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Alternative Investments

Guide to Understanding Alternative Investments

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Alternative Investments

Alternative Investments Overview

Alternative investments, or just “alternatives,” refer to any non-conventional approaches to investing.

Generating outsized, above-market returns has become increasingly difficult — therefore, alternatives have emerged to become an integral part of many modern portfolios.

In particular, alternatives have become regular holdings in the portfolios of those managing a larger amount of assets (e.g. multi-strategy funds, university endowments, pension funds).

Traditional investments comprise of debt issuances (e.g. corporate bonds, government bonds) and equity issuances by publicly-traded companies — which are vulnerable to the prevailing economic conditions and market fluctuations.

Moreover, if lower-risk securities are chosen, such as fixed income, the yield can oftentimes be insufficient to meet the desired target returns.

In contrast, alternative investments utilize riskier tactics such as leverage, derivatives, and short-selling to increase upside potential while still limiting downside risk with strategies like hedging.

Types of Alternative Investments

The common types of alternative investments are defined in the chart below.

Asset Class Definition
Private Equity
  • Private equity refers to investments in privately-held companies, i.e. those not listed on a public exchange.
  • The three primary subsets of private equity are the following:
    1. Venture Capital (VC): Funding provided to startups and early-stage companies.
    2. Growth Equity: Expansion capital for more established, high-growth companies with significant upside regarding revenue potential and scalability.
    3. Buyouts (LBOs): Majority stakes in late-stage, mature companies, where the acquisition is financed with a substantial amount of debt capital and returns stem from operational improvements, debt payment, and multiple expansion.
Hedge Funds
  • Hedge funds are investment vehicles that utilize various strategies to earn high returns independent of the market.
  • Investment strategies differ by firm, but the most common types are long/short, equity market neutral (EMN), activist, short-only, and quantitative.
Real Assets
  • Real assets are the largest asset class, consisting of real estate, land (e.g. timberland, farmland), buildings, utilities, infrastructure, and transportation.
  • The real assets category also includes physical assets such as artwork and collectible items.
Commodities
  • Commodities are most often natural resources (e.g. oil & gas, and precious metals) and agricultural products (e.g. corn, wheat, lumber, cotton, sugar).
  • The performance of commodities is highly dependent on global supply/demand and macro conditions.

Portfolio Asset Allocation of Alternatives

Alternative investments — in theory at least — should “complement” an investor’s traditional equities and fixed income holdings, rather than comprise the entirety of a portfolio.

Since the 2008 recession, more institutional investors have diversified their portfolios into alternatives such as hedge funds, private equity funds, real assets, and commodities.

While most of these institutions — e.g. university endowment funds, pension funds — have opened up to alternatives, the proportion of their capital placed in such vehicles as a percentage of their total assets under management (AUM) remains relatively small.

The recommended asset allocation into alternatives versus traditional investments depends on a specific investor’s risk appetite and investment horizon.

In general, the benefits of alternative investments are as follows:

  • Diversification: Complement traditional portfolio holdings and mitigate market risk (i.e. not entirely concentrated on just one strategy).
  • Return Potential: Alternatives should be viewed as another source of returns from the exposure to more securities and strategies.
  • Lower Volatility: Despite many of these funds being riskier, their inclusion in the portfolio can reduce the total portfolio volatility if strategically weighted (e.g. they can help offset losses against traditional investments in a recession).

Performance of Alternative Investments

Historical Performance of Alternatives

Historical Performance of Alternative Investments (Source: Merrill Lynch)

Risks to Alternative Investments

One major drawback to alternative investments is liquidity risk, since once invested, there is a contractual period during which the capital contributed cannot be returned.

For instance, an investor’s capital could be tied up and be unable to be withdrawn for long duration of time as part of an alternative investment.

Since most alternative investments are actively managed vehicles, there also tend to be higher management fees plus performance incentives (e.g. the “2 and 20” fee arrangement).

Given the higher risk of losing capital, certain strategies like hedge funds are only available to investors that meet certain criteria (e.g. income requirements).

The final risk to consider is that certain alternative investments have fewer regulations and oversight from the U.S. Securities and Exchange Commission (SEC), and the reduced transparency can create more room for fraudulent activities such as insider trading.

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