence about each type of alternative investment is featured, with research presented in a straightforward manner.

• Examines a variety of major alternative asset classes, from real estate, private equity, and commodities to managed futures, hedge funds, and distressed securities
• Provides detailed insights on the latest research and strategies, and offers a thorough explanation of historical performance, benchmarks, and other critical information
• Blends knowledge from the conceptual world of scholars with the pragmatic view of practitioners in this field

Alternative investments provide a means of diversification, risk control, and return enhancement and, as such, are attractive to many professional investors. If you're looking for an effective way to hone your skills in this dynamic area of finance, look no further than this book.

PART I

Introduction

CHAPTER 1

Alternative Investments: An Overview

H. KENT BAKER

University Professor of Finance, Kogod School of Business, American University

GREG FILBECK

Samuel P. Black III Professor of Insurance and Risk Management, The Behrend College, Penn State Erie

INTRODUCTION

Given historically low interest rates coupled with severe equity bear markets, interest in alternative investments has recently soared. Because sophisticated investors viewed the resulting investment environment for traditional investments as low return, many turned to alternative investments as a way of meeting their return objectives and, perhaps to a lesser extent, as a means of controlling risk. That is, alternative investments provide an opportunity to earn a reasonable return with manageable risk. Some alternative investments offer good opportunities to participate in different markets and to apply investment strategies that are unavailable to the general investing public. Thus, investors and portfolio managers who understand alternative investments have a substantial advantage over those who do not. Chen, Baierl, and Kaplan (2002), Amin and Kat (2003), Chen, Ho, Lu, and Wu (2005), and Anson (2006) find superior performance for the inclusion of alternative investments on a stand-alone basis or as a part of a portfolio consisting of traditional assets.

What are so-called “alternative investments”? Alternative investments refer to many asset classes that fall outside of traditional investments, such as stocks, bonds, and cash. Broadly speaking, anything else in which an individual or institution can invest may be called an alternative investment. Because alternative investments encompass a wide range of offerings, limiting the discussion of the various types to a few major categories is helpful. Yau, Schneeweis, Robinson, and Weiss (2007) place such investments into two broad categories:

1. Traditional alternative investments

• Real estate: Ownership interests in land or structures attached to land. Investors may participate in real estate directly or indirectly. Direct ownership involves investment in residences, commercial real estate, and agricultural land. Indirect investment includes investing in companies engaged in real estate ownership, development, or management; real estate investment trusts (REITs); commingled real estate trusts (CREFs); and infrastructure funds.
• Private equity: Ownership interests in publicly traded companies. Although private equity involves an array of investment activities, among the most important fields of private equity activity are venture capital (equity financing of new or growing private companies), closely held companies, and buyout funds (the buyout of established companies through private equity funds).
• Commodities: Agreements to buy and sell a tangible asset or an actual physical good that is generally relatively homogeneous in nature. The three major classes of commodities are energy (e.g., crude oil and coal), metals (e.g., gold, silver, platinum, copper, and aluminum), and agricultural products (e.g., coffee beans, corn, orange juice, soybeans, sugar, and wheat). Commodities are essential building blocks of the global economy.

2. Modern alternative investments

• Managed futures: Private pooled investment vehicles that can invest in cash, spot, and derivative markets for the benefit of their investors and that have the ability to use leverage in a wide variety of trading strategies. Managed futures offer the potential for reduced portfolio volatility and the ability to earn profit in any economic environment. Managed futures accounts can take both long and short positions in futures contracts and options on futures contracts in the global commodity, interest rate, equity, and currency markets.
• Hedge funds: Loosely regulated and actively managed pooled investment vehicles that use a wide variety of investment strategies, such as taking aggressive long and short positions and using arbitrage and leverage. Because hedge funds can take many forms, no precise legal or universally accepted definition is available. Nonetheless, the primary goal of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions.
• Distressed securities: Securities of companies or government entities that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition. The most common distressed securities are bonds and bank debt. As investments, distressed securities are usually very risky because the company might not recover.

Although each of these alternative investments has unique characteristics that require a different approach by investors, alternative investments have some common characteristics. For example, they may be relatively illiquid and may involve relatively high costs of purchase and sale compared to stocks and bonds. Appraising the performance of alternative investments is often difficult because of problems associated with determining the current market value of the asset and the complexity of establishing valid benchmarks. Limited historical risk and return data may be available.

Further, many alternative investments are unavailable or unsuitable for the general public due to their complexity or structure. The complexity associated with alternative investments is a limiting factor for the average investor because such investments may require due diligence and a high degree of investment analysis before buying. Structure refers to how the investment is offered. Many alternative investments are private offerings available only to sophisticated investors. Not surprisingly, the major investors in alternative investments are high-net-worth individuals (accredited investors) and institutional investors. According to Securities and Exchange Commission (SEC) guidelines, an accredited investor, in general terms, must have a net worth of at least $1 million in assets, or have income over $200,000 per year (last two years and expectation of the same for the current year), or both. Some offerings require investors to have more than $5 million in assets to qualify. Yet, the potential risk-diversification benefits of alternative investments offer broad appeal across investor types. This is because of their generally low correlation with traditional financial investments.

