The Alternative Investment Landscape
Alternative investment is a term typically used by investors to describe investments other than stocks and bonds. Strategies commonly classified under alternative investments include private equity, leveraged buy-out (LBO) funds, arbitrage, hedging etc. Some also classify commodities, real estate and venture capital as alternative investments.*The benefit of allocating to alternative investments include: potentially higher returns, reduced volatility, diversification, low correlation with other investments and in some cases enhanced liquidity. Alternative investments are often considered by institutional investors as alternatives with potentially less risk than investments in venture capital, commercial real estate, distressed securities, and junk bonds. The drawbacks include potential one time losses from rare events and high management fees.
** “Financial literature tends to define alternative investments as a negation to traditional assets or, in other words, if core asset classes include equities, bonds, real estate, commodities, currency, and if these are compounded by their respective derivatives, then alternative investment strategies are the resulting permutations and combinations thereof - such as hedge funds, structured products, etc. If we were to take this thinking a step further, then ‘alternative alternatives’ would be a negation of alternative investments.
If we classify the investable alternative alternatives on the basis of their exposure to non-market risk then these fall into three categories:
I. Pure alternative alternatives
Pure alternative alternatives are those that have a pre-dominant exposure to ‘exploitable risk premia’ that lie ‘outside’ the realm of financial markets. These include investments in:
1. Insurance related risk - life (mortality, longevity risk);non-life (natural catastrophe, etc)
2. Biological growth of trees (the rate at which a tree grows has nothing to do with financial markets).
II. Intermediary alternative alternatives
The source of exploitable risk premia may not exclusively lie outside financial markets. The process of exploiting the risk premia means that these wrappers are vulnerable to macro economic and idiosyncratic risks. Examples include:
1. Asset based lending strategies
2. Scarcity-led investments/investing in ‘physicals’ such as collectibles (although it is debatable as to whether their performance is influenced by, or mimics, that of market cycles), including wine, art, vintage cars, stamps, rare coins, autographs, memorabilia and stringed musical instruments such as violins.
III. Other alternative alternatives
Chosen for their alternative motive, these includes strategies where the source of exploitable risk premia is sourced in financial markets and may be conditioned by or extracted from market movements; hence there may be a higher correlation to financial market movements. Examples include:
‘Invest-for-the-future’ type theme investing (such as water, natural resources, equity investments in infrastructure, shipping, re-cycling resources and renewable fuels)
As the search for uncorrelated market returns intensifies, it is only a matter of time until they are more widely embraced and implemented within portfolio allocation. It is important to remember that it is not just traditional assets or mainstream hedge fund strategies to which alternative alternatives tend to show low - or no - correlation; they also maintain low correlation characteristics among themselves.
IV. Professional Bodies and Education Focused on Alternative Investments
In 1999, under the guidance of The Center for International Securities and Derivatives Markets (CISDM) and the Alternative Investment Management Association (AIMA), committed industry leaders undertook the task of creating a professional designation exclusively for alternative investment specialists. The result of their efforts is the Chartered Alternative Investment Analyst designation, or CAIA - the AI industry's first and only specialized educational standard (http://www.caia.org/)
AIMA (http://www.aima.org/), the Alternative Investment Management Association, is the hedge fund industry's global, not-for-profit trade association with over 1,100 corporate members worldwide. Members include leading hedge fund managers, fund of hedge funds managers, prime brokers, legal and accounting services and fund administrators.
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