Categories, Characteristics, and Compensation Structures of Alternative investments

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

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

In this context, traditional is not a synonym for “common.” Likewise, alternative is not a synonym for “unusual.” Alternative investments include assets such as:

• Private capital.
• Real assets.
• Hedge funds.

Alternative investments often supplement traditional investments held in a portfolio.

Why Consider Alternative Investments?

An investor should consider alternative investments for a number of reasons. To begin with, alternative investments offer a range of investments that have low correlations with traditional investments.

In addition, alternative investments allow investors to enhance the risk-return characteristics of their portfolios and increase their returns. Last but not least, alternative investments improve an investor’s return potential thanks to their higher yields.

Characteristics of Alternative Investments

Alternative investments have the characteristics listed below:

• 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.
• Alternative investments 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) and management fees.
• Alternative investments are typically concentrated portfolios.
• Alternative investments usually have limitations on redemptions, such as lockups and gates.

Categories of Alternative Investments

 Alternative investments are divided into broad categories:

1. Private Capital

• Private equity investors might participate directly or indirectly through private equity funds. Private equity funds make investments in both new and established businesses. Note that these firms may not be listed on a public exchange. Alternatively, private equity funds may invest in public companies with the intent to privatize them.
• Private debt is primarily provided to private entities. Examples of private debt include direct lending, mezzanine loans, venture debt, and distressed debt.

2. Real Assets

• Real estate investments are made in buildings or land, either directly or indirectly.  Such investments consist of private commercial real estate debt and private commercial real estate equity, such as the ownership of an office building, public real estate equity, and public real estate debt.
• Infrastructure assets are long-lived, capital-intensive real estate resources such as airports and power plants. An increasingly popular method of investing in infrastructure is the public-private partnership (PPP) strategy, in which case both public authorities and private investors have an interest.

• Natural resources include commodities, agricultural land (or farmland), and timberland.

• • Commodities: These investments may be made in physical commodity products, such as grains, metals, and crude oil.
  • Farmland/agricultural land: Agriculture involves the rearing of animals or plants. Investing in agricultural property, therefore, encompasses a variety of methods, such as leasing farmland or receiving income from the sale of agricultural produce such as corn, milk, or meat.
  • Timberland: Investing in timberland often entails putting money into managed or natural tree plantations to reap a profit when the trees are harvested.

3. Hedge Funds

Hedge funds employ numerous strategies to offer investors optimal returns. These private funds are actively managed—often by “star investors”—and apply aggressive strategies across asset classes.  Most hedge funds use derivatives, high leverage, arbitrage, and other investment strategies unavailable to traditional fund managers. Redemptions are typically restricted in some way such as lockup periods, notice periods, and redemption fees.

4. Other

Other alternative investments 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, offer investors new ways to invest their money outside traditional financial markets.

There are indices used to track the values of certain collectible markets, such as stamps, and these collectibles are auctioned in small markets. It is worth noting that some auctions are open to the public while others are not.

Question

Which of the following is most likely an example of private equity investment?

A. Investing in a mutual fund.

B. Investing in a publicly traded company.

C. Investing in a new or established business not listed on a public exchange.

 Solution

 The correct answer is C.

Private equity investments involve investing in companies that are not publicly traded and are usually acquired by private equity firms or funds. The aim of these investments is to provide capital to help the company grow and improve and eventually sell the company for a profit.

A is incorrect. Investing in a mutual fund (A) is typically a traditional investment strategy where investors pool their money to invest in a diversified portfolio of stocks, bonds, or other assets.

B is incorrect. Investing in a publicly traded company is also typically a traditional investment strategy, where investors buy shares in a publicly traded company on a stock exchange.