Introduction to Alternative Investments

Investment can be categorized into traditional investments and alternative investments. A traditional investment is an investment in well-known assets such as bonds, stock, cash etc with the expectation of capital gains, dividends and interest earnings. An alternative investment on the other hand is simply defined as any other investment that is non-traditional. Alternative investments can be grouped into five categories which are hedge funds, private equity, structured products and real assets and commodities.

Breaking down the five categories:

Hedge funds: As earlier discussed in this post (Introduction to hedge funds), an hedge fund is a private investment vehicle. Management is not saddled with the task of stringent disclosures and regulatory restrictions like the mutual funds. Hedge funds although risky, can earn great returns. They utilize leverage, derivatives, long- short positions and other strategies. Due to the sophisticated strategies undertaken, hedge funds can make significantly higher returns than traditional investments.

Private equity: Private equity investments are investments in debts and equities which are not publicly traded. Information of the financial performance of the companies invested in are not readily available so thorough due diligence must be undertaken in order to ascertain if the investment would suit the investment goal of the investor. Private equity investments include venture capital, leveraged buyout, distressed debt and mezzanine debt.

• Venture capital: venture capital is investment in a new company or start up. Venture capital are for companies who cannot obtain fund from the public equity, and also not financially buoyant and have not been in operation long enough to be granted a loan from financial institutions. Venture capitals are characterized with high risk, so investors should ensure they take proper due diligence before investing in them.

• Leveraged buyout: Leveraged buyout involves using large amounts of debt financing to buy a company’s outstanding equity and in so doing turn the publicly traded company private. The assets of the company to be taken over would serve as the collateral for the debt finance.

• Mezzanine debt: This is a type of subordinated debt; it can be described as an hybrid debt issue because it usually as an embedded equity instrument e.g a warrant attached to it, making it attractive to convert the debt into stock if the stock price rises; this therefore increase the value of subordinated debt. In other words, in private equity, Mezzanine debt is subordinated debt investments (with equity warrants or conversion options) in established companies seeking expansion or transition financing. e.g

• Distressed debt: This involves the purchase of debt by companies that are likely to go bankrupt, or have already filed for bankruptcy. It may sound absurd for anyone to invest in a bankrupt company, but investors invest in distressed debt in order to profit from the firm’s everyone from bankruptcy.

Structured products: Structure products segment the cash flow of flow traditional investments. They link the product’s return to one or more market value in order to achieve certain risk, return, tax or other objectives. As there are structured products for traditional investments, there are also structured products for alternative investments. A typical example of structured product from traditional investment is the debt and equity securities of a firm. Alternative investment structured products include collateralized debt obligation. Collateralized debt obligation is an investment in a mixture of debt securities which divides the actual or synthetic returns from a portfolio of collateral. A collateralized debt obligation is a type of structured asset –backed security backed by a pool of loans. The structured assets in a collateralized debt obligation are cash flow generating assets. The Collateralized debt security basically repackages this asset pool and slices it into tranches which has the cash flow of interest and principal payments in sequence based on seniority. This Collateralized debt obligations can then be sold to investors.

Real assets: This is an investment in non financial assets. Investments in real assets give you the right to consumption instead of a claim on assets like investment in financial assets such as bonds and socks give.

Types of real assets

• Real estate: Real estate is investment in physical properties particularly land. Real estate is popular among individual investors, investors have held real estate investments for decades and they regularly appreciate apart from the period of the sub prime mortgage loan that depreciated real assets back in 2007-2009, which eventually led to the economic depression of 2008/2009.

• Infrastructures: Infrastructures include government controlled tolls , roads utility companies, airports, seaports and other real assets. Investment in infrastructures is the claim on the cash flows generated by the above mentioned assets. For example a toll fee is paid for government controlled toll roads.

• Intangible assets: They are assets that cannot be seen or touched, but they are expected to produce future economic benefits. Examples of intangible assets are intellectual properties such as copyrights, patents, trademarks and royalty rights related to creative works.

Commodities: Commodities are standardized goods traded in a market by a large number of producers in large quantities. Commodities invested include agricultural products such as cocoa, coffee, metals such as gold and silver, and energy products such as crude oil. Investment in commodities can take various forms of ownership which includes investments in the physical commodity, investment in forward or futures contract, investment in the securities of commodity producing firms and exchange traded funds. (ETFs).

Limitations of investing in alternative investments

• They are often illiquid, difficult to dispose off for cash at the time of need. Liquidity is a concept in finance that measures how readily convertible to cash an asset is. A security described as being liquid should possess the quality of being frequently traded in the market so that securities can be bought or sold according to liquidity preferences of the investor. Illiquidity refers to securities with infrequent trading or low volume trading, illiquid assets cannot be readily sold, and this allows a small number of market participants influence its price through trade.

• Inefficiency in markets: Inefficiency in market means that not all available information is incorporated into asset prices. Alternative investment market can be inefficient because not may people invest ion them; traditional investments are characterized by a highly competitive bidding process if numerous participants who are able to establish both long and short positions quickly with low transaction costs. In other words, they can be seen as efficient markets because publicly available information is incorporated into the price of the security. Inefficient markets may suffer from fewer participants, lower competition, higher transaction costs, and the inability to establish long or short positions.

Recommended Reading

Alternative Investments: CAIA Level I (Wiley Finance)