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CHAPTER ONE
OVERVIEW OF ALTERNATIVE INVESTMENTS
Alternative investment is sometimes viewed as including any investment that is not simply a long position in traditional investment. Typically traditional investments include;
- Equity
- Fixed income
- Cash
Classes of Alternative investments include;
- Private equity – Includes both equity and debt positions that among other things are not publicly traded. In most cases the debt positions contain so much risk in cash flow uncertainty that their short-term return behavior is similar to that of equity position.
- Venture capital – refers to support via equity finance to start-up companies that do not have sufficient size, track record or desire to attract capital from traditional sources such as public markets or lending institutions.
- Leverage buy-outs – Refers to those transactions which the equity of a publicly traded company is purchased using a small amount of investor capital and a large amount of borrowed funds in order to take the firm private. The borrowed funds are secured by the assets or cash flows of the target.
- Mezzanine debt –Derives its name from its position in the capital structure of a firm between the ceiling of senior structure debt and the floor of equity. Refers to a spectrum of claims including preference shares, convertible debt and debt that includes equity kickers that allow the investors to benefits from any upside success in the underlying business also called hybrid securities.
- Hedge funds – They are privately organized investment vehicles that uses its less regulated nature to generate investment opportunities that are substantially distinct from opportunities offered by traditional investment vehicles which are subject to regulations such as those restricting the use of leverage and derivatives.
- Real assets –Involves direct ownership of non-financial assets rather than ownership through financial assets such as securities.
- Structured Products-Are instruments created to exhibit particular return, risk, taxation or other attributes. These instruments generate cash flows from a partitioning of the cash flows from a traditional investment or linking the return of the investment product to one or more market values.
- Commodities e.g. precious metals
STRUCTURES AMONG ALTERNATIVE INVESTMENTS
Structures are descriptive and definitional components of alternative investment, they are crucial to analysis of asset classes that create the alternative investment.
Structures denote a related set of important aspects that identify investments and distinguish them from other investments. There are 5 types of structures;
- Regulatory structures
Refers to the role of government including both regulation and taxation in influencing the nature of investment. E.g. Hedge funds (HF) are loosely regulated and typically must be formed in particular ways to avoid high levels of regulations.
Taxation can motivate the existence of some investment products and plays an important role in the transformation of the underlying cash flows into the investment products.
- Securities structures
Refers to structuring of cash flows through securitization. Securitization is the process of transforming asset ownership into tradable units. Cash flows may be securitized simply on a pass-through basis (pro-rata). Cash flows can also be structured through partitioning into financial claims with different levels of risk or other characteristics or timing of cash flows.
- Trading structures
Refers to the role of investment vehicles, investment managers in developing and implementing trading strategies. A buy and hold management strategy will have a minor influence on underlying investment returns while aggressive, complex, fast-paced trading strategy can cause the ultimate cash flows for a fund to differ from the cash flows of the underlying assets.
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- Compensation structures
Refers to the ways that organizational issues especially compensation schemes influence particular investments thus in the case of hedge fund organizational structure would include the financial arrangements contained in the partnership formed by the investors and the entry used by the fund managers such as arrangements usually determine the exposure of the fund’s investment managers to the financial risk of the investment, determine the fee structure used to compensate and reward managers and determine conflict of interest between parties.
- Institutional structures
Refers to the financial markets and financial institutions related to a particular investment such as whether the investment is publicly traded. Public trading of a security is an essential driver of an investment nature.
STRUCTURES AND THE 5 ALTERNATIVE INVESTMENT TYPES
It would be difficult to find a major investment that is not shaped or influenced in at least some small way by each of the 5 listed structures.
However, many investments tend to be heavily influenced by only a subset of these structures.
- Real Assets
It is a category dominated by real estate. Most real estates have an institutional structure of being privately held and traded REITS. The use of securities in the structuring of cash flows and securitization has also been important in driving the nature of real estate investments.
