Alternative Investments

Overview

Alternative Investments is a very broad category of investing. This applies not only to the type of asset, but also the focus and the methodologies used to generate wealth. The most widely known or recognized include Hedge Funds, Private Equity Funds, and Venture Capital Funds. Within the scope of Alternative Investments, one can include Real Estate, Art, Numismatics, Precious Metals, Bank Instruments, and nearly anything else.

In fact, the best way to describe Alternative Investments is to define what does not include. This can be summarized as an asset that is not traded on an organized exchange, an asset that is not acquired directly from an organized exchange, employs a strategy that is not simply a buy or a sell on an organized exchange, or has limited liquidity.

An Alternative Investment Fund, succinctly, is a fund that invests in alternative investment assets. These Funds can best be categorized into eight distinct types of funds: Collectables, Commodities, Hedge, Private Equity, Private Debt, Real Estate, Structured, and Venture Capital. For more information on each of the fund types, click on the name to be taken to that section on this page.

While each of the fund types are different in investment assets and objectives, they all share some similarities. Such as:


Hedge Funds

A Hedge Fund is also a catch-all phrase used to describe funds objective. The name is derived from the objective, which is to generate profitability in bull and bear markets. Often, Hedge Funds employ leverage and complex trading strategies to achieve their returns, which can be enormous. Though to, so can losses. Hedge Funds are not limited "off-exchange" transactions, frequently the Fund will use arbitrage, and other stratagems. There are four basic strategies of Hedge Funds: Global Macro, Directional, Event, and Relative-Value (Arbitrage).

Hedge Fund Strategies

Global Macro

Hedge funds using a global macro investing strategy take large positions in share, bond, or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return. Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements. While global macro strategies have a large amount of flexibility (due to their ability to use leverage to take large positions in diverse investments in multiple markets), the timing of the implementation of the strategies is important in order to generate attractive, risk-adjusted returns. Global macro is often categorized as a directional investment strategy.

Global macro strategies can be divided into discretionary and systematic approaches. Discretionary trading is carried out by investment managers who identify and select investments, whereas systematic trading is based on mathematical models and executed by software with limited human involvement beyond the programming and updating of the software. These strategies can also be divided into trend or counter-trend approaches depending on whether the fund attempts to profit from following market trend (long or short-term) or attempts to anticipate and profit from reversals in trends.

Within global macro strategies, there are further sub-strategies including "systematic diversified", in which the fund trades in diversified markets, or sector specialists such as "systematic currency", in which the fund trades in foreign exchange markets or any other sector specialization. 

Other sub-strategies include those employed by commodity trading advisors (CTAs), where the fund trades in futures (or options) in commodity markets or in swaps. This is also known as a "managed future fund". CTAs trade in commodities (such as gold) and financial instruments, including stock indices. They also take both long and short positions, allowing them to make profit in both market upswings and downswings.

Most global macro managers tend to be a CTA from a regulatory perspective and the main divide is between systematic and discretionary strategies. A classification framework for CTA/Macro Strategies can be found in the reference.

 

Directional

Schematic representation of short selling in two steps. The short seller borrows shares and immediately sells them. The short seller then expects the price to decrease when the seller can profit by purchasing the shares to return to the lender.

Directional investment strategies use market movements, trends, or inconsistencies when picking stocks across a variety of markets. Computer models can be used, or fund managers will identify and select investments. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies.

Directional hedge fund strategies include US and international long/short equity hedge funds, where long equity positions are hedged with short sales of equities or equity index options.

Within directional strategies, there are a number of sub-strategies. "Emerging markets" funds focus on emerging markets such as China and India,  whereas "sector funds" specialize in specific areas including technology, healthcare, biotechnology, pharmaceuticals, energy, and basic materials.

Funds using a "fundamental growth" strategy invest in companies with more earnings growth than the overall stock market or relevant sector, while funds using a "fundamental value" strategy invest in undervalued companies.

Funds that use quantitative and financial signal processing techniques for equity trading are described as using a "quantitative directional" strategy.

Funds using a "short bias" strategy take advantage of declining equity prices using short positions.

 

Event-Driven

Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event. An event-driven investment strategy finds investment opportunities in corporate transactional events such as consolidations, acquisitions, recapitalization, bankruptcies, and liquidations. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Large institutional investors such as hedge funds are more likely to pursue event-driven investing strategies than traditional equity investors because they have the expertise and resources to analyze corporate transnational events for investment opportunities.

Corporate transnational events generally fit into three categories: distressed securities, risk arbitrage, and special situations. Distressed securities include such events as restructurings, recapitalization, and bankruptcies. A distressed securities investment strategy involves investing in the bonds or loans of companies facing bankruptcy or severe financial distress, when these bonds or loans are being traded at a discount to their value. Hedge fund managers pursuing the distressed debt investment strategy aim to capitalize on depressed bond prices. Hedge funds purchasing distressed debt may prevent those companies from going bankrupt, as such an acquisition deters foreclosure by banks. While event-driven investing, in general, tends to thrive during a bull market, distressed investing works best during a bear market.

