Alternative Investments and Markets

What are the“Alternative Investments and Markets”?

Alternative assets and markets are a category of investing and markets that go beyond traditional investments of stocks, fixed income securities, money market funds, and related markets. These types of assets and markets typically include private equity, venture capital, hedge funds, real estate, commodities, infrastructure, derivatives, and extremely alternative assets. Usually, investors in alternative assets are pension funds, endowment funds, and high net worth individuals, as such investments require a substantially higher minimum investment when compared to traditional assets.

Although alternative investments have grown substantially in size, they account for only 25% of global assets, which is smaller than the proportion of investment in fixed income securities and equities.

Types of Alternative Investments and Markets

Hedge funds are among the most common and largest type of alternative investment. These funds are professionally run investment vehicles that pool capital from many investors. These funds, unlike mutual funds, can invest across any asset class (for example, stocks, bonds, currencies, commodities, derivatives, and real estate, among other assets) and are offered only privately to investors who are typically high net worth individuals and institutional investors such as banks, pension funds, and endowments.

Private equity funds typically invest in private companies at various stages of the company lifecycle: start-up ( venture capital), growth (growth equity), and mature (buyouts). Venture capital focuses on financing start-ups and ventures which are early-stage. Growth equity focuses on financing companies with sound business models, positive cash flows or profits, and good customer profiles. Buyouts often happen when a publicly listed company is going private and involves acquiring a majority or controlling stake i.e., more than 50% in a company.

Real estate investments are direct or indirect alternative investments in land and buildings. Investors typically focus real estate investments on commercial real estate including land, commercial offices, hotels, and retail and industrial properties, among others. This is because income generation for such asset class is often more predictable and secure. Determining the fair value of real estate investment is often a challenge. Investors can gain exposure to the real estate market by either investing directly or via private and public markets. Real estate limited partnerships and real estate equity funds are examples of private investments, while real estate investment trusts (REITs) involve investments via public markets.

Commodities are physical assets that are standard inputs to manufacturing and production e.g. crude oil, pork bellies, and copper. Commodities are traded on the spot and futures commodity markets. To be considered exchangeable, commodities need to be standardized and defined, particularly when they are traded on an exchange. The trading contract specifications ensure that the commodity traded has a uniform, defined characteristics. Commodity markets are characterized by volatility, and their value rises (falls) with higher (lower) demand or shortage (increase) of supply.

Derivatives are investments whose value is determined by an underlying asset such as specified interest rate, stock price, bond price, commodity price, foreign exchange rate, etc. Derivatives can be classified as either exchange-traded or over-the-counter (OTC) derivatives. There are four basic types of derivatives – forward contracts, futures contracts, options contracts, and swaps.

Infrastructure relates to investing in infrastructure assets, such as transport corridors, airports, power distribution networks, toll roads, and telecommunication networks. It is a form of alternative investment, which offers stable, long-term, and predictable cash flows that serve as a sound hedge against inflation and have limited downside risks. Infrastructure assets are pivotal to the health, growth, and long-term development of an economy and are emerging as a new asset class. These assets mostly come under the purview of regulators who permit the owner of regulated infrastructure assets to earn a specific rate of return on the amount of capital invested on the same. There is also a growing secondary market for such assets.

Extreme alternative investments are made into assets such as art, fine wines, stamps, diamonds, collectibles, and carbon credits. For such assets, possessing non-financial knowledge of these investments and related markets is usually more important than financial knowledge. Valuation of such assets is challenging, the process of selling them can take months or even years. Some funds specialize in the types of assets described above.

Characteristics of Alternative Investments and Markets

Alternative investments can be used to diversify a portfolio because they typically have a low correlation with traditional investment classes. Alternative investments, unlike traditional investments such as bonds and equities, tend to be much less sensitive to general market gyrations and have a low correlation with traditional assets, which offer excellent benefits while attempting to construct portfolios for diversification. However, during unusual times, such as the global financial crisis of 2008-2009 or market turbulence, alternative investments, typically hedge funds, do not produce low correlations with traditional assets.

Alternative investments and markets are much less liquid than traditional assets and require more specialist knowledge. Unlike equities that are regularly traded in a stock market, it may take months or years to sell them. However, as these assets have grown more popular as constituents of funds, they have become increasingly mainstream. Consequently, their value tends to be more stable or steadier than traditional assets. Therefore, when a fund invests in less liquid alternative assets, alongside traditional investments, the underlying aim is to ensure that the fund will not witness deep declines or steep losses in all of its constituents at any given point in time.

Alternative investments are not as strictly regulated as traditional assets. Consequently, riskier, less conventional investment strategies can be employed when looking at alternative investment strategies.

Alternative investments usually have significantly higher fee structures compared to traditional investments. Traditional investments usually have fees ranging anywhere from 5 basis points to a little over one percent. Alternative investment fees are often quoted as being ‘2 and 20’, i.e. 2% management fees and 20% performance fees. The performance fees refer to the fees that the fund or the fund manager keeps i.e., 20% of the fund’s profits. Given the high fee structure associated with alternative investments, it needs to be justified by solid performance in terms of lucrative or higher returns compared to traditional investments.

Higher investments and allocation

Alternative investments require significantly higher investment when compared to investment in traditional assets such as equities, bonds, and mutual funds. Further, the substantial allocation to alternative assets stems from their potential for significantly higher returns and diversification power. Therefore investors try to exploit these market inefficiencies through active portfolio management in search of higher returns.

Real Estate Valuation – An Example

To make profitable investments in real estate, assessing cash flows and the subsequent rate of return is imperative. The critical metric for the valuation of an income-generating real estate is the capitalization rate, which is the required rate of return on investment in real estate, net of the appreciation or depreciation of value.

For investors in real estate, choosing a suitable capitalization rate is one of the most important assumptions. For investors in real estate, choosing a suitable capitalization rate is one of the most important assumptions. One can define the capitalization rate vis-à-vis real estate investment as the rate applied to net operating income (NOI) to find out the present value of the real estate.

One can define the capitalization rate vis-à-vis real estate investment as the rate applied to net operating income (NOI) to find out the present value of a real estate.

Given below is an example, where we assume that a commercial real estate in New York in the U.S. is expected to generate a net operating income of $1.2 million. If this is discounted at a capitalization rate of 13%, the market value of this property is calculated below i.e. US$ 9.23 million.