What Are Alternative Investments?
Alternative investments represent asset classes that fall outside of the traditional broad asset categories of equities, bonds, and cash. Although there is no standard definition, alternative investments can be classified broadly into three groups for portfolio management analysis purposes:
- Alternative Strategy Funds
- Alternative Assets (e.g., commodities, real estate, collectibles)
- Private Equity
We discuss the main strategies of these funds and provide comprehensive explanations throughout this and the next chapter. For more detailed information, consider taking CSI’s Alternative Assets and Private Equity Course.
Alternative Strategy Funds
Alternative strategy funds operate with fewer regulatory constraints compared to conventional mutual funds, particularly in regards to short selling, leverage, and the use of derivatives. This higher flexibility allows these funds to invest in illiquid assets and employ strategies that generate risk and return profiles distinct from those of traditional bond and stock funds, even when employing the same bond and stock types.
The strategies of alternative funds fall into three primary categories:
-
Relative Value
- Profit from pricing discrepancies in related stocks, bonds, or derivatives.
-
Event-Driven
- Maintain positions in companies undergoing or expected to undergo corporate actions like mergers, restructurings, or buybacks.
-
Directional
- Profit from anticipated movements in asset prices, including bonds, equities, foreign currencies, and commodities.
Sub-groups within these strategies will be covered in the next chapter.
Alternative Assets
Alternative assets are real assets held directly or indirectly and exhibit risk-reward characteristics differing from traditional stock and bond portfolios. Common types include:
Commodities
- Basic homogeneous materials (agricultural products, precious and industrial metals, energy products).
- Often accessed via derivatives markets or in physical form.
- Typically exhibit low or negative correlation to traditional asset classes and positive correlation with inflation, supporting the pursuit of real, inflation-adjusted returns.
Studies, including the Ibbotson study, have shown such diverse characteristics pertinent to commodities.
Real Estate
- Includes land and buildings.
- Segmented into commercial, industrial, and residential sectors.
- Two key forms: physical real estate and securitized real estate (e.g., REITs).
Collectibles
- Rare and unique objects (fine art, classic automobiles, rare stamps, coins).
- High-net-worth individuals traditionally engage in such investments.
Infrastructure
- Encompasses projects like roads, ports, airports, water works.
- Increased investment needs due to globalization and growing middle class in non-Western countries.
- Typically involves large capital investments, distributed among few investing partners.
Natural Resources
- Includes timberland and farmland.
- Regular cash flows from sales (crops or timber) and value appreciation.
- Investment accessed via private funds, mutual funds, hedge funds, ETFs, REITs, and publicly traded corporations.
Private Equity
Private equity includes the equity and debt securities of firms typically not traded publicly, though some private equity firms list on stock exchanges. This category encompasses:
- Leveraged buyouts
- Growth capital
- Turnaround investments
- Venture capital
- Mezzanine financing
- Distressed debt purchases
Private equity will be elaborately covered in Chapter 22.
Additional Resources
For more comprehensive coverage of alternative assets and private equity:
Frequently Asked Questions (FAQs)
What Defines an Alternative Investment?
An alternative investment includes asset classes other than traditional stocks, bonds, or cash, often exhibiting unique risk-reward characteristics and not being heavily regulated.
How Do Alternative Strategy Funds Differ From Traditional Mutual Funds?
Alternative strategy funds lack the stringent regulatory constraints of traditional mutual funds regarding short selling, leverage, and derivatives, offering greater flexibility and investment in illiquid assets.
Are Real Estate and Commodities considered Alternative Investments?
Yes, real estate and commodities are considered alternative investments due to their distinctive risk-reward characteristics differing from traditional portfolio assets.
Glossary
Relative Value: Investment strategy exploiting price differences between related securities.
Event-Driven Strategies: Investment strategies based on the expected impact of corporate events like mergers and restructurings.
Directional Strategies: Trading based on predictions of asset price movements.
Real Assets: tangible assets like real estate, commodities, and collectibles.
Private Equity: investment in companies’ equity and debt that are not publicly traded, entailing high-risk, high-reward potential.
📚✨ Quiz Time! ✨📚
## What is not considered one of the traditional broad asset classes in investing?
- [ ] Equities
- [ ] Bonds
- [ ] Cash
- [x] Commodities
> **Explanation:** Traditional asset classes include equities, bonds, and cash. Commodities are considered alternative investments.
## Which of the following is an example of alternative strategy funds?
- [ ] Real estate investment trusts (REITs)
- [ ] Commodities
- [ ] Private equity
- [x] Directional strategies
> **Explanation:** Alternative strategy funds often use directional strategies along with other strategies like relative value and event-driven strategies. REITs, commodities, and private equity are alternative assets, not strategies.
## Which of the following best describes "relative value strategies" in alternative strategy funds?
- [ ] Maintaining positions in companies involved in corporate transactions
- [x] Attempting to profit by exploiting discrepancies in the pricing of related assets
- [ ] Profit from movements in asset prices
- [ ] Investing in long-only stock portfolios
> **Explanation:** Relative value strategies aim to profit from discrepancies in the pricing of related stocks, bonds, or derivatives.
## What type of investments typically fall under private equity?
- [ ] Investment in public mutual funds
- [ ] Commodities like gold and oil
- [x] Leveraged buyouts, venture capital, and distressed debt
- [ ] Securitized real estate
> **Explanation:** Private equity typically involves investments such as leveraged buyouts, venture capital, turnaround investments, and distressed debt purchases.
