Chapter 17: Alternative Investments “Alternatives”

What are alternative investments? Alternatives are those investments other than traditional investments, such as stocks and bonds. Examples include private equity funds and hedge funds. Both funds are typically structured as partnerships, and have a high barrier to entry due to the large minimum investments. A common structure may feature an asset-based management fee amounting to 1.5 to 2.0 percent per year as well as a bonus amounting to 20 percent of the profits.

Private equity funds usually have a longer-term focus, often purchasing companies to unlock value later through some liquidity event—such as a sale or public offering—or they may be focused on taking a publicly-traded company private.

Hedge funds often focus on trading strategies—trading stocks, bonds, currencies, and commodities. Hedge funds do not necessarily hedge their risk—often just the opposite. Many employ heavy use of leverage, and may amount to little more than a leveraged bet on a particular sector of the capital markets. Private equity funds use leverage as well.

Many hedge funds lack transparency. It can be difficult to pinpoint the true returns of hedge funds as a whole because so many of them go out of business, and their track record simply vanishes.

“Alternatives” may have a low correlation to traditional investments and are often used as a means of seeking greater portfolio diversification. Today, there are many investment vehicles in the alternative space, including some mutual funds, exchange-traded funds (ETFs) and exchange-traded notes (ETNs) which seek to mimic certain hedge fund strategies, such as long/short, arbitrage and others. Some provide exposure to a single commodity, such as oil, gold, silver, aluminum or copper. Some trade as open-end mutual funds and some, such as ETFs trade like individual stocks. Minimum investment amounts are lower as are the annual operating expenses compared to more traditional private equity or hedge fund partnerships.

In 2011, many investors were lured to alternative investments, hoping that they would find relief from hideously low bond yields and lackluster equity returns. Unfortunately, performance in the alternative space was disappointing as well—especially after fees are considered.

Exchange-traded notes are discussed in the next chapter.

Have a question? Contact Ed Mahaffy.

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