The Other Side of the Spectrum Alternative Assets

Introduction
Outside of the financial investment community, the paraphrase alternative investments or
alternatives would have little meaning for most people. So much so that even within the
financial investment community, not everyone would be aware of this new tool in the hands of
fund managers. However, this seems predestined to change in the near future. With a
meteoric rise in the number of investment opportunities and vehicles, more and more
investors including high net worth individuals are realizing the importance of this class of
investments and its ability to diversify and reduce the risk of most portfolios. As the
information gap narrows, and the level of investor sophistication increased, we will hear about
more opportunities available. The financial investment community has already started
embracing alternatives in a major way. Over the past five years, alternative assets have been
the fastest growing asset class with an average portfolio allocation today of five to seven
percent. Generally speaking, endowments and foundations have the largest allocations with
some investing more than 20% of their portfolio in alternatives.

Public Sector
Technology
Investment

Venture
Capital

Project Equity
Specialist
Property

LBOs
Other
Vehicles

Note: Bubble size approximates the relative

scale of each segment within the UK market

Equities

Medium

Return

High

Mezzanine
Finance
Alternative
Investment
Sector

General
Private
Equity

Bonds

Low

Property
Cash

Low

Medium

High

Risk
Alternatives The whys and the wherefores
Alternative investments are those investments that are a departure from traditional
investments. A traditional investment could be defined as an investment strategy or asset
class that is mainstream and in most cases is traded on major bourses in the world. Examples

in point are domestic large-cap stocks, small-cap stocks, or bonds. A short while ago, REITs
or Real Estate Investment Trusts and International bonds and equities were considered to be
alternative asset classes. However, with globalization and the advent of the Internet, investor
sophistication has increased. Country borders are no longer barriers for investors who can
safely invest sitting in the comfort of their home. With increase in investor sophistication has
come an understanding of various early alternative asset classes such as REITs. With
increasing amount of investments in REITs and other such vehicles, they can no longer be
classified as alternative but have entered the mainstream. As new asset classes gain
acceptance with the investment community and the amount of research available increases,
more and more investors move in for making a killing. However, with the increase in the
number of investors, profits for large fund managers somewhat decline and they start
searching for other avenues. As and when new avenues are discovered, they get added to
the list of alternative investments.
A major source of attraction to alternative investments is their complex nature, making them
extremely difficult to analyze. This in turn creates market inefficiencies that can be exploited
by firms willing to put in the time and effort to perform the required research. The primary
benefit that alternative investing offers to an otherwise traditional portfolio of financial assets
is diversification. Many alternative investment strategies have extremely low correlations to
price movements in more traditional financial securities. Maintaining a portion of a portfolio in
assets whose returns are somewhat independent of the financial markets can be enticing
from a risk control standpoint, especially when financial markets become overvalued. While
the opportunity for high returns might exist within the alternative investments arena, the
primary reason to consider alternatives is for diversification and risk control.
Alternative Investment Strategies
Presented here is a brief analysis of various alternative investment
strategies that are being followed in the market as of date. This list is by no means
exhaustive, and newer avenues and strategies are discovered almost every now and then.
Hedge Fund While the literal definition of the term hedge may imply a
conservative nature about this type of investment, the reality is often quite
different. Technically speaking, a hedge fund cannot be defined as just one type
of alternative investing strategy. Rather, hedge funds are simply vehicles used to
employ many types of non-traditional investment strategies. In fact, hedge funds
can invest in just about any way and in any asset class that they wish; they are
only limited by their own creativity and the willingness of investors to hand over
their money. Hedge funds are typically structured as private partnerships and sell
limited partnership interests to qualified investors. For this reason, the liquidity of

hedge funds is often limited. Unlike mutual funds, hedge funds are largely
unregulated.
Commodities Investors can choose to purchase commodities outright. There
are a number of choices available ranging from precious minerals such as gold to
natural resources like timber or natural gas. THIS asset class could also include
livestock or crops. Aside from being relatively illiquid, investors also must have
the ability to store and/or upkeep the commodity.
Direct Real Estate This involves actual ownership of real estate; either raw land
or buildings. The investment it takes to achieve sufficient diversification through
ownership of direct real estate makes this a poor option for all but the largest
investors. It is also sometimes difficult and time consuming to sell properties if
there is a need for cash.
Private Equity This strategy usually involves a form of equity investment in nonpublic companies. Buyouts and venture capital are the two most prevalent forms
of private equity although there are a variety of strategies in this area. Buyouts
occur when investors purchase all or part of a firm with the intention of reselling it
in the future at a higher price. In the 1980s, these deals were typically structured
with little or no equity financing (debt-to-equity was typically 10 to 1) giving birth to
the term leveraged buyout or LBO. Today, the success of these deals depends
more on the ability of the management team to create value and are not nearly as
dependent on leverage (2 to 1 is a typical debt-to-equity ratio today). Venture
capital (VC), the second largest area of investing in the private equity arena, is
the process of investing in companies that are in their initial to early stages of
their life cycle but with significant growth potential. The VC firm is usually very
involved with the management team and usually provides consulting services in
addition to capital. Private equity investments are typically illiquid and require a
long-term investment horizon.
Arbitrage Strategies These types of strategies attempt to exploit temporary
mis-pricings in the financial markets. It usually involves a long position in
conjunction with a short position. The arbitrage manager hopes to make a profit
as the spread between the two assets narrows. Some of the more common
strategies include those that try to capitalize on pricing inefficiencies in
companies involved in mergers or acquisitions, discrepancies in prices between
convertible securities and the underlying stock, and closed end funds that trade
at premiums or discounts to their net asset values.

Market Neutral A strategy that attempts to eliminate the market factor from a
portfolios return by simultaneously selling a dollar amount of stock (referred to as
the short position) equivalent to the dollar amount of stock owned in the portfolio
(known as the long position). By matching portfolio characteristics such as
sector weightings, market capitalization, and style biases, the manager can
attempt to engineer a return that is uncorrelated with the market, hence the
name market neutral.
Managed Futures This strategy is somewhat similar to investing in commodities
but is done so through the futures markets. The two primary commodity indexes,
the CRB and the Goldman Sachs Commodities Index, have historically
demonstrated a low degree of correlation with both stocks and bonds. In addition,
commodities tend to perform well in inflationary environments.
Global Macro A top-down approach to investing based on shifts in economies
around the globe. These funds will make bets primarily on currencies and interest
rates using derivative investments. The portfolios tend to be very concentrated
and actively managed.
Distressed Securities These funds will buy securities, debt or equity, of firms
that are in the midst of reorganizing or going through a bankruptcy. Many times
the distressed fund manager will become actively involved in the management of
the firm in which it is investing.
Fund of Funds Fund of funds is unique in that it is not a single in vestment
strategy, but rather a means for investors to access multiple strategies in one fell
swoop. Money is allocated among a variety of alternative investment managers
with complementary styles in an effort to improve diversification. THIS strategy is
beneficial to investors with limited resources as it facilitates diversification across
styles and managers in the alternative investing field. It also adds another layer of
fees as the manager of the managers charges a fee for the research and due
diligence provided on the individual hedge funds that comprise the fund of funds.
Sources
1.

Alternative Investment Managers Association (AIMA) survey 2001

2.

Larry Thompson Report on Alternative Investments