Risk arbitrage or merger arbitrage includes such events as mergers, acquisitions, liquidations, and hostile takeovers. Risk arbitrage typically involves buying and selling the stocks of two or more merging companies to take advantage of market discrepancies between acquisition price and stock price. The risk element arises from the possibility that the merger or acquisition will not go ahead as planned; hedge fund managers will use research and analysis to determine if the event will take place.

Special situations are events that impact the value of a company's stock, including the restructuring of a company or corporate transactions including spin-offs, share buy backs, security issuance/repurchase, asset sales, or other catalyst-oriented situations. To take advantage of special situations the hedge fund manager must identify an upcoming event that will increase or decrease the value of the company's equity and equity-related instruments.

Other event-driven strategies include credit arbitrage strategies, which focus on corporate fixed income securities; an activist strategy, where the fund takes large positions in companies and uses the ownership to participate in the management; a strategy based on predicting the final approval of new pharmaceutical drugs; and legal catalyst strategy, which specializes in companies involved in major lawsuits.

Relative Value

Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to under or over pricing of securities compared to related securities, the underlying security, or the market overall. Hedge fund managers can use various types of analysis to identify price discrepancies in securities, including mathematical, technical, or fundamental techniques. Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.

Other relative value sub-strategies include:

 

Miscellaneous

In addition to those strategies within the eight main categories, there are several strategies that do not entirely fit into these categories. Some of which include:

Collectables

While all fund types seek to make acquisitions of assets with the anticipation of selling at a later date, this category of fund requires the manager to be a true expert in not only finance, but in the specific asset class as well. An abridged list of asset types within this category include:

While diversification into this fund segment can be alluring due to the nature of the assets, there are a few additional risks above those typical to Alternative Investments: physical custody, significantly higher lack of liquidity, lack of established market, increased specialization, and higher per-asset unit acquisition costs.


Commodities

Perhaps one of the most widely recognized alternative investments. Commodities have many assets within this class, including precious metals, petroleum, food stuffs such as wheat, soy, beef, pork, and orange juice, cotton, and many others. Commodities generally are not interdependent on the movements of pubic equity markets. This class is subjected to supply and demand.

The assets can be held in many forms:


Private Equity

Private Equity takes many forms and serves many purposes. Ultimately however, this deals with non-publicly traded entities. The most familiar forms include:

In each of these forms, the fund makes an investment into the private company after thorough due diligence. While no two investment structures are the same, similarities include an equity position for the fund, an assignment of fund manager(s) / employee(s) to the private company's Board of Directors, a quarterly management fee, and various benefits to the private company.

Some of these benefits may include:


Private Debt

Private debt, succinctly, is debt provided by a non-financial institution. Often without the ridged requirement and restraints imposed by transitional lenders. Private debt is structured typically in a more advantageous method, perhaps including a scale up of repayment. Some of the uses companies have found include:

Terms can be provided on a bespoke basis, ensuring that both the Private Debt Fund and the Company (borrower) can achieve success.


Real Estate

As an asset class, Real Estate is not only the largest, globally, but also one of the most diverse. Real Estate, at the end of 2020, was valued above $326.5 Trillion globally . The professionally managed Real Estate for the same time period exceeded $10.5 Trillion globally.

The main classes of managed real estate are industrial, warehouse, multi-family, hospitality, and retail.

Funds derive income from recurring rental income and asset appreciation. Typically, Real Estate is acquired using a combination of equity and debt.

Structured Products

Structured Products can take many forms and usually are tied to some form of dividend paying instrument or derivatives thereof. They can be highly customized to meet requirements. Some forms these can take include Credit Default Swaps, Collateralized Debit Obligations, Mortgaged Backed Securities, and many others.

These forms can be highly leveraged as well through further derivatives such as options. As we saw during the housing crises in the late 2000's, these forms of interest can swing widely, with massive profits and massive losses.

Venture Capital

Perhaps the most widely recognizable type of fund, ever. Though technically, Venture Capital is a form of Private Equity, its wide-spread notoriety warrants its own section.

The importance of Venture Capital can best be summed up as:

    "Innovation and entrepreneurship are the kernels of a capitalist economy. New businesses, however, are often highly-risky and cost-            intensive ventures. As a result, external capital is often sought to spread the risk of failure. In return for taking on this risk through                 investment, investors in new companies are able to obtain equity and voting rights for cents on the potential dollar. Venture capital,                 therefore, allows startups to get off the ground and founders to fulfill their vision."

Some of the worlds most important or recognizable, successful companies that began with Venture Capital include Cisco, Google, and Facebook. It is important to realize however, that for every 10 Venture Capital investment a fund makes, the likely outcome is this: