Features and Categories of Alternative Investments

AnalystPrep Summary

Alternative investments are assets that fall outside traditional publicly traded stocks, bonds, and cash. Common categories include private capital, real assets, and hedge funds.

Alternative investments often differ from traditional investments because they may be less liquid, harder to value, more complex, and more dependent on specialized investment expertise. They may also offer diversification benefits because their returns can have lower correlations with traditional asset classes.

For CFA Level I candidates, the key is to understand the main categories of alternative investments, their defining features, their role in portfolios, and the risks they introduce.

Traditional vs Alternative Investments

Feature	Traditional Investments	Alternative Investments
Examples	Stocks, bonds, cash	Private equity, hedge funds, real estate
Liquidity	Often high	Often low
Valuation	Market prices	Often appraisal-based or model-based
Correlation	Often higher with public markets	Often lower
Investment Horizon	Short to medium	Medium to long
Complexity	Moderate	Higher
Transparency	Usually higher	Often lower
Typical Access	Public markets	Private funds or specialized vehicles

Key Takeaways

• Alternative investments extend beyond traditional stocks, bonds, and cash.
• Major categories include private capital, real assets, and hedge funds.
• Alternative investments may provide diversification benefits.
• Many alternatives are relatively illiquid.
• Specialized valuation methods are often required.
• Alternative investments may involve limited pricing transparency.
• Returns often depend on active management and unique investment strategies.
• Higher fees and longer investment horizons are common challenges.

Alternative investments represent a category of investments that do not fit into the traditional asset classes of public equity securities, fixed-income instruments, or cash. The term ‘alternative’ is used to describe these investments due to their unique characteristics and structure.

Understanding Alternative Investments

Alternative investments are investment assets that fall outside traditional publicly traded stocks, bonds, and cash. They include private capital, hedge funds, real assets, infrastructure, commodities, and natural resources.

Investors often use alternative investments to diversify portfolios, improve long-term return potential, gain exposure to private markets, and access assets with different risk-return characteristics. However, alternatives may also involve illiquidity, complex valuation, limited transparency, higher fees, and specialized due diligence.

This study note explains:

• The defining features of alternative investments
• Major alternative investment categories
• Private capital and hedge funds
• Real assets and infrastructure
• Portfolio diversification benefits
• Common risks and challenges
• CFA Level I applications

Why Do Investors Invest in Alternative Investments?

Investors use alternative investments for several reasons. The most common reason is diversification. Because many alternative investments behave differently from traditional stocks and bonds, they may reduce overall portfolio correlation.

Some alternatives may also provide inflation protection. Real estate, infrastructure, commodities, and natural resources may respond differently to inflation than traditional financial assets.

Other investors use alternatives to seek enhanced return potential, access private markets, generate income, or pursue strategies that are not available through traditional long-only stock and bond portfolios.

Alternative investments are especially common in institutional portfolios, such as pension funds, endowments, foundations, and sovereign wealth funds.

Alternative Investment Features

Unlike traditional public debt and equity securities, alternative investments possess unique features that set them apart. These features include:

• The requirement for specialized knowledge to value cash flows and risks: For instance, investing in a private equity fund requires an understanding of the specific industry, the company’s financials, strategies such as short selling and leverage, and the overall market conditions.
• Typically low correlation of returns with more traditional asset classes: For example, real estate investments may not follow the same market trends as stocks and bonds, providing a diversification benefit.
• Illiquidity, long investment time horizons, and large capital outlay: For instance, investing in a start-up company may require a significant initial investment and a long-term commitment, as the company may not go public or be sold for several years.

Common Features of Alternative Investments

Alternative investments often have features that distinguish them from traditional investments.

Many alternatives are less liquid because they do not trade frequently in public markets. Investors may need to commit capital for several years before exiting the investment.

Alternative investments also often require specialized knowledge. Evaluating a private equity fund, hedge fund, real estate project, or infrastructure asset may require different skills from analyzing publicly traded stocks or bonds.

Valuation can be more complex because prices may not be available from active public markets. Some alternatives rely on appraisals, models, manager estimates, or infrequent transaction prices.

