Description of Alternative Investments

Hedge Funds

Hedge funds employ 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); and
• equity hedging (“beating the markets”).

Funds of Hedge Funds hold equity in multiple hedge funds, similar to the mutual fund of funds.

Private Equity Funds

These funds are private investment vehicles, typically managed by the general partner on behalf of the limited partners. Common strategies include leveraged buyouts, venture capital, development capital, and distressed investing.  Like hedge funds, these funds employ 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 buy-out (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.

Venture capital investors typically deploy the fund assets in many small companies.  They do so with the hope that at least one will offer substantial returns to offset the risk of loss in the others. Venture capitalists can provide financing at various stages in a firm’s growth, from startup to mezzanine financing before an IPO.  Exit strategies include IPO, recapitalization, secondary sales, and write-offs.

Real Estate

Real estate is typically owned via 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, you have 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; and
• timberland.

Direct real estate investments usually have long holding periods, high transaction fees, and diverse landlord-related responsibilities. Rents 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.

Commodities

Investors have a variety of products available for their investment dollars in the commodity space.  Direct investment isn’t that common since the carrying and storage costs of commodities are significant. However, derivatives, equity, and other indirect investments allow investors’ exposure to this asset class.

Forwards and futures are contracts to buy (or sell) a fixed amount of a commodity at a set price, location, and time.  Futures are publicly traded contracts with market oversight. Other derivatives such as options and swaps can help investors invest in the underlying commodities without actually holding the commodities. Commodities futures and options accounts often require margin calls if the values fall below a threshold determined by a broker.

Equity investments such as stock in commodity firms (i.e., mining stocks, agricultural firms) offer a chance to hedge against inflation since government inflation statistics typically include the cost of oil, food, and other commodities.

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); and
• communication (broadcasting facilities, Internet backbone), among many others.

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

Other investments

Other investments in the alternative space include collectibles and other investments that don’t fall into the other 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 new ways for an investor to invest their money outside traditional financial markets.

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

 Question

Which of the following characteristics typically mark alternative investments?

1. High leverage
2. Arbitrage
3. Short and long positions
4. Use of derivatives

1.  i, ii & iii only
2.  ii & vi only
3.  All of the above

Solution

The correct answer is C.

With some exceptions, all of these features are common to alternative investing strategies.

Reading 50 LOS 50b:

Describe hedge funds, private equity, real estate, commodities, infrastructure, and other alternative investments, including, as applicable, strategies, subcategories, potential benefits and risks, fee structures, and due diligence