Alternative Investments - Best Practices

Alternative Investments

What are Alternative Investments? Meaning

Alternative Investments is an umbrella term that refers to all asset classes other than the traditional (conventional) ones, being Stocks, Bonds, and Cash. They include Hedge Funds, Private Equity, Commodity, Real Estate, Infrastructure, Structured Products, and others (like Antiques and Collectibles). They can be tangible (e.g., real estate, metals, antiques) or intangible (e.g., hedge funds, derivatives, copyrights).
Most alternative investment assets are held by institutional investors and accredited, high-net-worth individuals due to their complex nature, lack of regulation, and degree of risk.
Managers of alternative investments portfolios often use non-traditional, complex strategies such as the use of leverage and derivatives, short selling, and investment in illiquid assets. Managers make use of the market inefficiencies to find arbitrage opportunities (see Efficient Market Hypothesis).
The main objective of using alternative investments, along with the traditional assets, is to diversify the investment portfolio, i.e., to reduce the portfolio risk.

History of Alternative Investments

For centuries, humans had been investing in precious metals, agricultural products like grains, paintings, and artifacts, real estate (residential) – either for the sake of owning them or for trading (barter trade). The late 19th and early 20th century saw the rise of real estate, government debt, mortgages, and preferred stock as investment assets. Further on, agricultural debt and high-quality corporate debt also began to be traded.
The Modern Portfolio Theory (MPT) published by Harry Markowitz in his paper 'Portfolio Selection' (1952) drew light on the importance of portfolio diversification to maximize the returns for the given risk. With this, investors began to look for other investment assets like average-quality corporate bonds, international stocks, high-yield debt, small stocks, real assets, hedge funds, and private equity.

Characteristics of Alternative Investments

High fees: They are associated with high purchasing costs (or minimum investment costs). Also, the expertise and level of involvement needed in managing these assets classes (e.g., Private Equity) demands higher management fees (often with additional performance-based incentives)
High use of leverage: The high initial costs often necessitate external borrowing
Relatively lower Liquidity: Due to changing demands, it is tougher to sell these assets (e.g., Paintings, Wine bottles). Also, assets like Hedge funds or Private Equity have restrictions on redemptions, making it difficult to square off one's position.
Low diversification within the Alternate Investment portfolio: The high initial investment doesn't allow an investor to purchase multiple alternative investments, to create a diversification within that portfolio.
Different Legal and Tax considerations
Less Regulation and Transparency: Fewer regulations governing alternative investments as compared to traditional assets, like Equities, results in lower transparency.
Potentially problematic and limited historical Risk and Return data: The returns data often has an upward bias due to Survivorship bias (considering only currently surviving firms, which typically have above-average returns) and Backfill bias.
Narrow specialization of investment managers: With assets like Hedge Funds and Private Equities, managers often have specialized knowledge and expertise in a particular field.
Low correlation with Traditional investments: Alternative investments have returns that show a low correlation with the traditional investment returns over a longer period. Thus, pairing them with traditional assets in a portfolio yields Diversification benefits and reduces the overall portfolio risk.
Complex Valuation: The unpredictable demand patterns and the specific knowledge required to value them makes the valuation of alternative investments quite complicated. This is also because of their unique nature (e.g., paintings, artifacts).