Due diligence is also more important because alternative investments may have limited transparency, complex fee structures, leverage, lockup periods and strategy-specific risks.

Alternative Investment Characteristics

The unique features of alternative investments lead to certain characteristics:

• Different investment structures due to direct investment challenges: For example, a hedge fund might use a limited partnership structure, where the fund manager is the general partner and the investors are the limited partners.
• Incentive-based fees to address or minimize information asymmetry between managers and investors: For instance, a private equity fund manager might receive a performance fee based on the fund’s profits, aligning the manager’s interests with those of the investors.
• Performance appraisal challenges: Due to the unique nature and complexity of alternative investments, evaluating their performance can be challenging. For example, how do you accurately measure the performance of a private equity investment in a company that is not publicly traded?

Alternative investments often exhibit characteristics of both equity and debt. However, they typically demand a larger or longer financial commitment due to the extended life cycle of the underlying investments or the use of different methods and vehicles to align the interests of managers and investors over time.

Contrary to individual securities, the scale and type of some alternative investments may be unattainable to some investors. Large pension funds, sovereign wealth funds, and not-for-profit endowments, which have the longest investment time horizons, have a tendency to devote a higher portion of their portfolio to these assets.

Alternative Investment Categories

Major Categories of Alternative Investments

Alternative investments can be grouped into several major categories.

Private capital includes private equity, venture capital, growth equity, buyouts, and private debt. Investors use private capital to access companies or debt markets that are not publicly traded.

Real assets include real estate, infrastructure, natural resources, and commodities. These assets may provide income, inflation protection, and exposure to tangible assets.

Hedge funds use flexible investment strategies such as long/short equity, global macro, event-driven investing, relative value, and arbitrage. Hedge funds often seek absolute returns and may use leverage, derivatives, and short selling.

These categories differ in liquidity, risk, valuation methods, return drivers, and typical investor base.

Private Capital

Private Capital is a broad term that refers to the funding provided to companies from sources other than public equity or public debt markets. It is categorized into two main types: private equity and private debt. For instance, a tech startup might raise private capital from venture capitalists or angel investors rather than going public or taking on traditional debt.

Private Equity

Private Equity is the capital provided in the form of equity investments. It is used for investment in privately owned companies or in public companies with the intent to make them private. Private equity is typically used in the mature life cycle stage or for firms in decline. The key approach used in private equity is leveraged buyouts.

Consider a scenario where a private equity firm acquires a struggling retail chain with the aim of enhancing its operations and profitability before divesting it. Private equity managers often enact changes in management and strategy, which may involve shutting down, selling, or restructuring business lines. This strategic approach aims to enhance profitability over several years, leveraging the increased control and flexibility afforded by private ownership compared to public ownership.

Venture Capital is a specialized form of private equity where ownership capital is used for non-public companies in the early life cycle or startup phase. Often, an idea or business plan exists with a limited operation or customer base in this phase. For example, a biotech company with a promising new drug might receive venture capital to fund its clinical trials and other development efforts.

Private Debt

Private Debt is the capital provided as a loan or other form of debt. It includes private loans or bonds, venture debt, and distressed debt. Venture debt is extended to early-stage firms with little or no cash flow. Distressed debt involves public or private debt of corporate issuers believed to be close to or in bankruptcy that could benefit from investors with capital restructuring skills. For instance, a hedge fund might buy the distressed debt of a bankrupt airline, hoping to profit from its restructuring or liquidation.

Major Categories of Alternative Investments

Category	Typical Investments	Primary Objective
Private Capital	Private equity, venture capital, private debt	Capital appreciation
Real Assets	Real estate, infrastructure, natural resources	Income and inflation protection
Hedge Funds	Long/short, global macro, event-driven strategies	Alpha generation

Comparing Private Equity and Debt with Public Equity and Debt

Private equity and private debt are alternative investments with features similar to public equity and public debt. For example, both private and public equity investors are company owners with residual claims to future cash flows and dividends.

Investors in private equity have full access to company information and the ability to influence day-to-day management and strategy decisions. On the other hand, investors in publicly traded equity receive only publicly available information, such as annual reports and periodic financial statements, with voting rights limited to decisions requiring shareholder approval.

