Introduction to Alternative

Investments
•Defining alternative investments
•Importance of alternative investments
•Need for alpha-beta separation
Asset Classes
In order to have a diversified portfolio, we need to understand various asset classes as
investment options.

Assets are often classified into two distinct classes:

Traditional Assets, and

Alternative Investments
There is no fundamental economic difference between these classes except that
alternative investments generally:

Are less liquid

Are more difficult to value
Have limited historical risk and return data
Compared to traditional assets

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 Alternative Asset Classes
Investment Funds
Investment funds are intermediaries that invest investor pooled funds for a fee.

The investor usually receives a share of the fund proportional to his/her investment.

Investment funds are either managed or unmanaged.

Unmanaged funds are also called Unit Investment Trusts and hold
a fixed portfolio for the life of the trust and is often tax exempt.
Unmanaged funds are usually ready to redeem investors’ shares
immediately at market value.

Managed funds are in turn classified in terms of their

readiness to redeem investors’ funds.

Open-end funds (Mutual Funds) do redeem at request

Closed-end funds do not . Instead they issue shares
that are then traded on secondary markets
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 Traditional Asset Classes
Traditional asset classes include:
Domestic equity
U.S. treasury bonds
U.S. municipal bonds
International developed market equity
International emerging market equity
U.S. blue chip corporate bonds
Cash

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 Alternative Asset Classes
Alternative asset classes include:

Investment Funds
Tangible Assets
Commodities
Absolute Return Investments
Derivatives and Exotics

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 Alternative Asset Classes
Investment Funds
Valuation
The basic valuation metric is Net Asset Value (NAV), the per share value of the
investment company’s assets minus its liabilities. The most significant liability comes
from fees owed to investment managers (if any).

For unmanaged and open-end investment funds, the share value is the NAV as they
stand ready to redeem at market value.

For closed-end funds, the share price is determined in a secondary market and may be at
a premium to the NAV or at a discount to it.

Fees are usually calculated as a % and are either

one-time or periodic (e.g. annual). One-time fees
may be front-end loaded (a % of purchase) or
back-end loaded (a % of value at exit). Back-end
charges may be declining (reduce as you stay in
the fund)
 Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
ETFs allow investors to buy or sell exposure to an index through a single financial
instrument. They trade on a stock market just as shares of any individual company.

ETFs have many advantages:

Can assist in diversification. With a specific type of ETF (say an
equity-oriented ETF), the investor can gain exposure to
different types of capitalization (large cap, mid cap, etc.), style
(value or growth), sector, industry or country or region.

ETFs trade as stock and can be sold long or short or bought on

margin.

Traditional mutual-funds often are traded only once a day at

closing, ETFs trade throughout the day.

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 Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
ETFs advantages (cont’d):
For many – if not most – ETFs, there exists futures and
options contracts on the same index.

ETF portfolios are published on a daily basis whereas other

funds are only published quarterly at best.

ETFs are cost efficient. You can buy exposure with one
transaction that otherwise would require establishing an
entire portfolio wit many individual transaction fees

ETFs are cost effective. There are no load fees, and the
expense ratio can be held low as there is no shareholder
accounting at the account level.

Dividends are reinvested immediately whereas for mutual

funds timing of reinvestment varies.
 Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
ETFs dis-advantages:

In many countries, actively traded ETFs track only

a narrow-based index, such as only large-cap
stocks. No ETFs are often available for mid and
small cap investments. This is NOT the case in the
US.

Some ETFs do not have sufficient trading volume

to have a small bid-ask spread.

ETFs are often of limited use to very large

institutional investors as they can invest directly in
an index (roll their own). The costs may be less
and the tax situation usually better.

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 Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
Risks of ETFs:
The following are the risk elements that must be considered when valuing an ETF. Note
that not all risks impact all ETFs uniformly:

Market risk: Like all other market based investments, the value/price of an
ETF (NAV) changes with the changes in the market.
Asset class/sector risk: Any asset class or sector may underperform the
market.
Trading risk: As there may always be market impediments, the ETF may trade
at a discount to its NAV.
Tracking error risk: ETFs are constructions. They are designed to track their
corresponding index closely. They cannot guarantee this.
Country and currency risk: ETFs may be subject to unfavorable fluctuation in
currency or stability of the country in which the ETF has invested. 10
 Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
Applications of ETFs

Implementing asset allocation: ETFs can be used to effect asset allocation among
baskets of stocks, bonds and other assets
Diversifying sector or industry exposure: ETFs can be used to diversify away the sector
or industry specific event risks
Gaining exposure to specific market on a broad basis
Equitizing cash: By investing in ETFs investors may be able to put idle cash to good short-
term use
Adjusting the portfolio: Investors can use ETFs to quickly adjust exposure to an industry
or sector to re-align an overall strategy

Applying sophisticated tactics: Investors can long, short, leverage and time ETFs
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 Alternative Asset Classes
Tangible Assets
Tangible assets, as opposed to financial assets, are those assets that may be touched and
seen in themselves in addition to their ownership documents.

