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.

“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

Hig

hM

ediu

mLo

w

Risk

Ret

urn

Low Medium High

Alternative Investment Sector

Cash

Bonds

Equities

Property

Project Equity

Venture Capital

Specialist Property

General Private Equity

LBO’s

Mezzanine Finance

Other Vehicles

Public Sector Technology Investment

Note: Bubble size approximates the relative scale of each segment within the UK market

Hig

hM

ediu

mLo

w

Risk

Ret

urn

Low Medium High

Alternative Investment Sector

Cash

Bonds

Equities

Property

Hig

hM

ediu

mLo

w

Risk

Ret

urn

Low Medium High

Alternative Investment Sector

Cash

Bonds

Equities

Property

Project Equity

Venture Capital

Specialist Property

General Private Equity

LBO’s

Mezzanine Finance

Other Vehicles

Public Sector Technology Investment

Note: Bubble size approximates the relative scale of each segment within the UK market

Project Equity

Venture Capital

Specialist Property

General Private Equity

LBO’s

Mezzanine Finance

Other Vehicles

Public Sector Technology Investment

Note: Bubble size approximates the relative scale of each segment within the UK market

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 non-

public 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 1980’s, 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

portfolio’s 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 Manager’s Association (AIMA) survey 2001

2. Larry Thompson Report on Alternative Investments