Categories of Alternative Investments

PrepNuggets | by Keith Tan, CFA
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CFA® Level 1 (2021/2022) - Complete Alternative Investments

Deep dive into Alternative Inv with the Bestselling CFA® prep course provider | With visual learning + Quizzes

01:38:39 of on-demand video • Updated June 2021

  • You will learn the features of hedge funds, private equity, real estate, commodities, and infrastructure investments.
  • You will understand the fee structures for hedge funds and PE funds.
  • You will learn the potential benefits of alternative investments in the context of portfolio management.
  • You will understand the issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure.
  • You will learn the risk management aspects of alternative investments.
English [Auto] In this introductory lesson, we discussed the differences between alternative and traditional investments, have a brief overview of the various categories of alternative investments and discuss the role of alternative investments in a portfolio. Let's get started. Alternative investments differ from traditional investments in the types of assets and securities included in the structure of the investment vehicles and characteristics. Traditional investments tend to center around just stocks and bonds, while alternative investment portfolios can often include others, like derivatives and illiquid assets such as real estate, the assets can be bought with leverage and employ short positions. While the investment structure for traditional investments tends to be straightforward between the issuer and investor, the structure for many alternative investments tends to be much more complicated. For example, a common structure for hedge funds and private equity funds is a partnership where the fund is the general partner and the investor is a limited partner. Fee structures for alternative investments are also different than those of traditional investments with higher management fees on average and often with additional incentives based on performance. We shall be discussing more about the structures and fees for the different categories of alternative investments in the coming lessons. Characteristics wise, alternative investments as a group have had low returns, correlations with traditional investments besides the assets held and the portfolio as a whole are generally less liquid than traditional investments. There's more specialization by investment managers, less regulation and transparency, different legal issues and tax treatments, and more problematic and less available historical return and volatility data. In this course, we'll examine six categories of alternative investments here, we briefly introduce each of these categories. Hedge funds are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies they may employ, long and short positions are often highly leveraged and aim to deliver investment performance that is independent of broad market performance. Don't get fooled by the name, they do not necessarily hedge risk, as the name might imply. Private equity funds invest in the equity of companies that are not publicly traded or in publicly traded firms that the fund intends to take private, the majority of private equity funds are leveraged buyout funds, which use borrowed money to purchase equity in established companies with solid customer bases, proven products and high quality management. Some private equity funds are venture capitals, which typically invest in or provide financing to start ups or young companies with high growth potential. Real estate investments can be direct investments in residential or commercial properties, as well as indirect investments through real estate backed debt. Such structures can include private commercial real estate, equity or debt, real estate investment trusts and mortgage backed securities. Commodities investments may be in physical products such as grains, metals and crude oil. To gain exposure to changes in commodities prices, investors can own physical commodities, commodities, derivatives or the shares of commodity producing firms, some funds seek exposure to the returns on various commodity indices, often by holding derivatives contracts that are expected to track a specific commodity index. Infrastructure refers to long lived assets that provide public services. These include economic infrastructure assets such as airports and utility grids and social infrastructure assets such as schools and hospitals. Investors may directly invest into individual products or gain exposure indirectly through shares of companies, exchange traded funds, private equity funds, listed funds and unlisted mutual funds that invest in infrastructure. And the others, this category includes investment in tangible collectible assets such as fine wines, stamps, automobiles, antique furniture and art, as well as intangible assets like patents. So why consider alternative investments? As we've mentioned earlier, alternative investment returns have historically had low correlations with those of traditional investments. So for a manager whose portfolio consists mainly of traditional assets like stocks and bonds, he can consider adding alternative investments to the mix. As you learn, under portfolio management, adding assets with low correlation of returns with a portfolio can have the effect of reducing the overall portfolio risk. So if the manager adds alternative investments into his portfolio mix, the expected standard deviation is likely to be lower. However, risk measures like standard deviation that we use for traditional assets may not be adequate to capture the risk characteristics of alternative investments when considering potential portfolio combinations, historical downside frequencies and worst return in a month may be included in the analysis. Besides low return correlation, historical returns for alternative investments have been higher on average than for traditional investments. As such, adding alternative investments to the portfolio may increase expected returns. You may be wondering why do alternative investments on average have higher returns? One reason could be that alternative investments are less efficiently priced than traditional assets. This provides opportunities for skilled managers to outperform. Another reason could be that alternative investments being illiquid are priced to give higher returns as a compensation. Also, alternative investments often use leverage, which has the effect of increasing the risk and returns. While it seems that adding alternative investments to a portfolio will improve both portfolio risk and expected return, choosing the optimal portfolio allocation to alternative investments can be complex. As it turns out, the data supporting the notion that the historical returns of alternative investments are higher than traditional investments can be biased. Two of the most common biases are the survivorship bias and the backfill bias. Survivorship bias refers to the upward bias of returns if only the data for surviving firms is included, since surviving firms tend to be those that had better returns, excluding the returns, data for failed firms results in average returns that are biased upward. Backfill bias can be introduced where new funds are added to a benchmark index, since funds that are newly added to an index tend to be those that have outperformed better than average, including their returns for prior years, tends to bias the index returns upward. And that concludes this introductory lesson on alternative investments. Up next, we discuss in detail the various categories of alternative investments, starting with hedge funds. See you soon.