Tangible assets come in a wide variety including:

 Land
 Buildings
 Natural resources (timber, minerals, fish)
 Vehicles (e.g. ships), containers, etc.
 Artworks

We will concentrate on Real Estate (land, buildings and land based

resources), as it is by far the largest section of this category

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 Alternative Asset Classes
Real Estate
Real estate investments may be actual (tangible) or derivative (intangible).

Actual real estate may be:

Non-value added (land)

Value-added (land and buildings)
Value-adding real estate (timberland, mines, etc.)

Derivative real estate investment are securities derived from the sale of real estate or
related to the sale of real estate (such as buying mortgages or mortgage-backed security
bundles)

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 Alternative Asset Classes
Real Estate
Forms of Real Estate Investment
Free and clear holding: Unencumbered full ownership rights for an indefinite period

Leveraged equity: Full ownership rights for an indefinite period encumbered by debt (a
promissory note unrelated to the real asset under consideration) or a mortgage (a pledge
that in case of inability to discharge the debt, the ownership would transfer to the
mortgagor)

Mortgages: Loans secured by the underlying real estate made to third parties

Aggregation vehicles: Aggregates investors and gives them access to real estate investment
to which they may not otherwise have access. Real Estate Limited Partnerships (RELP) and
Real Estate Investment Trusts (REIT) are examples of these aggregation vehicles

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 Alternative Asset Classes
Real Estate
Valuation
Real estate valuation is very difficult
One often has to estimate the actual value of the asset, AND the value of the potential
“value added” income streams, AND the on-going cost of ownership
Note that:
Properties are immovable and usually indivisible and
as such usually very illiquid
Properties are only approximately comparable in
value
There is no national or international real estate
auction market, to determine values by consensus
Transaction costs and management fees are usually
very high

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 Alternative Asset Classes
Real Estate
Valuation
Basically there are four approaches:

1. The replacement cost approach:

How much would it cost today to replace this real asset? Of course one needs
to estimate the value of land (an independent exercise), PLUS estimating
today’s cost of the current improvements.

This approach is limited in value as a) we still

need to estimate the value of the land, and b)
the market value of a building may differ
enormously from its construction cost (an
office building may be very valuable because it
has some prestigious, long term tenants)

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 Alternative Asset Classes
Real Estate
Valuation
2. The sale comparison approach:
How does this property compare to a similar property whose value is known,
or the median or average of a collection of “similar” properties.
A variation called hedonic valuation is when the major characteristics of a
property are evaluated on an ordinal (1-10) or absolute ($) scale and and used
to modify the estimate.

This approach has become

standard in valuation of
residential properties and
its use in commercial
appraisals is increasing

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 Alternative Asset Classes
Real Estate
Valuation
3. The income approach:
This method uses a perpetuity discount model to value real estate.

The perpetuity is the annual Net Operating Income (NOI). NOI is gross potential
income minus expenses including vacancy, collection losses, insurance, property
taxes, repairs, utilities, and maintenance costs.

Appraisal rate = NOI ÷ Market Cap Rate

where Market Cap Rate = Benchmark NOI ÷ Benchmark Transaction Price

Benchmark may be a single property or the average or median of a number of

properties

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 Alternative Asset Classes
Real Estate
Valuation
4. The discounted after-tax cash flow approach:
This method is based on the fact that an investment is worthwhile when its
expected net present value is positive. Alternatively, the investment yield (internal
rate of return) should exceed the investor’s required rate of return.

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 Alternative Asset Classes
Commodities
While investing in most stocks and in corporate bonds allow the investor to invest in an
economy’s manufacturing and service sectors, and government bonds allow investment
in the government, commodities allow investment in the primary production of an
economy.
Commodities generally come in three categories:

Energy:
Agricultural and farming products (soft
Oil, gas, electricity
commodities:
Fibers, grains, livestock, beverages
(coffee, cocoa, etc) , spices, dairy
Minerals:
Gold, silver, copper,
coal, aluminum

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 Alternative Asset Classes
Commodities

Most investors do not wish to store grain or oil or tend to animals. Very few investors
(as opposed to consumers) buy the actual commodity.

Investment in commodities is usually indirect by way of:

Future contracts
Commodity or inflation indexed bonds
Stock of primary production companies

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 Alternative Asset Classes
Commodities
Futures Contracts
As we have learned, a futures contract is a standardized, exchange-traded agreement
between two parties in which the buyer agrees to buy an asset from the seller at a
future date at a price agreed upon at contract time.

Futures contracts are the easiest and cheapest way to invest in commodities.

There are two types of commodities futures indices:

Broad-based (tracker)
Investible Index

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 Alternative Asset Classes
Commodities
Futures Contracts
Broad-based Tracking Indices:
Several commodity indices have been developed. Some traditional indices are broadly
based and have a global perspective and aim to track the changes in input prices.

Investible Indices:
are in turn based on a limited basket of the most liquid commodity futures contracts
so they can be easily replicated by taking proportional positions in the participating
commodities. For example, the Goldman Sachs Commodity Index (GSCI) is a world-
production weighted index of 24 commodities with liquid futures contracts

Although available elsewhere, commodities usually have their own

exchanges. For instance the Chicago Mercantile Exchange (CME) is the
largest of its kind in the US.