Types of Alternative Investments. Classes

Hedge Funds: They are investment pools that are available to a limited number of qualified institutional and wealthy individual investors. They are typically set up as limited partnerships, with the management firm as the General Partner and the investors as the Limited partners. The fund managers enjoy greater flexibility than traditional fund managers by employing a wide range of strategies, such as the use of leverage, short selling, or use of derivatives. These strategies and systems used by the managers have lesser transparency in terms of disclosures. Hedge fund investments are less liquid, with restrictions on redemptions such as the Lockup period (the period post the initial investment after which withdrawals are not allowed) and Notice period (investors have to inform in advance about their decision to make a withdrawal).
Private Equity: Private equity consists of investments in the equities (Common shares and Preferred shares) or debt securities of privately-held firms or firms that are about to go private; such assets typically have risk exposures like equities. Private equity includes Leveraged buyouts or LBOs (includes Management buyouts/MBOs and Management buy-ins/MBIs), Venture capital or VC (early-stage funding to startups), investing in risky debt-securities (e.g., Mezzanine debt or distressed debt), and Minority Equity investing (e.g., Private Investment in Public Equities or PIPEs). Similar to hedge funds, Private Equity funds are structured like limited partnerships, with the investors pooling together the Committed Capital.
Real Estate: The assets under Real Estate include Residential properties, Commercial properties, and Mortgage-backed securities or MBS (loans with Real Estate as the collateral). The cash flows from these assets are in the form of rents or capital gains. Investors could also invest in Real Estate Investment Trusts or REITs (firms that hold income-earning real estate assets and issue publicly traded shares). Timberland and Farmland are two other forms of Real Estate assets. The price volatility of real estate assets is based on economic factors, local demand, and interest rate (since leveraging forms an essential aspect of Real estate investments). These assets provide a hedge against Inflation risk and have a low correlation with traditional assets.
Commodities: It is possible to invest in Commodities such as Agricultural products, Energy (Oil & Gas), and Industrial and Precious metals. Derivatives (futures, forwards, options, and swaps) are the most commonly used instruments for this purpose. Some other commodity investments include Index funds (e.g., Exchange-traded funds or ETFs), Commodity funds (funds that directly invest in the underlying commodities), investing in equities of Commodity producer firms, or managed futures funds (actively managed funds that are structured as mutual funds or hedge funds). The returns on commodities are from price changes only, and not from income streams. The overall returns from commodities have been lower than traditional assets like stocks and bonds, but they are less correlated with these assets (hence used for diversification). Also, the prices of commodities change with the inflation rate, thus acting as a hedge against inflation risk. The prices of commodities tend to have higher volatilities due to the changing global demand and supply.
Infrastructure: Investments in infrastructure include assets like roads, highways, airports, railways, ports, electricity generation and distribution facilities, schools, and health care facilities. The investments could be Greenfield Investments (infrastructure assets that are yet to be constructed) or Brownfield Investments (already built infrastructure assets). Greenfield investments have uncertain and lower yields but have higher growth potential; brownfield investments provide stable cash flows but lower growth potential. Investments in infrastructure can be made by directly operating government assets, by constructing the assets and selling or leasing them to the government, or by purchasing existing government assets and leasing them back (lease-buyback) or operating them directly. These investments have a longer asset life, higher initial costs, and lower liquidity. Infrastructure investments are subject to regulatory risks, operational risks, and risk from financial leverage.
Structured Products: These include financial products engineered to yield risk and return opportunities better than long positions held in traditional assets. An example of Structured products is Collateralized Debt Obligations (CDOs). CDOs are a pool of income-bearing assets or securities (like mortgages or bonds) that are sold in small packages to investors. A package consists of various securities belonging to different tranches (categories with specific credit risk).
Other Alternative Investments: These include tangible assets like paintings, artifacts, old wine bottles, stamp collections, and collectibles, and intangible assets like copyrights. These assets often tend to be illiquid. Specialized knowledge is required while purchasing and valuing them.

Advantages of Alternative Investments. Benefits

Diversification benefits
Higher returns, rewards
Direct ownership of physical assets

Disadvantages of Alternative Investments. Limitations

Higher initial and maintenance fees
Higher risks
Lesser transparency
Low liquidity
Difficult to value

⇒ What are your views and experiences with using alternative investments along with traditional asset classes?

Sources:
Chambers, D. R., Black, K. H. & Lacey, N. J. (2018) "Alternative Investments: A Primer for Investment Professionals", 2018, CFA Institute Research Foundation & CAIA Association, pp. 1 – 20
BlackRock Investments (2020) "What are alternative investments?", 2020, BlackRock
Beardsley, B., et al. (2017) "The Innovator's Advantage", 2017, Boston Consulting Group, pp. 9-11
Chen, J. (2020) "Alternative Investment", 2020, Investopedia
CFI Education Inc (n.d.) "What is an Alternative Investment?", n.d., Corporate Finance Institute
Fraser, B. (n.d.) "6 Benefits of Alternative Investments", n.d., Aspen Funds