Primer to Alternative Investments By: Gabriel PotterMBA, AIFA® 2012.05.05

What is an Alternative Investment?

Simply put, an alternative investment is an investment product other than the traditional investment of stocks, bonds or cash.  That definition is broad because there are a great number of alternative investment strategies.  It includes access to alternative markets (private equity, commodities, real estate) and alternative manager strategies (e.g. – arbitrage strategies or global macro strategies).

 What are some of the advantages of Alternative Investments?

The traditional stock markets have been very depressed for the past decade with low, sometimes negative, returns.  Alternative managers have an unlimited mandate; they are not confined to typical market investments.  It is, therefore, unsurprising that managers with the flexibility to pursue non-traditional assets and strategies have outperformed the market indices over the past decade.

Furthermore, many alternative investment strategies have exhibited solid returns, with moderate risk and low correlations to traditional investment classes.  The low correlation to traditional asset classes is critical.  In asset allocation analysis, investors select an optimal combination of assets (stocks, bonds & cash) that provide the greatest return for a given level of risk.  With alternative investments, investors can often improve the risk and return metrics of their portfolio.  Therefore, asset allocation models typically include alternative investments during optimization analyses.

What are some of the disadvantages of Alternative Investments?

First, fees are high.  Alternative investments are typically more expensive than classic, traditional investing options.  For example, industry professionals refer to the typical hedge fund fee as “two and twenty”; that’s a flat 2% standard fee and an additional 20% of any profits earned.      

Second, investment professionals depend on data to make decisions and the historical data for alternative investments is often questionable.  The historical record is not very long for these strategies; the risk and return data for alternative indices does not go back as far as traditional investments, and that limits the usefulness of asset allocation modeling.  Furthermore, trying to use an alternative investment index to predict the risk and return metrics of a unique investment strategy is difficult, if not completely irrelevant.  Alternative investments are idiosyncratic by nature and do not lend themselves to easy comparison.   

Third, manager risk can be much more significant for these products.  Traditional equity and bond managers try to outperform their benchmarks, but they generally perform relatively close to their benchmarks.  Alternative strategies may be attractive to the investment manager because of the lack of restrictions on concentration, leverage, reporting standards, and so on.  Alternative investments, given their flexibility, have a much higher dispersion of performance relative to the benchmark.  In other words, the chances that an alternative investment will perform close to any benchmark are comparatively low.   

Fourth, transparency is another problematic issue for investors.  Transparency is often used to promote responsible governance.  However, alternative managers tend to be more secretive and often prefer not to reveal their complex methods for extracting value from the marketplace.  Worse, fraudulent hedge fund managers (e.g. – Bernie Madoff) were able to shield their deceitful practices behind poor regulatory oversight & low transparency.  The process of investment manager selection is, by necessity, rigorous and fiduciaries are often restricted by the lack of manager transparency.

Fifth, there may be severe issues with lock-ups and limited liquidity.  For example, private equity programs often require a lock-up of funds (and future contributions, i.e. a “capital call”) for a period of years.  For another example, many hedge funds reacted to the financial crisis of 2008 by imposing limits on withdrawals:  so-called “gates”.  In other words, investors could invest their money into the products, but they sometimes could not get it out as easily.  Poor liquidity does not necessarily stem from obstinate investment managers. Some managers simply do not invest their funds into Level 1 assets:  those assets that trade on a daily, liquid market.  Hedge funds and private equity products often invest in illiquid assets whose fair value can only be estimated.  Guessing the approximate value of the investments may take time and painstaking calculations; actually finding a buyer, willing to trade liquid cash for them, can take even longer.

Sixth, alternatives often have complex tax structures which may to delays or tax filing extensions.

Given the disadvantages with pure alternative investments, the market has responded by creating hybrids of traditional investments that use alternative techniques:  liquid alternatives.  Liquid alternatives typically follow an alternative strategy within a mutual fund vehicle.  Liquid alternatives lack the pure exposure to the asset strategy and sometimes restrict the manager’s ability to extract value.  Liquid alternatives tend to be more expensive than traditional management, but fees are still lower than pure alternatives.  The lower fees repel the most exclusive alternative managers.  Still, many institutional investors are grateful for the higher transparency and liquidity that liquid alternatives provide and these investments have been growing in popularity for several years. 

