Characteristics of Alternative Investments

What are the “Characteristics of Alternative Investments”?

Alternative investments are assets that do not fall into conventional financial investment classes such as stocks, bonds, or cash investments. Examples of alternative investments are private equity, hedge funds, private debt, real estate, commodities, and structured products. Typical investors in alternative assets are pension funds, endowments, and high net-worth individuals.

Alternative investments can be used in conjunction with traditional investments in a portfolio to reduce the overall risk profile. The key characteristics to consider when looking at alternative investments are correlation, fee structure, liquidity, minimum investment requirements, regulation, and returns.

Key Characteristics of Alternative Investments

Alternative investments are sometimes used to diversify an investment portfolio to reduce the overall risk exposure. Below are a few of the most common characteristics which differentiate alternative investments from traditional investments:

Correlation: Alternative investments tend to have a low correlation compared to traditional assets like equities and fixed income. So, they have less exposure or are less sensitive to general market swings. This is of great benefit when it comes to portfolio construction and diversification. However, the criticism of alternative investments and specifically hedge funds is that during the financial crisis or during market turbulence the correlation increases. And, when an investor is in desperate need of diversification to dampen equity volatility, hedge funds or alternative investments do not produce the low correlation that it has historically.

Fee Structure: Fees for traditional investments can range anywhere between 0.05% to a little bit over 1%. Alternative investments on the other hand, usually have much higher fees – usually broken up into a management fee of 2% and a performance fee of 20%. So, in addition to the already high management fees of 2%, the fund or fund manager also keeps 20% of the profits of the fund. This really high fee structure is usually justified by strong performance. Alternative investments usually have high entry and exit costs.

Liquidity: liquidity can vary from benchmark to benchmark and from fund to fund, but it is usually significantly lower than traditional investments. In fact, most hedge funds have a lock-up period where investors can only withdraw money on a monthly or quarterly, or even yearly basis. Private equity funds could lock up funds for even longer. Investing in alternative assets requires more patience from investors, as one needs to have a longer investment horizon relative to traditional assets.

High minimum investments: many hedge funds have minimum investment requirements of 1 million to 5 million dollars and private equity funds have even higher minimum requirements.

Limited regulation: Alternative funds and alternative strategies are not as constrained by regulatory bodies – allowing them to potentially employ investment strategies that could boost returns. Of course, you would expect that comes with additional risk.

High returns: alternative investments have the potential for very high returns if managers perform well. Higher risk has historically provided higher returns.

Value: the value of alternative investments can be hard to determine, as there is unlike traditional assets, no mark to market – particularly of private investments in private equity where there is no daily valuation of investments.

According to Yale University, Endowment 2017 Annual Report with reference to what is so special about alternative Investments, they state that the heavy allocation to non-traditional asset classes is because of their return potential and diversifying power. In addition to returns, this diversifying power is expected to produce lower volatility for the portfolio overall. Lastly, they feel that alternative investments are less efficiently priced in the marketplace than traditional marketable securities i.e. equities and fixed income securities – allowing for the potential of excessive returns.

Investors in Alternative Investments

Investors in alternative investments tend to pension funds, endowments, and high net worth individuals who are willing to invest in less regulated investments that come with a lot less liquidity and substantially more risk. Some jurisdictions only allow individuals with significant wealth or income to invest in these less-regulated investments. Many regulators have put restrictions on high net worth individuals and their ability to invest in alternative investments.

Investors use alternative investments to diversify their portfolios and enhance their risk/return profile. The expectation is that because these investments behave differently from traditional equity and fixed income investments, they will provide a buffer throughout the economic cycle. Data is very mixed on whether the industry as a whole has been able to accomplish that – particularly in periods of extreme market stress.

Investing in Alternative Assets – Hedge Fund, Example

If an investor invests in a hedge fund, he or she has to bear the following costs – a fixed fee, typically 2% and an incentive-based management fee, typically 20%

Given below is an example of an investor who invests in a hedge fund. We calculate his or her gross and net return. Assume that investor A invests US$1.2 million in a hedge fund at the beginning of Year 1 and at the end of year 1, his or her account is worth $1.4 million. So, the account goes up in value by $200,000, so the simple gross return calculated below is 16.7%.

Most hedge funds charge a fixed fee, which is typically 2% annually, based on the percentage of assets under management. Therefore, we need to deduct the charge of 2%. Consequently, investor A has to pay $28,000 in fees at the end of year 1.

In addition to the above, hedge funds charge an incentive-based management fee too, typically 20% of all returns that are in excess of 5%. This fee is calculated as a percentage of profits above some benchmark rate of return (for example, 5%).

Here the 5% benchmark rate implies that investor A does not have to pay the fees on $ 60,000. Therefore, an incentive of $140,000 is multiplied by 20% – which adds to an additional $28,000 to the total cost of the hedge fund.

If we were to subtract both the 2% and 20% fees, we get a final net amount of $144,000. In percentage terms, the investor gets a net rate of return of 12% on his or her investment. The net return is significantly lower than the gross return.