Alternative Investments

Alternative investments are investable asset classes or instruments that are deemed as ‘non-mainstream’, hence the name ‘alternative’. They differ from the conventional investable asset classes like bonds and equities, and some alternative investments may have unique characteristics that separate them from the rest (like exotic, complex strategies). Other alternative investments may also be less accessible, available perhaps only to institutions or sophisticated investors. Below are some of the more widely-known alternative investments.

Commodities

Also known as resources, commodities are the ‘building blocks’ of the real economy. They are tangible assets that we rely on a day-to-day basis, whether its corn and sugar (for our daily consumption in food and beverages), metals like copper and iron (for construction) or oil (for jet and automobile fuel or the manufacturing of plastics). They represent an asset class by themselves, and because they tend to behave differently than the more-understood asset classes of fixed income and equities, industry practitioners tend to classify them as ‘alternative’.
Commodity prices are driven primarily by demand and supply dynamics. When the amount of demand surpasses the amount of supply available, prices will rise. Conversely, if supply far surpasses demand, prices tend to fall. Historically, commodity prices also tend to trend alongside inflationary pressures (think of cost-push inflation effects of the oil shocks in the 1970s), making them a viable inflation hedge. Asset classes like fixed income may not do well during periods where the rate of inflation outpaces the yields that bonds offer, whereas commodities perform differently.
Commodities are typically traded via derivatives, which are financial instruments that represent a claim on the particular asset. For example, an investor desiring to purchase crude oil would usually purchase contracts on crude oil. These derivatives include futures contracts and option contracts. The producers of commodities (oil & gas extractors, miners, farmers) tend to use these derivatives to hedge out their price risks by locking in a price they would like to sell their goods at some point in the future. On the other hand, investors and speculators who wish to make money from the price movements of commodities use these derivative contracts as a means to express their views on prices. Thus, there are a few ways to gain exposure to this asset class, and they include commodity derivatives, commodity exchange-traded funds (ETFs) as well as via the equity securities of commodity-related firms.

Real Estate

Most people are familiar with real estate, or also known as property. Office buildings, residential apartments and private houses, as well as land all fall under this category. Ownership of real estate was considered of utmost importance even before the Industrial Revolution, and because the ownership of a primary residence is more common than the ownership of financial assets and investments, people understand it better.
Traditionally, the only way to invest in real estate is via a direct purchase of the asset itself, and investors normally go to real estate for regular income from rental yields. However, an investor could also gain exposure to real estate via the purchase of an equity security of a publicly-listed company that has a portfolio of real estate or is involved with real estate development. These days, the existence of Real Estate Investment Trusts (REITs) also allows investors with less capital to gain exposure to portfolios of real estate!

Hedge Funds

Hedge funds are essentially a more sophisticated version of mutual funds – alternative investment vehicles that pool investors’ capital and employ various types of strategies in order to generate returns for their investors. They are largely unregulated investment vehicles that are typically offered to institutions as well as high net worth individuals. Their initial minimum investment amounts are usually relatively high as well, making it difficult for investors with lesser capital to gain access. Since many of these products are offered only to sophisticated investors, there are few that are specifically structured for retail investors. Private banks as well as family offices would have a range of alternative investment products like hedge funds for their clients.
The strategies employed by hedge funds are typically not available to the managers of mutual funds, and it is important to note that within the hedge fund universe, there exists an entire plethora of very diverse strategies and styles. Hedge funds are also known to differ from mutual funds in their fee structures, in that they tend to levy an incentive fee on overall performance (typically 20% of any outperformance) on top of the usual management fees.
One technique available to hedge fund managers is short-selling, which allows an investor to profit when an underlying asset that is sold short declines in its price. Hedge funds which go long on some stocks and go short on others are known as long short hedge funds, and if their hedges are properly in place, they could better protect investors’ capital during market downturns or unexpected sell-offs. Some hedge funds strategies like fixed income arbitrage are relative value bets, meaning that they look for mispricing between related groups of assets and make money when markets revert to normalcy and these sort of mispricings disappear. This way, their performances do not rely solely on the overall market direction, but rather on the relative performance of related groups of assets.
Another hallmark of many hedge funds is the use of leverage, meaning that they may borrow money to implement their strategies. This is either done through the provisions of credit facilities or by using leveraged instruments like financial derivatives. The use of leverage magnifies both investment gains as well as losses.
Some typical hedge fund strategies include:

• Equity Long Short
• Fixed Income Arbitrage
• Event Driven Strategies (Merger & Acquisitions arbitrage, Activist Investing)
• Global Macro
• Distressed

Private Equity (PE)

Like hedge funds, private equity (PE) tends to be accessible only to institutional investors as well as sophisticated investors and high-net-worth individuals. Private equity is essentially the concept of owning privately-owned companies (companies not publicly-listed on stock exchanges). Investment vehicles are set up by private equity managers to pool capital together and to purchase stakes in privately-held companies; the function of making investment decisions on behalf of the group of investors is delegated to the general partner of the private equity fund. The rest of the investors are known as limited partners.
Private equity managers employ various strategies in order to manage their investment vehicle and generate returns for their investors. They may look for inefficient public companies that could be ‘revitalised’ and take them private in order to reorganise them to make them more efficient in maximising shareholder value. They may also look for private companies that need capital or are looking to go public in the foreseeable future. Private equity funds that invest in innovative start-ups that often have no sustainable earnings growth yet require funding are known as Venture Capitalists.
Due to the nature of private equity strategies, investments tend to be illiquid, and general partners require a number of years to source for attractive deals, commit and invest the pooled capital, and to prepare their exit strategies, which consist of liquidating their investments and returning monies to their limited partners. This entire time period is known as a ‘Charter Life’ and the typical duration of a private equity fund’s charter life is normally about 10 years. In the early phases of a fund’s charter life, the managers would be drawing down and deploying capital during the deal-sourcing process, leading to a ‘dip’ in net asset value (NAV). As investment returns are later realised, an upward revaluation of the fund’s NAV would be seen as managers prepare to distribute capital gains back to investors towards the end of the charter life.
Institutional investors like pension and endowment funds may invest in private equity vehicles as they tend to have a long term investment mandate, allowing them to take on some illiquidity and be suitable limited partners of private equity funds.
Like hedge funds, private equity funds tend to levee management fees as well as incentive fees (fees on performance). The incentive fee component of private equity funds can either be levied on a deal-by-deal basis or on an aggregate basis based on a mandated targeted rate of return.