What are some are the investible options?

Commodities:  

  • Direct ownership – Investors can simply purchase a non-perishable commodity (like buying shares of gold).  Similarly, an investor can purchase a royalty trust.  For example, buying a share in a natural gas royalty trust entitles the investor to revenues from a natural gas well.
  • Indirect exposure via equities.  For instance, an investor can purchase a mining company stock for gold exposure or an agriculture company for cotton exposure. 
  • Managed Futures – Some investors directly purchase “futures” – the right to buy or sell a commodity an a given price at a specified date, but many more work with Commodity Trading Advisors (CTAs) to manage a portfolio of options and futures.
  • Master Limited Partnerships (MLPs) trade like ordinary stocks, but these special companies avoid corporate income taxes by passing through income directly to investors.  Mostly, they are pipeline companies that move and store oil & natural gas, but there are other MLPs in timber, minerals and other businesses. 

Commodity products tend to emphasize their ability to hedge against inflation risk and low correlation to the equity markets.  

Real Estate

  • Real Estate Investment Trusts (REITs) also avoid corporate income taxes by passing through income directly to investors.  REITs, both global and domestic, invest across the real estate market including retail (shopping malls), healthcare (hospitals), residential (apartments) offices, and mortgages.
  • Private residential or commercial real estate investment is also common.  Simply owning a house is, after all, a real estate investment.  Many limited partnerships also exist to provide investors access to the real estate market.

Real estate investments tend to highlight income generation and /or inflation hedging capability.

Defensive Strategies:  

  • Covered Call strategies buy stocks, but sell options on those stocks.  In practical terms, this provides downside protection in flat or downward moving markets.
  • Event Driven strategies try to exploit price differences after corporate events, such as a merger or acquisition.  For instance, a Merger-Arbitrage fund buys the stock of an acquisition target company and shorts the purchasing company.
  • Convertible Arbitrage strategies generally buy a convertible security (which is a bond like instrument that can be converted into a stock) and shorts the common stock for the same company.
  • Market Neutral strategies do not depend on the upward direction on the stock market.  They can, for example, buy an undervalued stock and short a similar overvalued position (same industry, capitalization or sector) in an attempt to neutralize market direction.

Defensive Strategies generally emphasize their low correlation to market risk (low beta).  They tend to highlight the benefit to a portfolio’s risk and return profile once the strategy is included.

Aggressive Strategies:   

  • Global Macro strategies are top down, large scale bets on world economies, political changes, and inter-country relationships.
  • Long-Short strategies can be purely market neutral if they have as many long positions as short positions (sometimes called “portable alpha”).  But most long / short managers tend to have more long positions than short – such as 130/30 strategies.
  • Dedicated Short strategies depend on correctly selecting stocks that with falling prices.  This risky strategy has managers selling assets they don’t have (receiving cash today) with the intention of buying the assets later.  Risks are high, but bearish investors may appreciate the ability to hedge against the overall market direction.
  • Distressed strategies are bargain hunters.  They typically invest in companies (bonds or stock) that are undergoing bankruptcy or significant financial restructuring. 
  • Private Equity strategies, as the name suggests, involve investments in made outside of the public stock market.  This includes leveraged buyouts, venture capital for new businesses and other arrangements. 

Aggressive strategies tend to have higher correlations to the equity market and higher cyclical market risk, but they tend to emphasize their goals of outpacing the market and maximizing returns. 

Adding a layer of complexity, many alternative products are often combined.  Funds of hedge funds are commonly used by institutional investors to allocate money between several individual hedge fund manager and strategies.  Similarly, liquid alternatives are frequently bundled into multi-alternative “diversifier” funds which may have broad exposure across commodities, real estate, aggressive and defensive strategies.

In Closing

Given the eccentricities of alternative investments, the fiduciary standard for these vetting these products is substantially higher than traditional investment products.  Including alternatives to a portfolio or a fund line-up will require a thorough understanding of the product and diligent, ongoing discussions with your investment consultant and / or fiduciary consultant. As always, we look forward to continuing this discussion with you.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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