Real Assets

Real assets encompass a broad range of assets, which can include tangible items like real estate and natural resources, as well as intangible holdings like patents, intellectual property, and goodwill. These assets have the potential to either generate immediate or anticipated future cash flows, or they may serve as a reservoir of value. For instance, a piece of land (real estate) can generate cash flow through rent, or its value can appreciate over time, providing a return on investment.

Real Estate

Real estate encompasses both borrowed and owned capital invested in structures or land, and it can be categorized into developed and undeveloped land.

Commercial real estate comprises properties where the primary source of revenue is derived from private business activities, like a shopping mall where rental income from stores constitutes the primary cash flow.

On the other hand, the cash flows in residential real estate are generated through rents or mortgage payments made by households. For example, in the case of an apartment building, the primary cash flow source is the rent collected from tenants.

Publicly traded forms of real estate investments encompass entities like real estate investment trusts (REITs), which issue equity securities and mortgage-backed debt securities.

Infrastructure

Infrastructure represents a unique category of real assets, often comprising land, buildings, and other durable fixed assets designed for public benefit, offering crucial services. Infrastructure projects may be initiated either solely by governmental entities or through a public-private partnership (PPP) involving private investors.

Infrastructure assets produce revenue either directly through fees, leases, or compensation for access rights or indirectly by stimulating economic growth and boosting a government’s ability to generate higher tax revenue from future economic activities. Take, for instance, a toll road developed through a Public-Private Partnership (PPP), which can generate direct cash flows through the collection of toll fees.

Natural Resources

Natural resources encompass underdeveloped land, which inherently holds economic value, or naturally occurring goods that can be extracted. Underdeveloped land categories consist of farmland, timberland, or land designated for the exploration of natural resource deposits like minerals or energy sources.

Farmland can yield revenue through the sale of crops, while land containing a gold mine can generate income by extracting and selling gold. The potential returns from such underdeveloped land types include anticipated price appreciation over time and generated cash flows.

Commodities are standardized, traded goods, including plant, animal, energy, and mineral products used in goods and services production. Commodities do not themselves generate cash flows but, rather, are ultimately sold by commodity producers to commodity consumers for economic use.

For example, a farmer who grows wheat (a commodity) does not generate cash flow from the wheat itself but from selling the wheat to a bread manufacturer. Investors seek to benefit from commodity price changes based on their future economic use as well as a lower correlation of returns versus other asset classes over the economic cycle.

Other Real Alternative Assets

Among the various alternative assets, there are other tangible collectible items like fine art, wine, rare coins, watches, and similar unique holdings. Additionally, there are intangible assets like patents, litigation claims, and what is commonly referred to as ‘digital assets.’ This term, ‘digital assets,’ encompasses a wide range of assets that can be electronically created, stored, and transmitted and possess associated ownership or usage rights.

For example, a patent for a new technology is an intangible asset that can generate cash flows through licensing fees, while a rare coin can appreciate in value over time, providing a return on investment.

Hedge Funds

Hedge funds are a unique type of private investment vehicle. They have the flexibility to invest in a wide array of assets, including but not limited to public equities, publicly traded fixed-income assets, private capital, and real assets. For instance, a hedge fund might invest in shares of a publicly traded company like Apple Inc. or in private equity of a startup company. However, the distinguishing factor of hedge funds is not merely the investments they make but the unique approach they adopt towards investing.

Hedge funds often employ a diverse range of investment strategies, including:

• Use of Leverage: Involves using borrowed money to increase potential returns. For example, a hedge fund might borrow money to invest in a risky venture, with the hope that the returns from the venture will exceed the cost of borrowing.
• Derivatives: Financial contracts whose value is derived from an underlying asset. For instance, a futures contract on gold is a derivative, as its value is derived from the price of gold.
• Short selling: This involves selling assets that are not currently owned with the intention of buying them back at a lower price. For example, a hedge fund might short-sell shares of a company if it believes that the company’s share price is overpriced and is going to fall.

