Types and Categories of Alternative Investments

Every possible investment choice is either an alternative or a traditional investment. Traditional investments are:

• Long-only, publicly traded investments in stocks.
• Long investments in publicly traded bonds.
• Cash.

Traditional is neither a synonym for “common,” nor “unusual.” Therefore, alternative investments include assets such as:

• Derivatives (options, futures or forward contracts, swap contracts, etc.).
• Real estate.
• Short-selling stocks.
• Commodities.
• Fine art.
• Racing horses.
• Anything outside the traditional pool of investment classes.

Alternative investments often supplement traditional investments held in a portfolio. For example, holding a common stock and options on the same stock to protect or enhance investment returns.

Characteristics of Alternative Investments

• Investment managers limit their specialization to alternative investments.
• Alternative investments have a relatively low correlation of returns to traditional investments.
• Alternative investments have less transparency and regulation compared to traditional investments.
• They have inadequate historical risk and return data.
• Alternative investments have unique tax and legal issues.
• Alternative investments have higher fees, usually made of performance (incentive) fees.
• Alternative investments are usually concentrated portfolios.
• Alternative investments usually have limitations on redemptions, such as lockups and gates.

Categories of Alternative Investments

Hedge funds

Hedge funds employ numerous strategies to offer their investors absolute returns (net of fees and taxes). These private funds are actively managed (often by “star investors”) and employ aggressive strategies across asset classes. Many will use derivatives, high leverage, arbitrage, and other investment strategies unavailable to traditional fund managers. Redemptions are typically restricted in some way (lockup period, notice period, redemption fees). Strategies vary, but many fall into the following categories:

• Event-driven (mergers, restructuring).
• Relative value (arbitrage).
• Macro (top-down, global economic models).
• Equity hedging (“beating the markets”).

Funds of hedge funds hold equity in multiple hedge funds, like the mutual fund of funds.

Private Capital

These funds are private investment vehicles, typically managed by the general partner on behalf of the limited partners. Common strategies employed in these funds include leveraged buyouts, venture capital, development capital, and distressed investing.  Like hedge funds, these funds apply alternative investment strategies which are quite different from those of a typical mutual fund.  Fund managers have a lot of freedom to invest the capital of the funds. Leveraged buyout (LBO) funds look for opportunities to use leverage to improve the performance of firms with poor management, high borrowing costs, undervalued stock prices, and inefficient structures.

LBO financial interventions may assume two forms:

• Private equity.
• Private debt.

Private equity investors might participate directly or indirectly through private equity funds. Private equity funds make investments in both new and established businesses. These firms do not necessarily have to be listed on a public exchange. In fact, private equity funds may invest in public companies with the intent to take them private.

Private debt is primarily provided to private entities. Examples of private debts include direct lending, mezzanine loans, venture debt, and distressed debt.

Real Estate

Real estate is typically owned via a title, often registered by the local government in the land registry. Mortgages and construction financing are private debt investments, while MBS and collateralized obligations are public debts available to investors. On the equity side, there are direct ownership, partnerships, and joint ventures as private real estate investments.

Public equity investments may be REITs or shares in real estate corporations. Real estate falls into many categories such as:

• Residential.
• Commercial.
• Industrial.
• Agricultural.
• Timberland.

Direct real estate investments usually have long holding periods, high transaction fees, and diverse landlord-related responsibilities. Real estate rent can be adjusted regularly, offering a hedge against inflation. Returns come in the form of net income from the property and capital gains from any sales. Due diligence on real estate often includes environmental assessments and other legal concerns for landlords.

Natural Resources

These include commodities, agricultural land (or farmland), and timberland.

• Commodity investments may entail investment in such physical commodity products as grains, metals, and crude oil.
• Farmland and timberland are used to raise livestock and plants. An investor can, for example, invest capital in natural forests. Alternatively, they may manage tree plantations to earn a return when trees are harvested.

Infrastructure

Investors often look for stable returns and predictability from their investments. For example, investing in existing infrastructure projects is a “brownfield” investment.  These assets are either being sold or leased by the current owner (often, the government) and have historical data for an investor to analyze.

“Greenfield” projects are new projects, and investors must rely on projections to assess the viability of the investment.  Infrastructure investments include:

• Transportation (toll roads, bridges, railways, public transit).
• Utilities (dams, power stations, gas plants).
• Communication (broadcasting facilities, Internet backbone), among many others.

Some infrastructure projects are government-sponsored, while others are private.

Other

Other investments in the alternative space include collectibles and other investments that don’t fall into the traditional categories. Collectors have been around for centuries, and the investments are as varied as the collectors themselves.  Traditional collectibles such as stamps, cars, furniture, gems, fine art, and others still dominate the market. However, new collectibles such as baseball cards, action figures, and almost anything you can imagine offers investors new ways to invest their money outside traditional financial markets.

There are indices used to track the value of certain collectible markets, such as stamps. These markets are typically auctioned in small markets. It is worth noting that some are open to the public while others are not.

 Question 1

 Which of the is least likely a characteristic of alternative investments?

1. Less regulation.
2. Concentrated portfolios.
3. High correlation with traditional investments.

Solution

 The correct answer is C.

Alternative investments have a comparatively low correlation of returns with traditional investments.

Other characteristics of alternative investments include:

• Less transparency and less regulation than traditional investments.
• Inadequate historical risk and return data.
• Unique tax and legal factors.
• Higher fees, including performance or incentive fees.
• Concentrated portfolios.
• Restrictions on redemptions.
• Narrow specialization of the investment managers.

Question 2

Which of the following would you describe as a traditional investment?

1. The loose change in your pocket.
2. A promise to buy GM stock at a fixed price one month from today.
3. Starry Night by Vincent Van Gogh.

Solution

The correct answer is A.

Cash (option A), publicly-traded stocks, and publicly available bonds are available to investors in traditional investments.

Option B is incorrect. A promise to buy GM stock at a fixed price one month from today is a derivative. It would be a one-month call option on GM stock.

Option C is incorrect. Starry Night by Vincent Van Gogh is a painting and would be categorized as fine art.