Purpose of the Book

The purpose of Alternative Investments—Instruments, Performance, Benchmarks, and Strategies is to examine the many and varied areas that are now viewed as alternative investments. The survey nature of this book involves trade-offs given the vast footprint that constitutes alternative investments. Although no single book can cover everything associated with this topic, this book highlights key topics. Readers can gain an in-depth understanding of the major types of alternative investments and the latest trends within the field. Empirical evidence about each type of alternative investment is featured. Cited research studies are presented in a straightforward manner, focusing on the comprehension of study findings, rather than the details of mathematical frameworks. Authors contributing chapters consist of a mix of academics and practitioners.

Although each chapter is self-contained, the chapters are organized into five sections: (1) introduction, (2) real estate, (3) private equity, (4) commodities and managed futures, and (5) hedge funds. These topics not only incorporate the major types of alternative investments discussed by Yau et al. (2007) but also expand upon their list. Within each category, the book provides a discussion of such topics as the market for the investments, benchmarks and historical performance, specific investment strategies, and issues about performance evaluation and reporting.

Features of the Book

Alternative Investments—Instruments, Performance, Benchmarks, and Strategies has several distinguishing features.

• Perhaps the book's most distinctive feature is that it provides a detailed discussion of alternative investments, including empirical evidence and practice within the various topics covered. The book attempts not only to blend the conceptual world of scholars with the pragmatic view of practitioners, but also to synthesize important and relevant research studies in a succinct and clear manner and to present recent developments. Thus, the book reflects the latest trends and cutting-edge research involving alternative investments.
• The book contains contributions from numerous authors, ensuring a variety of perspectives and a rich interplay of ideas.
• Each chapter ends with a summary and conclusions section that provides the key lessons of the chapter.
• When discussing the results of empirical studies that link theory and practice, the objective is to distill them to their essential content so that they are understandable to readers, including theoretical and mathematical derivations to the extent to which they may be necessary and useful to them.
• The end of each chapter contains at least four discussion questions that help to reinforce key concepts. Guideline answers are presented at the end of the book. This feature should be especially important to faculty and students using the book in classes.

Intended Audience

The book's unique set of features should be of interest to various groups, including practitioners, investors, academics, and students. Practitioners can use this book to navigate through the key areas in alternative investments. Individual and institutional investors will also benefit as they attempt to expand their knowledge base and apply the concepts contained within the book to the management of their portfolios. Academics can use this book in their undergraduate and graduate investment courses and as a source for understanding the various strands of research emerging from this area. The book also has the potential for being used in the Chartered Alternative Investment Analyst (CAIA) program because the topics included in the book closely mirror those required by the CAIA program.

STRUCTURE OF THE BOOK

The remaining 27 chapters of the book consist of five sections. A brief synopsis of each chapter by section follows.

Part I. Introduction

Alternative investments include real estate, private equity, commodities, managed futures, and hedge funds, among others. These investments have the potential to enhance the risk-adjusted performance of existing portfolios of traditional investments. Chapter 2 highlights the role that alternative investments play in strategic asset allocation. Chapter 3 explores long-term trends that have emerged in alternative investments because of the financial crisis of 2007−2008. Because many alternative investments operate in private markets under less regulated conditions, Chapter 4 points out the increased importance of investor due diligence when including alternative investments within a portfolio.

Chapter 2 The Role of Alternative Investments in Strategic Asset Allocation (Douglas Cumming, Lars Helge Haß, and Denis Schweizer)

This chapter introduces a framework for strategic asset allocation using alternative investments along with traditional investments. The approach accounts for time series biases with alternative asset indices. A strategic asset allocation model is used that is flexible enough to capture the risk-return profile adequately, as well as to incorporate real investor preferences. The empirical results show that bonds are highly important in all portfolios, but defensive portfolios tend to use stocks of large U.S. firms. In all portfolios, emerging markets gain in relevance with decreasing risk aversion. For alternative investments, all portfolios use the maximum allocation of hedge funds and a medium allocation of commodities. Private equity is comparatively more important in defensive portfolios, whereas REITs gain in importance as risk aversion decreases.

Chapter 3 Trends in Alternative Investments (Erik Benrud)

The market for alternative investments has changed considerably since the financial crisis of 2007−2008. This chapter examines those changes and posits which ones reflect important, long-term trends that emerged from the turbulence of the crisis. The most important overall trend is an increase in the responsiveness of managers to the demands of investors in an effort to keep capital invested. This trend has led to more specific trends, such as an increase in transparency and liquidity in existing products and the introduction of new products with more investor-friendly properties. Although these trends will likely have positive effects, they may also have undesirable implications for the returns on alternative investments.

Chapter 4 Alternative Investments and Due Diligence (Gökhan Afyonoğlu)

Alternative investments such as hedge funds, private equity funds, real estate funds, timberland and commodity funds are drawing ever-increasing amounts of attention and capital. Alternative funds are private investment vehicles that are subject to less regulation than traditional asset classes. From an investment perspective, managers of such investments typically use sophisticated and opaque investment strategies; trade complex instruments such as derivatives; util...

Table of contents

• Cover
• Series
• Title Page
• Copyright
• Acknowledgments
• Part I: Introduction
• Part II: Real Estate
• Part III: Private Equity
• Part IV: Commodities and Managed Futures
• Part V: Hedge Funds
• Answers to Discussion Questions
• Index