- Hedge funds
Are primarily traded by the trading structure; the use of active, complex and proprietary trading strategies. Are also distinguished by regulatory structures (use of offshores structures due to tax regulations) and compensation structures including the use of heavily influenced other structures.
- Commodities
Are primarily driven by their securities structure since they are usually traded using future contracts but tend not to be heavily influenced by other structures.
- Private equity
Is clearly distinguished by the institutional structure that it is not publicly traded. Compensation on securities and trading structures also play non-trial roles in changing the nature of private equity.
- Structured products
Are clearly distinguished by securities structure. However, structured products are typically moderately influenced by institutional, regulatory and compensation structures.
Distinction Between Alternative Investment (AI) And Traditional Investment (TI) Based On:
- Return characteristics
Investment characteristics exhibit returns that are substantially from return of traditional stock and bonds might be viewed as being AI.
- Diversification
An investment opportunity with returns that are uncorrelated with/only or slightly correlated with traditional investments is often viewed as an AI. An attractive aspect of this correlation is that it indicates the potential to diversify risk. In the context, AI are synonymous with diversifiers.
Investment products viewed as having little or low correlation with TI are also termed as absolute return products since their returns should generally be internalized on an absolute basis rather than returns of TI.
- Illiquidity
TI have institutional structure that they tend to be frequently traded in financial markets with substantial volume and high number of participants. Therefore, the returns tend to be based on liquid prices observed from reasonably frequent trades at reasonable levels of volume. AI are illiquid implying that the investment trades infrequently or with low volumes.
- Inefficiency
The prices of most TI are determined in markets with relatively high degree of competition and therefore with relatively high efficiency.
Inefficiency refers to the deviation of actual variations from these variations that would be anticipated in the efficient market.
- Non-normality
Returns of TI can be approximated as being normally distributed. AI exhibits non-normally in that they cannot be accurately approximated using standard bell-curve.
- Method of analysis
AI can also be distinguished from TI through the methods used to analyze measure and manage their returns and risks.
- Return computative methodologies
Return analysis of publicly traded stocks and bonds is straight forward given the transparency in regularly observable market prices, dividends and interest payments. Return to some AI especially illiquid investments can be problematic. One major issue is that in many cases a reliable value of the investment can be determined only at limited points in time unlike in AI.
- Statistical methodologies
Much of TI analysis is based on the representation of investment return distribution using only mean and standard deviation. Many AI exhibit non-normally distributed returns over medium to long-term time intervals.
- Valuation methodologies
Fundamental and technical analysis methodologies of pricing traditional investments and potentially identifying mispricing securities. Many HF managers utilize the same general and fundamental and technical methods in attempting to identify mispriced stocks and bonds. However HF managers may also utilize highly active trading strategies and strategies based on identifying relative mispricing.
- Portfolio management methodologies
Issue such as illiquidity, no normal returns introduces complexity portfolio management techniques. Requires application of techniques designed to these issues.
GOALS OF ALTERNATIVE INVESTMENTS
- Active management
Refers to the efforts of buying and selling securities to earn superior combinations of risk and returns. AI focuses on evaluating active managers and their systems of active management. Since most AI are actively managed.
Passive investing tends to focus on buying and selling of securities in an effort to match the risk and return of a target such as highly diversified index.
Active management generates active risk and return. Active risk is that risk that causes a portfolio’s return to deviate from the returns of the benchmark due to active management.
- Absolute and relative returns
An absolute return standard means that the returns are to be evaluated relative to zero or relative to the riskless rate and therefore independently of performance in the equity markets, debt markets or any other markets.
A relative return standard means that returns are to be evaluated relative to a benchmark. An investment program with a relative return is expected to move in random with a particular market but has a goal of consistently outperforming that market.
- Arbitrage, return enhancers and risk diversifiers
The concept of arbitrage is an active absolute return strategy.
Pure arbitrage is the attempt to earn risk free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets. Modern finance often derives price relationship based on the idea that the actions of arbitragers will force the price of identical asset toward being equal such that pure arbitrage opportunity do not exist or at least do not persist.
