W hat constitutes an alternative investment varies substantially. That’s because it is largely a new field on which consensus has not emerged, and also a rapidly changing one for which consensus will probably remain elusive. But, broadly speaking, alternative investments lie outside the definition of long-only investments in shares, bonds and cash. In other words, they are an alternative to long-only positions in shares, bonds and cash, and include investments in assets such as real estate, options, financial derivatives, exchange-traded funds, commodities and the like.
Returns
A popular way to distinguish between traditional and alternative investments is by comparing their return characteristics. Investment opportunities exhibiting returns substantially distinct from returns of traditional stocks and bonds might be seen as alternative investments. Here, stock returns refer to those from publicly traded equities. Similarly, returns from bonds refer to returns from publicly traded fixed-income securities.
Illiquidity
Many alternative investments are illiquid. In this context, illiquidity means the investment trades infrequently and/or with low volume. It means the returns are difficult to observe due to a lack of trading and realised returns may be affected by the trading decisions of a few participants. The risk of illiquid assets may be compensated for by higher returns. Illiquid assets can be difficult to sell as thin volumes or lock-up provisions prevent the immediate sale of the asset at a price close to its potential value.
The urgent sale of an illiquid asset can, therefore, be at a price consistently lower than the value that could be obtained from a long-term comprehensive search for a buyer. Given the difficulties of selling and valuing illiquid investments, investors demand a risk premium, or a price discount, for investing in illiquid assets. Some investors specifically increase their allocation to illiquid investments to earn this risk premium.
Inefficiency
The prices of traditional investments are determined in markets with a relatively higher degree of competition and, therefore, with relatively greater efficiency. In this context, competition is described as numerous well-informed traders able to take long and short positions with relatively low transaction costs and high speed. Efficiency refers to the tendency of market prices to reflect all available information. Inefficiency refers to the deviation of actual valuations from valuations that would be anticipated in an efficient market. Informationally inefficient markets are less competitive, with fewer investors, higher transactions costs and/or an inability to take both long and short positions. Accordingly, alternative investments usually offer higher returns based on pricing inefficiencies.
Non-normality
To a great extent, returns from almost all investments, and especially traditional investments, can be approximated as being normally distributed. The normal distribution is the commonly discussed bell-shaped distribution. However, over longer intervals, returns from many alternative investments exhibit non-normality in that they cannot be accurately approximated using the standard bell curve.
The non-normality of medium- and long-term returns is a potentially important characteristic of many alternative investments.
Risk management
Risks vary across alternative investments. The risks associated with investing in private markets, such as private equity (PE) funds, differ from those associated with investing in publicly traded markets like commodity futures. PE involves selecting companies and selling them years later. PE and hedge funds may have longer lock-up periods. As a result, investors’ funds may be tied up for years. The intermediate valuations are challenging. As a result, any malfeasance or mismanagement may go undetected for years, so due diligence on part of the investor is critical.
The illiquid nature of alternative investments also creates a lingering drag on the portfolio.
Alternative investments pose unusual challenges for investors seeking to manage risk. They are often characterised by asymmetric risk and return profiles, limited portfolio transparency and illiquidity. Because of the active use of derivatives, operational, financial, counterparty and liquidity risk are key considerations for investors.
Returns from some types of alternatives, such as PE, may rely to a great extent on the manager’s skill than on general asset class performance.
Though alternative investing can add value to an investor’s portfolio, to be effective it requires thoughtful implementation, including consideration of the amount to allocate to alternative investments and diversification. The portfolios of publicly traded securities are more liquid, with prices that are more timely and observable. For those who seek liquidity, publicly traded securities, such as shares of real estate investment trust, exchange-traded funds, and publicly traded PE firms, may serve as a means for investing in alternative investments.
As an individual investor, one can decide on an allocation keeping in mind his risk tolerance. The investor needs to decide the vehicles and the amounts to be allocated to each alternative investment class.
Navigating the road less taken
* Risks vary across alternative investments. The risks associated with investing in, say, PE funds, differ from those associated with investing in publicly traded markets like commodity futures
* Alternative investments pose unusual challenges for investors seeking to manage risk. They are often characterised by asymmetric risk and return profiles and limited portfolio transparency and illiquidity
The writer is associate professor of finance and accounting at IIM Shillong