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What are Alternative Investments?
Types of Investments (Figure 1)
Two Categories: Hedge Funds & Private Markets
Hedge Funds vs. Private Market Alternatives (Figure 2)
Alternative Investments v Traditional Investments
Key Differences Between Alts and Traditional Investments (Figure3)
The Benefits of Alternative Investments
- Income Generation (Asset Class Yields)
- Portfolio Diversification (Efficient Frontier)
Download: Product Comparison Grid
Alternative Investments is an umbrella term that refers to any investments that are not traditional investments such as stocks, bonds, and cash and cash equivalents.
Historically, alternative investments were only used by large institutions and endowments. However, they have become more mainstream in recent years because not only are they more popular among individual investors, but there are also more products available, making investing in alternatives possible for a much broader universe of investors. Other key drivers of the explosive growth of alternative investments are regulatory changes and technological innovation.
Figure 1 below shows the different types of traditional and alternative investments and who typically utilizes them. As you can see the alternative investments are intended for a very specific type of client, hence their limited availability.
Alternative Investments (Alts) can be divided into two main categories:
Hedge funds are typically structured as a limited partnership (LP) or a limited liability company (LLC). They are pooled investment vehicles with a limited number of qualified investors. Hedge funds are publically listed and traded on the open market.
Hedge fund managers typically use complex trading, portfolio construction, and risk management techniques to improve performance. These trading techniques can include leverage, short-selling, arbitrage, hedging, derivatives, and other speculative investment practices that make these investments risky. There are a wide variety of investment strategies deployed by hedge fund managers including: long/short equity, global macro, relative value, managed futures, and distressed. Hedge funds may appear similar to mutual funds, but they are not necessarily subject to the same regulatory requirements as mutual funds.
Unlike mutual funds, hedge funds can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, and often charge high fees that can impact performance. Additionally, they may involve complex tax structures and delays in distributing tax information.
Private Market Investments, unlike Hedge Funds, are closed-end investments that are not publicly listed or traded. They are legally structured as Partnerships where each investor is a Limited Partner (LP) and a professional manager acts as the General Partner (GP). The LP raises capital from investors to make investments in private companies. The investors are accredited investors or institutions that have ownership or interest in an entity that is not publicly listed or traded.
Closed-end Funds (CEFs)
CEFs are investment companies that pool the assets of shareholders to invest in a wide range of securities. Because capital does not flow freely into and out of CEFs, they are referred to as "closed-end" funds. CEFs are traded similarly to ETFs. However, the difference is that a CEF has a fixed set of outstanding shares available to be traded. This causes a much more drastic difference between the price and net asset value of a closed-end fund called “discount or premium to NAV”. The premium/discount data gives insight into the supply and demand of the security, and affect the performance of the fund as well.
Two main types of CEFs: publicly traded and unlisted (both are regulated under the Investment Company Act of 1940).
Illiquidity
Private equity investments are highly illiquid with very limited ability to withdraw investments. Private equity funds usually do not have any redemption rights and are organized to have a limited life cycle, usually in the range of 7 to 15 years. The illustration below shows the various investments on the liquidity spectrum.
Getting back to Hedge Funds and Private Market investments, Figure 2 shows a general comparison between these two categories of alternative investments.
There are many key differences between Alternative Investments and Traditional Investments. For example, unlike Traditional Investments, Alternative Investments are sold by private placement (using a Private Placement Memorandum or 'PPM') to accredited investors. Their upfront minimum initial required to invest in an alternative investment strategy is usually large and typically illiquid.
Alternative investments utilize a different approach to investing than traditional equity or fixed-income investments. This approach may involve holding both long and short positions in securities and holding private securities instead of publicly traded investments, and there may be derivatives or hedging strategies as well. Investors using alternatives may also have a goal of achieving a particular level of absolute return as opposed to relative performance versus an index.
Table 1 below summarizes other key differences between alternative investments and traditional investments.
Alternative investments cover a wide spectrum, with various approaches offering different portfolio benefits (and presenting varying tradeoffs such as liquidity and fees).
Three primary roles that alternatives may play in portfolios are:
1. Income Generation top
Alternatives can potentially offer higher yields compared to public equity and fixed-income markets. The chart below, Asset Class Yields, depicts yields across various investment classes and illustrates alternatives as a higher-yielding asset class. Performance of Alternative Investments
2. Portfolio Diversification topst
Adding Alternatives to a portfolio may reduce volatility and potentially increase returns. While alternative investments on their own may have higher volatility than more traditional investments, particularly fixed income, they typically have low correlations to or do not move in lockstep with, more traditional asset classes. The chart below shows how adding 20% to portfolios along the efficient frontier tends to result in lower overall volatility and higher returns.
(Source: Bloomberg, Morgan Stanley Wealth Management GIC, Private Equity Index data: The Cambridge Associates)
3. Access to a broader opportunity set of long-term growth potential topv
Because they have a wider universe in which to invest (public and private) and do not have some of the same investment constraints (can short and hedge), alternative investments have the potential for higher long-term performance than traditional investments.
Higher fees. Alternative investments can have higher fees. For example, fees can include an annual management fee (1–2%) and an additional incentive fee (10–20%). Fund of funds may also charge yet another management fee. While higher than traditional investments, these fees may or may not be justified when comparing returns net of fees.
More complicated. Alternative managers may invest in a wide variety of investments, including derivatives, and utilize short selling. Understanding complicated investment strategies requires more upfront and ongoing due diligence.
Less transparent. There can be limited transparency into the underlying holdings of these investments. Additionally, many manager evaluation tools are not as well suited for alternative investments, making a manager’s investment ability more difficult to assess. Also, some alternative investments are largely unregulated.
Less liquid. Limited partnerships may hold illiquid investments and as such restrict an investor’s ability to redeem money. For example, managed futures only offer monthly liquidity; many funds of hedge funds do not allow redemptions in the first year and only annual or quarterly thereafter; and private equity may not allow redemptions for seven or more years. The underlying investments used in an alternative investment strategy may also be exposed to a significant lack of liquidity in stressful trading environments.
Less tax-friendly. Most alternative investment strategies have little to no focus on minimizing taxes. Also, those whose legal structure is a partnership issue a K-1 statement rather than a 1099.
May disappoint in strong up markets. Investments that seek to generate an absolute return often use short selling strategies, and as such tend to lag long-only strategies in strong up markets, which may discourage some investors.
May not diversify risk in extreme down markets. In periods of dislocation, the correlations of many types of investments, including alternatives, may increase significantly, as was the case in the extreme down market of 2008.
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