THE ABCs of ALTERNATIVE INVESTMENTS
What is an alternative investment? There are many ways this question can be answered. Alternative investments are often described as any investment that is not a traditional investment such as a stock or a bond.
Alternative investments are usually defined as an investment that produces returns that are not highly correlated with stocks and bonds. In other words, they are investments that can add diversification when added to a portfolio of stocks and bonds. A clear example would be an investment with returns that are completely uncorrelated with stocks and bonds – often termed an absolute return product. Another feature of alternative investments is that they are more likely to be able to provide superior returns (and inferior returns) because they tend not to be actively traded in competitive markets.
Here is my favorite definition of an alternative investment: an alternative investment is any asset or investment strategy that is not well described and analyzed in most textbooks on investments. Alternative investments tend to either be assets that are esoteric or types of investment strategies that are esoteric. For example, the basics of investing in stocks, bonds, mutual funds, options and futures contracts are covered in almost every good investments textbook. But investment in private equity is rarely covered with depth in general investment textbooks. Similarly, the methods and models of investing in private equity tend to be covered only in specialized books understood by relatively few professionals. Private equity is clearly an alternative investment.
Another major category of alternative investments is real assets. Real assets includes land, farmland, timberland, natural resources commodities, infrastructure and intellectual property. Increasingly alternative assets include intellectual property – intangible assets such as patents, artistic creations and technologies. These asset types are understood by relatively few experts and are rarely discussed in traditional investment forums.
Real estate is an example of an investment that is viewed as traditional by some experts and alternative by others. Some extremely complex securities generally known as structured products are usually classified as alternative.
One of the most fascinating types of alternative investments is hedge funds and managed futures. Hedge funds and managed futures are investment pools that are managed with a high degree of complexity. Traditional mutual funds tend to trade their holdings relatively infrequently. Hedge funds and managed futures are often traded very frequently, often with high degrees of leverage and with highly complex strategies. Hedge fund strategies are described with esoteric terms such as long/short, merger arbitrage, fixed income arbitrage, global macro and equity market neutral. The nature of the returns to most of these dynamic trading-based strategies is quite distinct from the nature of the traditional returns of buying and holding stocks or bonds. Thus, even though the underlying strategies might involve stocks and bonds, investing in hedge funds is clearly not traditional investing.
Liquid alternatives have recently become quite popular in the U.S. Liquid alternatives are mutual funds that legally resemble ordinary mutual funds but that have trading strategies resembling hedge funds or managed futures. Not all hedge fund strategies can be implemented in liquid alternatives because of regulatory constraints and because not all hedge funds strategies possess adequate liquidity to meet the liquidity requirements of being a mutual fund in the U.S. Liquid alternatives are increasingly providing ordinary investors with access to invest in sophisticated strategies. There hedge fund strategies have been used for years in private partnerships to generate enhanced returns and diversification benefits. Now any of the strategies can be accessed through publicly traded mutual funds.
But investors need to be especially careful with regard to investing in alternative assets. Traditional investing involves many decisions that are not extraordinarily difficult or critical. For example, selecting between broadly diversified mutual funds with low expense ratios is a relatively benign exercise. The successful analysis of alternative investments usually requires tremendous skill and experience. The difference between good decisions and bad investment decisions in the realm of alternative investments can have enormous risk and return implications.