Alternative Investments

Alternative investments comprise various types of investments that do not fall under the heading of traditional investments, which refers to long-only investments in cash or publicly traded stocks and bonds.

Managers of alternative investment portfolios may use derivatives and leverage and short securities. Structures that employ such strategies but utilize publicly traded stocks and bonds are also termed alternative investments. Many types of real estate investment are considered alternatives to traditional investment as well.

Types of alternative investment structures include hedge funds, private equity funds, and various types of real estate investments. Alternative investments typically are actively managed and may include investments in commodities, infrastructure, and illiquid securities.

Fee structures for alternative investments are different from those of traditional investments, with higher management fees on average and often with additional incentive fees based on performance.

Compared with traditional investments, alternative investments typically exhibit several of the following characteristics:

• Less liquidity of assets held.
• More specialization by investment managers.
• Less regulation and transparency.
• More problematic and less available historical return and volatility data.
• Different legal issues and tax treatments.
• Relatively low correlations with returns of traditional investments.
• Relatively higher management fees and incentive fees based on performance.
• Restrictions on redemptions.
• Relatively more concentrated portfolios.

The perceived benefits of including alternative investments in portfolios are risk reduction from diversification (due to low correlations of alternative investments with traditional investments) and possible higher returns from holding illiquid securities and from markets for some  alternative investments possibly being less efficient than those for traditional investments. Although correlations of returns on alternative investments with returns on traditional investments may be low on average, these correlations may increase significantly during periods of economic stress.

We will examine several categories of alternative investments in detail in our reading on Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds. Here we introduce those categories:

1. Hedge funds: These funds may use leverage, hold long and short positions, use derivatives, and invest in illiquid assets. Managers of hedge funds use a great many different strategies in attempting to generate investment gains. They do not necessarily hedge risk as the name might imply.
2. Private equity: As the name suggests, private equity funds invest in the equity of companies that are not publicly traded, or in the equity of publicly traded firms that the funds intend to take private. Leveraged buyout (LBO) funds use borrowed money to purchase equity in established companies and comprise the majority of private equity investment funds. Venture capital funds invest in young, unproven companies at various early stages in their lives.
3. Private debt: Funds may make loans directly to companies, lend to early stage (venture) firms, or invest in the debt of firms that are financially distressed (struggling to make their debt payments or have entered into bankruptcy).
4. Real estate: Real estate investments include residential or commercial properties, as well as real estate–backed debt. These investments are held in a variety of structures, including full or leveraged ownership of individual properties, individual real estate–backed loans, private and publicly traded securities backed by pools of properties or mortgages, and limited partnerships.
5. Commodities: To gain exposure to changes in commodity prices, investors can own physical commodities, commodity derivatives, or the equity of commodity-producing firms. Some funds seek exposure to the returns on various commodity indices, often by holding derivatives contracts (futures) that are expected to track a specific commodity index.
6. Farmland: Agricultural land can produce income from leasing it out for farming or from raising crops or livestock for harvest and sale.
7. Timberland:Forested land is purchased or trees are planted for harvesting, which provides cash flows.
8. Infrastructure: Infrastructure refers to long-lived assets that provide public services. These include economic infrastructure assets, such as roads, airports, and utility grids, and social infrastructure assets, such as schools and hospitals. While often financed and constructed by governmental entities, infrastructure investments have more recently been undertaken by public–private partnerships, with each holding a significant stake in the infrastructure assets constructed. Various deal structures are employed, and the asset may revert to public ownership at some future date.