Alternative assets 101: The basics
Alternative assets, or alternative investments, are those that are not considered to be mainstream assets like equities, bonds, or cash.
Classic examples of alternative assets include commodities and hedge funds. However, the alternative asset universe is fluid with new instruments constantly being developed.
Alternative assets typically have a low or negative correlation with traditional asset classes. Therefore, they can help investors diversify their portfolios efficiently and can provide enhanced returns.
However, transaction costs for alternative assets can be high and their secondary markets are less liquid than those for conventional assets.
What is an alternative asset?
Alternative assets (or alternative investments) are generally considered to be assets that are not mainstream (“traditional”) assets such as debt and equity. Examples of alternative assets include real estate, hedge funds, private equity, commodities, and currencies.
Alternative assets typically exhibit the following characteristics:
- Limited investment history
- Illiquid (or non-existent) secondary market
- Different performance characteristics to traditional assets
- Specialized skills required on the part of the asset manager
In contrast, traditional assets are typically traded in liquid public markets and are managed by mainstream strategies.
There is some debate over classification of alternative assets. For instance, some consider real estate to be a mainstream asset. However, because real estate offers a different set of features and characteristics to stocks, bonds, and cash (which are the foundation of traditional investment portfolios), it is categorized here as an alternative asset.
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Investors in alternative assets
There are two categories of investors in alternative assets.
Institutional investors
Institutional investors are attracted to alternative assets as these investments are long-term and illiquid in nature, thus enabling them to match these assets to their long-duration liabilities.
High net worth investors (HNWIs)
Sophisticated private investors are leading investors in alternative assets. Some of these invest directly; for example, wealthy individuals may invest in start-up businesses in return for an equity stake, while other investors may invest directly in real estate.
Types of alternative asset
The main types of alternative asset are as follows:
- Real estate
- Hedge funds
- Private equity
- Infrastructure
- Exchange-traded funds (ETFs)
- Commodities
- Currencies
- Distressed securities
- Credit derivatives
- Managed futures
- Volatility
- Art and collectibles
Regulation of alternative assets
Historically, alternative assets have generally been subject to light regulation. For example, until recently, hedge funds were exempt from many of the regulatory requirements of the Securities and Exchange Commission (SEC).
Alternative assets came under the regulatory spotlight following suggestions that some funds and instruments contributed to the global financial crisis. For instance, hedge funds can be vulnerable through overreliance on leverage or on “crowded” trading strategies that amplify any downturn.
Under the Dodd-Frank Act, hedge funds in the US are required to register with the SEC and both they and private equity firms are subject to greater disclosure requirements – although there are some exemptions to this rule. Private investors must meet minimum “qualified purchaser” requirements in terms of income and net worth.
The Alternative Investment Fund Managers Directive (AIFMD) forces hedge funds in the European Union to register with national regulators. This directive increases capital requirements for hedge funds and places further restrictions on leverage utilized by the funds.
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Liquid alternatives and their drivers
Following the global financial crisis, interest rates in the major global economies fell to historical lows and have remained low ever since. This resulted in minimal, and even negative, returns on cash and some interest rate-related investments.
Investors, desperate for yield, began to divert more of their portfolios into equities. But equities can be affected by any sort of uncertainty in the markets and global economy, which can lead to volatile returns and losses.
Institutions and individuals with large sums to invest have always been able to use hedge funds as a conduit to improve returns, but investors with smaller portfolios have generally been restricted to standard investment funds such as mutual funds (at least until the emergence and rapid growth of exchange-traded funds [ETFs] from the 1990s onward). Most of these funds specialize in “long-only” positions and their returns are constrained by a low interest rate environment or exposure to a sudden downturn in the market.
Fund managers, recognizing the problems that these investors were experiencing, responded by expanding their choice of funds. These newly-created funds had the characteristics of safe and regulated investment funds as well as the return enhancements offered by hedge funds. These hybrid funds are mostly known as “liquid alternatives” (or simply “liquid alts”), but may also be referred to as “absolute return” or “40 Act” funds.
Investors regard liquid alternatives as a way of maintaining returns, regardless of financial market volatility and direction, and obtaining portfolio protection in times of crisis. Many investors maintain positions in long-only funds in order to take advantage of rising markets, but also have a significant percentage of their portfolio in liquid alternatives as part of a diversification strategy.
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This content is taken from Intuition Know-How, the world’s premier digital learning solution for finance. Click here to learn more about Know-How.
