An Introduction to Alternative Investing

By: Chadd Evans, CFA, CAIA in Educational Content September 1, 2020

An introduction to alternative investing

Institutional investors, including pension plans and charitable endowments, have a long history of investing beyond what is available in the public markets.  Their extremely long-term horizons made them among the first to embrace alternative asset types that also had long lives.  Over time, individual investors have often sought to copy the best practices of institutions, seeking to improve returns or mitigate risk by exploring a broader array of investment categories beyond the typical 60/40 mix.  As a result, so called “Alternative Investments” are gaining wider acceptance as a necessary part of a well-designed portfolio.

What are alternative investments?

The term “Alternative Investment” is no more descriptive than the term “mutual fund”.  Neither phrase reveals much about the investment itself.  And in the case of Alternatives, the name is more about what an investment is not (stocks, bonds or cash) than what it is.  This catch-all category must therefore be vast and varied.  And indeed, it is, encompassing assets as diverse as venture capital and art, commodities and farmland, real estate and private equity.

Alternative InvestingThis report will not attempt to address each potential type of investment in the Alternatives category. Instead, we will focus on sectors that have gained wide acceptance among institutional investors and have sufficiently long histories over which to evaluate their characteristics.  We will also demonstrate that alternatives are not beyond the reach of many individual investors for whom their attributes can be a perfect fit.

Primary attributes

Alternatives Investments have some characteristics in common that span this diverse asset class.  Typically, these investments are “private”, meaning that they are not quoted on an exchange and therefore lack trading liquidity.  This is both a positive and a negative, depending on an investor’s perspective.  A lack of trading liquidity suggests that investors who need ready access to their money should steer clear of alternatives, but for investors with long time horizons, the lack of trading means that the investment doesn’t “mark-to-market” as financial indexes rise and fall, adding to portfolio stability in the short term.  This can also mean a lower correlation of returns with other asset types, also enhancing portfolio diversification.

Alternative investments can be restrictive, with most funds requiring that investors meet certain wealth and/or income criteria.  Funds can also limit the number of specific investors in each vehicle, leading managers to generally set high minimum investment amounts from each of them in order to maximize their overall fund size.

Lastly, while private investment vehicles do not price their assets daily, they are still required to report to their investors, typically on a quarterly or semi-annual basis.  Private investment funds often receive capital from their investors over time, rather that all up front, meaning the some of this reporting is keeping investors abreast of how they are deploying capital, market conditions and how much capital they are “calling” in the present period. These characteristics are markedly different from those of public investments.

Alternative investment categories

As described above, this report will focus on the categories of alternative investments that have seen the widest deployment among wealthy investors and institutions.

Private Equity:

Managers of private equity funds raise capital from investors to deploy into promising private companies.  There are a variety of management approaches to this segment.  The term “growth equity” refers to supplying capital to growing private companies. Usually these firms have reached a certain size to have proven their staying power.  This is in contract to a “buyout” model which often uses leverage to help founders exit, or to consolidate multiple competitors in an industry niche.  The common theme is the private equity firm brings capital, networks and management talent to help the acquired company grow with the objective of exiting the position in later years at a profit.

Broadly speaking, private equity funds have been able to generate returns in excess of those of the S&P500.  This has attracted additional attention to the asset class. Yet, like common stocks, the returns from private equity funds are greatly influenced by the year in which you begin investing. This “vintage year” issue makes it wise to view private equity as a very long-term investment that will be implemented over many years – essentially spreading out the vintage year problem.

Real Assets:

The realm of real assets is broad, from natural resources to real estate to infrastructure. Investors tend to be familiar with real estate, but usually through Real Estate Investment Trusts, or REITs, that are traded on exchanges. REITs are easy to purchase, and are completely liquid, but tend to have high return correlations with the equity markets.  Private real estate, on the other hand, is a very long-term asset that has limited liquidity.  Private real estate funds can be as varied as investing in multi-family (apartment) assets, office, medical, warehouse, self-storage or retail.

On the periphery of the real estate segment, but popular with large institutional investors, one finds funds that are focused on timberland, farmland, infrastructure and even government buildings.  The common feature among real estate funds is usually cash flow from rents or from harvesting resources.   These funds are popular with large institutional investors but are less often available to individuals.

Credit Strategies:

Increased banking regulations have limited the activities of the nation’s commercial banks when it comes to lending to smaller, less creditworthy firms.  This has opened the lending segment to the private (non-banking) sector.  Firms that lend to these companies can position themselves to earn relatively high interest rates, while still delivering value to the borrower (since this capital is still less costly than selling equity in the firm.)

Credit managers often specialize on a particular segment of corporate debt financing – often called “senior” (less risky, since it has claims to assets before other lenders) or “mezzanine” (which is junior in liquidation, but still is senior to the holders of common equity, who tend to be last!)  These managers are as meticulous as bankers when it comes to monitoring the financial status of their borrowers, and they are often seen as important partners in a company’s growth.

Venture Capital:

While venture capital is similar to private equity in that the managers invest in private companies, the venture capital segment is more often focused on earlier stage companies.  As such, it is rightly perceived as being materially riskier, but also more exciting to the investor.  Promising young companies often launch with the help of so called “angel” investors and continue to seek external funding as they progress from modest revenue to positive cash flow.  Many never make it that far, but investors continue to be lured by the possibility of finding the next Amazon or the next Google.

Hedge Funds:

Hedge funds are private investment partnerships that largely invest in marketable securities.  What makes them unique are the multitude of styles of management that are employed by these firms.  The common denominator among hedge funds is the idea that the manager’s acumen, and not the direction of the securities markets, will determine success.

The original “hedge funds” were just that – hedged, attempting to earn returns on common stocks, for instance, without being fully exposed to the ups and downs of the markets.  These days, only a small portion of the hedge fund universe is truly hedged – segments known as “equity long/short” or “arbitrage”, which both attempt to profit from the price relationship between multiple securities.

Other segments of this include “macro trend” managers (investing in currencies, commodities, equity and debt securities and other instruments to profit from significant trends globally), “distressed” funds (who attempt to extract value from companies, or particular securities, that are under some duress) and “event driven” managers, who use corporate mergers and other events to earn their returns.

Why should alts be in my portfolio?

While each investor’s situation is unique, institutional investors (pensions, endowments) wealthy families have been drawn to alternative investments for several reasons. The search for returns is always front of mind, and many of these segments have provided investors with a return premium versus the public markets.  Nearly as important among these investors is the desire to have returns that are independent from those same public equity and fixed income markets.

Investors who can segregate “very long-term assets” from their other investments have the advantage of choice. The idea that one could compound a high rate of return over ten years is an appealing one.  The “illiquidity” premium that comes from being willing to lock up your money for a period appears to be real and enduring (although not always rewarded.)  That less of an investor’s future is tied to stock market cycles is undoubtedly another factor pushing investors to explore alternative.

What else should I know?

As we have discussed, alternative investments are not for every investor.  Their lack of liquidity is one of the primary drawbacks for an investor who needs to access some or all their funds soon. They are often opaque — reported on quarterly, at best. One must do substantial due diligence on each fund to determine their legitimacy and competence.  And they are very long-term in nature. One makes this decision and must abide by it for many years.  Lastly, these funds can be exclusive, open only to investors who can write a big check or who meet very high wealth standards.

Altera tries to address some of these shortcomings by providing access vehicles that permit investors to gain “access” to funds that otherwise may have been out of reach (due to high minimums.)  And by providing due diligence, investors can have more confidence that what they see is that they should get.

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