What are alternative investments?
They are investment instruments, for which the concept of risk and returns are significantly different from the risk and returns of the equity and bond markets. The main “markers” of alternative investments: relatively low liquidity, complexity in estimating the “fair” price and yield, high cost of due diligence and analysis.
What are the main types of alternative investments?
Main types of alternative investments include real property, private equity (direct private funding), commodities (goods), hedge funds, manages futures, and distressed securities (instruments of troubled securities). Please note, that this is a broad description or alternative investments; for example, one could say that another alternative investment would be an investment into pieces of art.
Some types are well known, while others look more complicated…
Real estate is the most famous and traditional type of alternative investment. Investments are made either directly in commercial and residential real estate, or in real estate funds, such as Real Estate Investment Trusts (REITs), which are more or less liquid. Professor Jack Francis from Baruch College and Professor Roger Ibbotson of Yale figures show the latest generations: from 1978 to 2004 residential real estate brought an average return of 8.6% per annum, commercial real estate – 9.5%. At the same time, investments in stocks provided a yield of 13.4% per annum. That is, the average annual returns of real estate during this period are lower, but due to the low correlation with the stock market, investments into real estate reduce investment portfolio risk.
Private equity is the second type of traditional alternative investment. It involves the ownership of shares in private (as opposed to public) companies. From the investment banking point of view, the term “private equity” applies when capital is raised through a private placement offered to a group of accredited investors, as opposed to a public offering when shares are offered to the general public. Typically, investments in private equity are sold via special funds; databases of such funds are sold via the internet by specialized companies. Venture funds and leverage buyout funds are the two most famous private equity sectors. Venture funds invest in high risk projects, such as new ideas, projects that require financing for launching either production or sale of product. Leverage buyout funds invest in public companies by buying shares from the market and making the companies private. More often than not, there are changes in management, restructuring, strategic decisions made in regards to development. The company becomes more efficient and is valued higher than that at which the fund had bought it. It is worth mentioning that such a seemingly unusual private equity sector as leverage buyout has 2 to 3 times more assets under management (depending on the time of calculation) than venture capital. The majority of private equity investors are institutional investors: pension funds, charities, etc. Historically, returns on private equity in the U.S., for example, greatly varies and is dependent on the time interval calculation. For example, in the mid-2000s, the average annual returns on venture capital funds was 16.5% when calculating data for 20 years, and 26.5% when calculating data 10 years. Venture capital funds returns exceed those of the S&P Index when estimated for the same periods, which, is not the case if comparing returns on venture capital funds and S&P Index companies at intervals of 3 and 5 years.
Commodities or, goods, are the third traditional category of alternative investments. We have touched on this subject before. The fact that goods are sold on this market, is clear. The question is: what kinds of goods are being sold and how? There are three basic types of goods: key agricultural products like corn and wheat; metals like steel and aluminum; and energy products, like oil and gas. The main trade in goods takes place on exchanges. In the 20th century, commodity prices fell. At first glance, if prices have declined for 100 years, why invest in a commodity market? Since 1998, the prices of goods on average have more than doubled. With the appearance of institutional investors the commodities market changed, as was the case with the foreign exchange market. For example, during the 1970’s, the foreign exchange market was used for export and import operations. Today, after banks and other institutional investors have penetrated the market, export- import operations do not exceed 2% of the turnover of the foreign exchange market. Investments in commodities are carried out mainly in the form of futures contracts. Computations for 1990-2004 show that average return on the commodity market, as measured by the GSCI Index was 7.08%, the S&P Index was 10.94%. Then why do investors include commodities in their portfolios? Commodities reduce portfolio risk as the yield of the commodity market weakly correlates with the yields of stocks and bonds. The best time to invest in commodities is during the last stages of economic recovery, when inflation is gaining momentum. During this time, bond yields, for example will fall as inflation will “eat” earnings. The same applies to stock. In addition, to reduce inflation, the government will increase interest rates, which will limit the growth of market shares and bonds, but not commodities.
A relatively new type of alternative investment is the hedge fund. The first hedge fund was established in the late 1940’s. They are private funds with various strategies, usually aimed at maximizing capital gains for investors, that is, maximizing absolute returns. These funds are poorly regulated (although there has been increased regulation, particularly in Europe and the U.S.) and are unavailable to the general public, but welcome accredited and institutional investors. The past 15 years has seen a boom in hedge funds. These funds apply various complicated investment strategies; the most comprehensive among them being investing in other funds, the so-called “funds of funds” arbitrage strategy, a strategy of investing in emerging markets. The main source of remuneration for managers of hedge funds depends on the achieved result. They are compensated from a percentage of the earned income (around 20%) along with a small commission depending on the assets under management. Investing in hedge funds conceals numerous pitfalls which include yield calculations to the distortions in the estimates of risk, which could be discussed separately. Hedge funds have about $2 trillion (USD) in assets under management.
Managed futures as an alternative investment class emerged the late 1960’s. They are private investment pools operating on the derivatives market applying leverage to achieve higher returns. This type of alternative investment is similar to hedge funds. The difference is that managed futures invest in a more narrow class of derivatives, such as, working with forwards, futures, and options contracts, while the strategies of hedge funds are more broad and diverse. The managed futures market is hard to assess. As an estimate, the Barclays Trading Group grew from $1 billion USD in 1980 to $130 billion USD in 2004.
The last category of a relatively new type of alternative investment is distressed securities. Distressed securities funds invest in funds of troubled securities. Distressed securities as a type of investment originated in the U.S. in the late 1930’s. The strategy is to invest in securities of companies in the state of financial instability or close to bankruptcy. Often, purchasing securities is done via a hedge fund. There are many strategies, but the desired end result is that the company will recover from its instability. Or, an arbitrage strategy can be applied where investors purchase corporate bond and sell short the common stock. This strategy is counting on the fact that the share price of the company experiencing financial problems will fall if the situation gets worse, and common stock share prices will fall lower for fundamental reasons. If the company improves its financial condition, the value of bonds will significantly rise, since bondholders have priority in payments over common stock shareholders.
What are the general benefits offered by alternative investments for an investor’s portfolio?
Alternative investments offer the benefit of portfolio diversification, as their returns often poorly correlate with the returns of stocks and bonds when calculated for the same periods. Many managers consider alternative investment markets are less efficient, and they can often find “market distortions”, false priced assets, which, in turn, is earned income.
Disclaimer: This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service. Performance data shown represents past performance. Past performance is no guarantee of future results. No part of this article may be copied, distributed, transmitted or published without the prior written consent of the author.
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