These strategies often result in a risk and return profile that is substantially different from that of simply buying and holding the underlying assets in an investment portfolio.

Investors also have the option to invest in a portfolio of hedge funds. This is often referred to as a fund of funds. For instance, an investor might choose to invest in a fund of funds that includes hedge funds focusing on technology companies, emerging markets, and real estate, thereby diversifying their investment.

How Do Hedge Funds Differ from Traditional Funds?

Hedge funds differ from traditional funds because they often have more flexible investment mandates. They may use leverage, derivatives, short selling, concentrated positions, and active risk management to pursue returns.

Many hedge funds seek absolute returns rather than simply outperforming a benchmark. This means the manager may try to generate positive returns across different market environments.

Hedge funds may also charge performance fees in addition to management fees. These fee structures can align manager incentives with investor returns, but they also increase total investment costs.

For CFA candidates, the key is to understand that hedge funds are not one single strategy. They include many approaches, such as long/short equity, global macro, event-driven, relative value, and arbitrage strategies.

Advantages and Challenges of Alternative Investments

Advantages	Challenges
Diversification	Illiquidity
Lower correlation potential	Complex valuation
Higher return potential	Limited transparency
Inflation protection	Higher fees
Access to private markets	Longer holding periods
Active strategy exposure	Greater due diligence requirements

How Do Alternative Investments Fit into a Portfolio?

Alternative investments can play several roles in a portfolio. They may improve diversification, provide exposure to different return drivers, reduce reliance on public markets, and help investors pursue long-term return objectives.

Institutional investors such as pension funds, endowments, foundations, and sovereign wealth funds often use alternatives as part of long-term asset allocation. Wealth managers may also use alternatives for qualified investors seeking diversification beyond traditional stocks and bonds.

However, alternatives should be evaluated carefully. Investors must consider liquidity needs, fees, valuation uncertainty, leverage, transparency, risk tolerance, and investment horizon.

For CFA candidates, the important point is that alternative investments can enhance diversification but may also introduce complexity and additional risks.

Example: Building a Diversified Portfolio

Suppose an investor primarily owns publicly traded stocks and bonds. The portfolio has strong market exposure but may be highly sensitive to equity market declines and interest rate changes.

The investor may allocate a portion of the portfolio to private equity, real estate, and hedge funds.

Private equity may provide long-term capital appreciation. Real estate may provide income and inflation protection. Hedge funds may provide exposure to active strategies with different return drivers.

Although these investments may be less liquid and more complex, they can reduce overall portfolio correlation and improve long-term diversification when used appropriately.

Question #1

Which of the following factors is least likely a consideration when incorporating alternative investments into a portfolio?

1. The liquidity and market efficiency of the investments.
2. The current market trends and popular investment choices.
3. The potential for greater diversification and higher expected returns.

The correct answer is B.

When adding alternative investments to a portfolio, it’s crucial not to rely solely on current market trends and popular choices. While these trends offer insights, decisions should be based on a profound understanding of specific asset classes like private equity, hedge funds, real estate, and commodities. Consideration should extend to their risk and return profiles and how they integrate into the broader portfolio, rather than being driven solely by the prevailing market trends or popular choices.

The decision to incorporate alternative investments into a portfolio should be based on a thorough analysis of the investor’s risk tolerance, investment objectives, time horizon, and other personal circumstances. Following market trends or popular investment choices without a proper understanding of the underlying asset class can lead to poor investment decisions and potential losses.

C is incorrect. The potential for greater diversification and higher expected returns is indeed a consideration when incorporating alternative investments into a portfolio. Alternative investments can provide diversification benefits due to their low correlation with traditional asset classes, and they can potentially offer higher returns, albeit at a higher level of risk.

A is incorrect. The liquidity and market efficiency of the investments are also important considerations when incorporating alternative investments into a portfolio. Many alternative investments are illiquid and inefficiently priced, which can create opportunities for skilled investors but also pose significant risks.

Question #2

In the context of hedge funds, how would you most likely define the concept of leverage, and how does it impact the potential returns of the fund?