## What is a defining characteristic of alternative strategy funds compared to conventional mutual funds?
- [ ] More regulatory restrictions
- [x] Fewer regulatory restrictions on short selling, leverage, and derivatives
- [ ] Exclusively invest in bonds and stocks
- [ ] Cannot invest in illiquid investments
> **Explanation:** Alternative strategy funds have fewer or no regulatory restrictions on the use of short selling, leverage, and derivatives compared to conventional mutual funds.
## Which of the following is not a type of alternative asset?
- [ ] Commodities
- [ ] Real estate
- [ ] Collectibles
- [x] Bonds
> **Explanation:** Bonds are part of traditional asset classes, whereas commodities, real estate, and collectibles are considered alternative assets.
## How can investors access commodity investments?
- [ ] Only through physical possession
- [ ] By investing only in gold
- [x] By using derivatives markets or holding them in physical form
- [ ] Through leveraged buyouts
> **Explanation:** Investors can access commodity investments using the derivatives markets or by holding them in their physical form.
## In what kind of market condition do commodities typically exhibit real, inflation-adjusted returns?
- [ ] Deflationary environment
- [x] Inflationary environment
- [ ] Market recession
- [ ] Low-interest rate environment
> **Explanation:** Commodities typically exhibit real, inflation-adjusted returns during an inflationary environment.
## What does the investment in "infrastructure" usually include?
- [ ] Stocks and bonds
- [ ] Digital assets like cryptocurrency
- [x] Projects such as roads, ports, airports, and water works
- [ ] Corporate buybacks
> **Explanation:** Infrastructure investments typically include projects like roads, ports, airports, and water works.
## Which type of investment might a high-net-worth individual engage in due to its rarity and the potential for appreciation over time?
- [ ] Equities
- [ ] Bonds
- [x] Collectibles such as fine art or classic automobiles
- [ ] Treasury bills
> **Explanation:** High-net-worth individuals often invest in collectibles like fine art or classic automobiles due to their rarity and potential for appreciation over time.
## Which of the following strategies involves exploiting discrepancies in the pricing of related stocks, bonds, or derivatives?
- [x] Relative value
- [ ] Event-driven
- [ ] Directional
- [ ] Growth capital
> **Explanation:** Relative value strategies attempt to profit by exploiting discrepancies in the pricing of related stocks, bonds, or derivatives.
## Event-driven strategies primarily involve holding positions in companies involved in what kind of activities?
- [ ] Commodity trading
- [ ] Currency exchange
- [x] Corporate transactions like mergers, consolidations, and restructurings
- [ ] Investment in real estate
> **Explanation:** Event-driven strategies maintain positions in companies involved in corporate transactions such as mergers, consolidations, restructurings, and other capital adjustments.
## Which type of alternative asset involves land and its associated fixed assets?
- [x] Real estate
- [ ] Commodities
- [ ] Collectibles
- [ ] Infrastructure
> **Explanation:** Real estate refers to land and any fixed assets on it, including buildings, houses, or factories.
## Timberland and farmland investments fall under which category of alternative assets?
- [ ] Commodities
- [x] Natural resources
- [ ] Infrastructure
- [ ] Private equity
> **Explanation:** Natural resources include timberland and farmland investments.
## What are the two main forms of real estate as an investment?
- [x] Physical real estate and securitized real estate
- [ ] Physical real estate and mutual funds
- [ ] Securitized real estate and hedge funds
- [ ] Mutual funds and hedge funds
> **Explanation:** The two key forms of real estate investments are physical real estate and securitized real estate.
## Which investment is likely to generate a return through both the ongoing sale of crops and land value appreciation?
- [ ] Infrastructure investment
- [ ] Commodities
- [x] Farmland
- [ ] Collectibles
> **Explanation:** Farmland investments generate returns through the ongoing sale of crops and appreciation of the land's value.
## What type of alternative investment becomes liquid when shares in a pool of assets are resold to investors?
- [ ] Commodities
- [ ] Collectibles
- [x] Real estate investment trusts (REITs)
- [ ] Private equity
> **Explanation:** Real estate becomes a liquid investment when securitized through REITs, where shares in a pool of real estate assets are resold to investors.
## Which characteristic is not typically associated with investments in collectibles?
- [ ] Rare and unique
- [ ] Highly desirable to individuals
- [x] Low correlation with market inflation
- [ ] Often held by high-net-worth individuals
> **Explanation:** Collectibles are rare and unique objects, often highly desirable and typically held by high-net-worth individuals. However, they do not have a straightforward correlation with market inflation.
## When private equity firms invest in a company’s distressed debt, what type of investment strategy are they employing?
- [ ] Real estate
- [ ] Event-driven
- [ ] Commodities
- [x] Private equity
> **Explanation:** Private equity firms investing in a company’s distressed debt is an example of private equity investment strategy.
## What type of event typically drives investments in infrastructure projects like roads, ports, and water works?
- [ ] Corporate restructurings
- [ ] Currency market shifts
- [x] Repair or replacement of aging structures and building new projects
- [ ] Commodity price fluctuations
> **Explanation:** Investments in infrastructure projects are typically driven by the need to repair or replace aging structures and to build new projects due to increased demand and globalization.