Guide to Alternative Investments: General Overview of Alternative Investments and why they make sense in an investor

canary-wharf2-hedgethink Guide to Alternative Investments: General Overview of Alternative Investments and why they make sense in an investor

The term ‘alternative investment’ is an umbrella for all sorts of investments that don’t fall into one of the traditional asset classes of stocks, bonds, and cash. The term usually denotes investments in things like private equity, commodities, hedge funds, financial derivatives, or real estate, but it can also refer to any investment that falls outside these asset classes, including wine, art, or even classic cars.

Traditionally, alternative investment vehicles such as managed futures, hedge funds, and private equity funds have been the exclusive preserve of high-net-worth individuals, and there were several reasons why the investors in this group have been drawn – and continue to be drawn – to alternative investments.

Diversification:
One of the main appeals of alternative investments is that they tend, for the most part, to have a low correlation with the performance of traditional investments such as stocks and bonds. With a traditional, long-only investment in equities, your capital is very susceptible to major market movements, such as a market crash for example. By investing in things that have a low correlation with these movements, you use these investments to diversify your portfolio and therefore your exposure to specific market risks.

Top talent:
Despite the impact of regulations such as the Dodd-Frank Act on the alternative investment industry, it remains an attractive career option for the most talented capital markets professionals. As well as giving them more freedom to pursue profitable strategies, it can be extremely rewarding financially, and the wide prevalence of hedge fund managers in Forbes Magazine’s The World’s Billionaires list is as good an advertisement as any for the profession. This, in turn, makes it more attractive to investors, who see the value of investing with the most successful money managers, even if their large fees often take a hefty chunk out of the profits, as their returns over the long term tend to justify these high levels of compensation.

Returns:
Although the returns from alternative investments vary widely, most investors choose to allocate capital to alternative investments such as venture capital and private equity funds in search of higher returns than they can obtain from traditional investments such as mutual funds and ETFs. These types of investments typically require a greater degree of investment analysis before buying, as the cost of purchase may be relatively high – for example the management and performance fees charged by top hedge fund managers. Other potential issues with alternative investments, particularly in the case of investments in private companies or assets such as art or coins include the fact that it can be difficult to determine the current market value of the asset, and the amount of historical risk and return data that you can use for analysis may be limited. However, with this uncertainty comes the chance that you could make a much bigger return than you might with a more predictable and better-documented asset.

Exclusivity:
While anyone with a bit of money put aside can invest in retail investment vehicles such as mutual funds, most alternative investments are available exclusively to high-net-worth, ‘accredited’, or “qualified’ investors – meaning that they meet strict criteria such as having an income of over $200,000 per year or a net worth of over $1m, or more if the purchase is coming from an organization such as a charity or trust.

Personal involvement:
While many of the best investments are highly unlikely to pique the interest of a wealthy investor much beyond their profit potential, many investments that fall under the category of ‘alternative’ are chosen for reasons other than their potential returns. For example, someone with an interest in wine or art could indulge this by making investments in them, and these could well prove to be highly profitable over the long run. Or, someone who has made their money in business might wish to get involved with startup or growth companies in a venture capital capacity where they could choose to play the role of a silent investor, perhaps through a venture capital fund rather than a direct investment, or take an active role in helping the company to grow and therefore increase the value of their investment.

Regulations:
In the pre-crisis years, alternative investment vehicles such as hedge funds were able to benefit from having a lower regulatory burden than retail investment products such as mutual funds. This meant that money managers in the alternatives sector had a lot more freedom in terms of the instruments that they could trade, the strategies that they could employ, and the level of risk that they could take on, than their counterparts in the more heavily-regulated mutual fund industry. As well as keeping compliance overhead low, this enabled them to be able to deliver much more impressive returns for their investors – and of course for themselves. This is one of the reasons why so many top money managers made the switch from mutual funds into the alternative investment industry in the 1990s and 2000s.

However, the years following the crisis have brought a raft of new regulations into the alternative investment industry, and today alternative investment vehicles are subject to a far greater regulatory burden. According to a KPMG survey, hedge funds spent $3bn on meeting new compliance costs between 2008 and 2013, adding 10% to their average annual running costs. This switch has not been without its benefits, however, as the higher costs of compliance at hedge funds have created an environment that is more welcoming to institutional investors, who have even stricter compliance obligations of their own to fulfil.

Article published under: HedgeThink Authority Publishing Partnership

HedgeThink Authority Publishing Partnership is a section produced by HedgeThink in coordination with the brand partner FNEX. This section is an integrated and by-invitation content-production and sharing platform that enables companies and marketers to join HedgeThink platform with specific thought leadership content, education, narratives and special industry expertise.You can contact FNEX directly here.