1. Leverage is the process of investing only in high-risk assets to maximize potential returns.
2. Leverage is the process of investing in a diversified portfolio to spread the risk and potentially increase returns.
3. Leverage is the process of buying more assets than the fund’s capital would allow, thus increasing the potential returns but also the risk of loss.

The correct answer is C.

Leverage, in the context of hedge funds, is indeed the process of buying more assets than the fund’s capital would allow, thus increasing the potential returns but also the risk of loss. Hedge funds use leverage to amplify their potential returns by borrowing money to invest in more assets. This strategy can significantly increase the potential returns of the fund if the investments perform well. However, it also increases the risk of loss if the investments perform poorly.

The use of leverage can magnify both gains and losses, making it a double-edged sword. It is a key characteristic of hedge funds and a major reason why they can deliver high returns. However, it also makes them riskier than traditional investment vehicles. Therefore, investors in hedge funds need to be aware of the risks associated with leverage and be prepared for the possibility of significant losses.

A is incorrect. Investing only in high-risk assets to maximize potential returns is not the definition of leverage. While it is true that leverage can increase the potential returns of a fund, it does not involve investing only in high-risk assets. Leverage involves borrowing money to invest in more assets, regardless of their risk level. It is a strategy that can be used in conjunction with a variety of investment strategies, including investing in both high-risk and low-risk assets.

B is incorrect. While investing in a diversified portfolio is a common strategy used by many investment vehicles, including hedge funds, to spread the risk and potentially increase returns, it is not what is meant by leverage. Diversification and leverage are two different investment strategies. Diversification involves spreading investments across a variety of assets to reduce risk, while leverage involves borrowing money to invest in more assets to increase potential returns.

Glossary

Alternative Investment — An investment outside traditional publicly traded stocks, bonds, and cash.

Private Capital — Investments in private companies or private debt markets.

Private Equity — Equity investment in companies that are not publicly traded.

Venture Capital — Private equity investment in early-stage or high-growth companies.

Private Debt — Debt financing provided outside public bond markets.

Hedge Fund — A pooled investment vehicle that uses flexible strategies to seek returns.

Real Asset — A tangible asset such as real estate, infrastructure, natural resources, or commodities.

Infrastructure — Long-lived physical assets such as roads, utilities, airports, and energy systems.

Natural Resources — Assets linked to resources such as timber, farmland, energy, or minerals.

Commodity — A physical good such as oil, gold, wheat, or copper.

Leverage — The use of borrowed money or derivatives to increase investment exposure.

Illiquidity — The difficulty of selling an investment quickly without a significant price discount.

Diversification — The process of spreading investments across assets with different risk and return drivers.

Alpha — Return generated beyond what would be expected from market exposure alone.

Frequently Asked Questions

What are alternative investments?

Alternative investments are assets that fall outside traditional publicly traded stocks, bonds, and cash.

What are the main categories of alternative investments?

The main categories include private capital, real assets, and hedge funds.

Why do investors use alternative investments?

Investors use alternative investments for diversification, long-term return potential, inflation protection, income generation, and access to private markets.

What are real assets?

Real assets are tangible assets such as real estate, infrastructure, natural resources, and commodities.

What is private equity?

Private equity is investment in companies that are not publicly traded.

What is venture capital?

Venture capital is private equity investment in early-stage or high-growth companies.

What is private debt?

Private debt is debt financing provided outside public bond markets.

How do hedge funds differ from mutual funds?

Hedge funds usually have more flexible strategies and may use leverage, derivatives, short selling, and performance fees. Mutual funds are generally more regulated and more liquid.

Why are alternative investments less liquid?

Many alternative investments do not trade frequently in public markets and may require long holding periods or lockups.

How do alternative investments improve diversification?

Alternative investments may have return drivers that differ from traditional stocks and bonds, which can reduce overall portfolio correlation.

Alternative Investments at a Glance

Concept	Summary
Private Capital	Investments in privately owned businesses or private debt
Real Assets	Tangible assets such as real estate and infrastructure
Hedge Funds	Flexible investment vehicles using active strategies
Key Benefit	Portfolio diversification
Main Challenge	Illiquidity and valuation complexity
Common Investor Base	Institutions and qualified investors