Alternative investments are investments other than traditional investments. Traditional investments are long-only positions in stocks, bonds, and cash. They are not necessarily uncommon/recent investment classification because real estate and commodities, two segments of alternative investments, are arguably a few of the oldest investment classes. Another significant category of alternative investments is the investment through special vehicles such as private equity funds, hedge funds, etc. which use non-traditional investment approaches.
Growth in alternative investments is driven by the institutional investors and high-net-worth individuals seeking diversification (due to their lower correlation with traditional investments), and improvement in their risk-return profile.
Alternative investments are characterized by active management, even though passively managed investments exist in commodities and real estate. Further, alternative investments through special vehicles have high-fees, concentrated positions, high leverage and restrictions on redemptions.
Other special characteristics of alternative investments include: (a) illiquidity, (b) manager specialization, (c) low correlation with traditional investments, (d) less regulation and transparency, (e) limited historical risk and return data, and (f) unique legal and tax considerations.
Investors must be careful in evaluating the historical return of alternative investments because the data may be inconsistent, for example, (a) direct real estate and private equity are based on appraisal values and not actual transactions, (b) hedge funds suffer from survivorship and backfill biases, etc.
An investor in alternative investments needs to have a long-term horizon because only then can it exploit the pricing inefficiencies, illiquidity premiums, etc.
Categories of alternative investments
Major categories of alternative investments include:
Hedge funds are private investment vehicles investing in securities and derivatives through a variety of strategies. They may use both short/long positions, have high leverage, and attempt to generate return independent of the broad market performance.
Private equity funds
Private equity funds invest in private companies or take established public companies private through leveraged buyouts. Venture capital (a component of private equity) provides finance to early-stage companies who have nowhere else to go for funding.
Real estate includes direct and indirect investment in buildings and land (including farms and timberland). Indirect investment takes the form of equity in or issuance of debt to real estate firms, REITs, mortgage-backed securities, etc.
Commodities represent cash investment in wheat, sugar, oil, etc. and indirect investment through derivatives, commodities index funds, and shares of companies engaged in the production of commodities.
Infrastructure represents investments in public infrastructure, either directly or through investments in companies operating them or PE funds financing them.
These include special-interest tangible (art, antiques, etc.) and intangible assets (patents, etc.)
Return to alternative investments
Most alternative investments are actively managed which means that they attempt to generate excess return. Major active-management strategies related to alternative investments include:
- Absolute return: These strategies attempt to generate a return independent of the broad market. Their benchmark is typically stated either with reference to Libor or absolute real or nominal terms.
- Market segmentation: These strategies allow alternative investment managers to exploit market segments that are not accessible to traditional investment managers due to restrictions imposed on them due to portfolio risk and return requirements, and other constraints.
- Concentrated positions: These strategies involve concentrating funds among a few investments with results in less diversification but may achieve higher returns because not all investors are willing to take such positions.
It is important to determine alternative investments’ excess return potential with reference to their risk. Sharpe ratio is a popular measure that is calculated by dividing excess return over the risk-free rate with the standard deviation of returns. But the Sharpe ratio has shortcomings: (a) it assumes a normal distribution of return (which is not valid in case of alternative investments because most of their returns are skewed), and (b) it penalizes both positive and negative deviations. Sortino ratio, which is calculated by dividing excess return (over a benchmark) by the downside deviation (over the benchmark) attempts to alleviate some of these problems. Investment managers also use downside frequencies (i.e. frequencies of return falling below 1%, 5%, etc.) and worst monthly returns.
However, both these measures fail to recognize the low correlation that alternative investments have with traditional investments and which reduces the overall standard deviation of the portfolio when alternative investments are added to traditional investments. However, the expected diversification benefits of alternative investments may not always be realized, particularly when they are most needed i.e. in financial crises, because the correlations between traditional and alternative investments increase during financial stress, approaching 1 during financial crises.
Common investment structures for alternative investments, particularly private equity and hedge funds, include a general partner, who manages the fund (and theoretically bears unlimited liability but in reality, does not), and limited partners, who have investments in the funds. A limited partnership is restricted to the individual who understands the risks, this is why the structure is less regulated.
Such funds pay a management fee, which depends on assets under management, and an incentive (or performance fee) which is based on return (sometimes on return in excess of the hurdle rate). Most funds have a high-water mark provision, which means that return is calculated on a cumulative basis. This benefits the investors because the manager must first recover any losses before earning any incentive. In other words, fund managers cannot earn incentive fees twice for the same performance.