WHAT ARE ALTERNATIVE INVESTMENTS?
Alternative investments is a term used to describe investments in nontraditional asset classes. Traditional asset classes include stocks, bonds, and sometimes commodities, and foreign exchange. Alternative investments include hard assets, collectables, real estate funds, private equity, venture capital, managed futures funds, hedge funds, and sometimes even structured products like CLOs and CDOs. Every institution seems to have its own set of rules for what is and is not an alternative investment.
Investors obtain alternative exposure by investing in vehicles such as private limited partnerships and alternative mutual funds. Alternatives may offer attractive portfolio benefits to investors, although on a stand-alone basis they can be more volatile or less liquid than traditional investments.
The more established and better understood traditional asset classes can be described as having large global markets, significant pools of liquidity, a high degree of price transparency, and regulation, along with well-established market microstructures. Stocks and bonds have been available to investors for centuries. Even mutual funds have been around in various shapes and sizes for well over 100 years. Alternatives and hedge funds, on the other hand, by even the broadest measures, only started in the late 1960s and really only began to grow in the early 1990s.
Alternative investing is not a mature industry. Alternative investments are considered relatively young in terms of life cycle and track records. Hedge funds are perhaps the newest form of alternatives and as such may also be the least understood. Their business models are also not as stable, well developed, or mature as those associated with traditional investing or even earlier forms of alternatives, such as real estate and private equity. The market value of publicly traded equity and debt is well over $250 trillion today. There are more than $15 trillion of investments in traditional stock and bond mutual funds in the United States and over $30 trillion globally. This compares to about $3 trillion invested globally in hedge funds at the end of Q1 2015.
So what exactly constitutes an alternative as opposed to a traditional investment? There are a few broad categories that most professionals would agree make up the universe of alternative investment opportunities.
- Real estate investing includes direct investments or funds that invest in commercial or residential real estate or mortgages that produce rental income, interest income, and capital appreciation. Most funds are organized in specific regions or by specific types of properties.
- Private equity investing includes direct investments or funds that take equity ownership in existing private companies in the hope of streamlining or improving management, negotiating favorable leverage terms with banks, and improving performance so that the fund may ultimately profit from an initial public offering (IPO) of the company’s shares.
- Venture capital investing includes direct investments or funds that provide day-one capital to fund new business ideas. These early-stage investors hope to profit by sale of the company to a strategic investor or perhaps to a private equity fund that ultimately will help the company go public.
- Managed futures investing includes funds that are specially dedicated to trading futures contracts based on directional or trend-following models. These funds are similar to hedge funds in many ways. They are different from hedge funds in that they are restricted to trading listed futures contracts and are regulated by the Commodity Futures Trading Commission (CFTC).
- Hedge fund investing includes investments in either private investment partnerships, mutual funds or UCITS that trade stocks, bonds, commodities, or derivatives using leverage, short selling, and other techniques designed to enhance performance and reduce the volatility of traditional asset classes and investments.
In addition to the more established categories of alternative investments mentioned here, there continue to be newer emergent or exotic alternative strategies that come to the market every year. These exotic alternative investments include direct investments or funds that invest in life insurance settlements, farmland, weather derivatives, or collectables such as artwork, comic books, vintage automobiles, and rare coins (even Bitcoins). Most of these exotic and collectable investments still lack a minimum level of liquidity or price transparency, and are subject to greater fraud risk or are very difficult to value. These investments tend to remain in the domain of pure speculators, hobbyists, and those who are equal parts product enthusiasts and investors.
Most of the established and exotic alternative investments share at least a few common attributes or qualities. Most, if not all, alternative investment managers are experts in their area of investment, are major investors in the fund they manage, and get paid both a management and an incentive fee. Many also use leverage to enhance returns; some create portfolios that are illiquid at times; most only provide limited transparency to investors; and some alternative investments can be difficult to value.
When thinking about an alternative investment, here are seven things to consider:
- Expert management. Does the manager of the investments have significant experience in a specific market segment, industry, or area of investment? This extra level of skill and focus can allow the manager to identify unique values or opportunities not readily seen by the investor community at large.
- Manager co-investment. Do the manager and many of the partners or employees of the management company have a significant investment in the fund? This serves to align the interests of the investors with those of the manager.
- Performance fees. Does the manager get paid a percentage of the profits of the investments, in addition to any flat fees for managing the fund? The widespread use of an incentive fee is based on the principle that it further aligns the interest of the manager with that of the investor.
- Leverage. How much money or securities does the fund borrow to make investments? The use of a fund’s investor capital, plus leverage obtained from banks or derivatives, allows the fund to magnify gains or losses from each investment and achieve higher rates of return.
- Illiquidity. How long do investors need to lock up money in the fund before they can sell or redeem? Many times funds require investors to lock up their money for an extended period of time before they can redeem their investment.
- Limited transparency. Does the fund disclose its investments to its investors on a daily basis? Many times a manager may restrict the amount of periodic information provided to investors related to positions, strategy, leverage, or risk.
- Hard to value. Can the investment or the underlying instruments owned in the portfolio be valued on an exchange or do they require an over-the-counter (OTC) quotation or p...