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Alternative Asset Classes
Commodities
Commodity-Linked Bonds
During inflationary periods, many governments have
been forced to offer loans (bonds) with coupons or
principal indexed to either the price of a specific
commodity or an inflation index.

Examples are: The Gilt in Britain (based on the price of

gold and introduced in the 1980s) and the Treasury
Inflation Protected Securities (TIPS). The principal is
indexed to the consumer price index CPI and as such
(somewhat indirectly) to commodity prices.

Many other countries such as France, Australia, Sweden,

Canada, and Italy have offered bonds based on the price
of gold, oil, or agricultural products.

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 Alternative Asset Classes
Commodities
Stock of Primary Production Companies
BHP Billiton (BHP) is an Australian conglomerate involved in oil production, oil
exploration, gold mining, agriculture, coal, bauxite, and commodities management. Of
course buying a share of BHP Billiton would be investing in a diversified basket of
commodities!!

There are many companies similar to BHP and those that are more focused on a single
or narrow range of commodities such as Exxon-Mobil. Single product mining
companies are a good example of a stock very directly influenced by the price of the
underlying product.

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 Alternative Asset Classes
Commodities
Investment Features
Commodities tend to have positive correlation with inflation
They tend to have a low or negative correlation with stocks
Supply and demand clearly has a determining role in the price of commodities as often do
weather and fuel (transportation) costs.
The general growth in population and demand from emerging nations would in long-term
help to increase all commodity prices
Improvements in technology, transport and means of production would tend in long-term
to lower commodity prices.

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 Alternative Asset Classes
Commodities
Investment Examples
Futures:

Cocoa (CJ, CC); Coffee (C, KC, KT, KO); Corn (ZC); Cotton (TT, CT)

Company Stock:

Monsanto (MON); Deere and Co. (DE); Bunge (BG)

Funds:

DB Agriculture Fund (DBA); MLCX Grains Index (GRU); Dow Jones USB Cocoa Total
Return (NIB); Dow Jones USB Sugar Total Return (SGG)

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 Alternative Asset Classes
Absolute Return Investments
Many investments seek above market returns (alpha) through pursuing opportunities
that do not correlate with specific market securities, indices or securities markets. In
fact, the only way to generate alpha is to go beyond the characteristics and provisions
of the market.
There are two ways of creating such absolute return:

Working outside the “market”

Playing “against” the market

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 Alternative Asset Classes
Absolute Return Investments
Private Equity Investing
Working outside the markets means creating absolute return and hopefully absolute
value, by working outside or almost outside the context of the public securities market.
Private Equity Investment is the means by which an investor can play outside or almost
outside the securities markets sandbox. There are several approaches:

 Venture capital investing

 Privatization through buy-outs, takeovers,
(management buy-outs), and leveraged buy-outs
 Vulture (distressed asset) Investing

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 Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Playing against the market means using hedging and other techniques to try to create
opportunities to reduce or eliminate risk or increase return not normally available in
the regular market.
Although the original “hedge funds” were funds that used hedging to secure an
advantage, today this term is applied to a wide variety of funds whether or not they
engage in hedging. Colloquially, a hedge fund these days is any fund that:

 Uses sophisticated means and vehicles of

investing to isolate specific bets to generate alpha
 Is focused on performance relative to a pre-
assigned benchmark
 Has greater flexibility (fewer constraints) in how it
can invest
 Has a small and “elite” client base with high barrier
to entry

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 Alternative Asset Classes
Absolute Return Investments
Private Equity Investing
Private equity investing has several characteristics that although some are common to
other alternative investing in general, make private equity investing what it is:

 Illiquidity
 Long term commitment required
 Difficulty in valuation
 Limited historical risk and return data
 Investor (equity company) and
management mismatch
 Hands-on

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

 Long/Short (Real Hedge) Funds

 Market-Neutral Funds
 Macro (Global Macro) Funds
 Managed Futures Funds
 Emerging Markets Funds
 Emerging Sectors Funds
 M&A Arbitrage Funds
 Fund of Funds Funds

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Long/Short funds are traditional hedge funds, taking short and

long bets in generally common stocks. They vary their long and
short exposures according to forecasts, use leverage and operate
on numerous markets throughout the world. They often maintain
net positive or net negative positions.

These funds are seeming the simplest in terms of philosophy but

often amongst the most sophisticated in terms of execution and
technology (they need to be).

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Market neutral funds attempt to hedge against a general market movement. They
take bets on valuation differences of individual securities or funds within some
market segment. This could involve simultaneous long and short positions in
closely-related securities with a zero net exposure to the market itself. A market-
neutral portfolio is usually constructed so it is:
Dollar neutral (equal $ value of long and short positions)
Beta neutral (total sensitivity of long positions equal that of short positions)

Long positions may be (usually are) in stocks considered undervalued, and the
shorts are in stock considered overpriced.

Leverage is generally and often liberally used to enhance the returns

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Global Macro Funds take bets on the direction of a market, a

currency, an interest rate, a commodity, or any macroeconomics
variable. These funds tend to be highly leveraged and make
extensive use of derivatives.

There are many sub-groupings but three are particularly

prominent:

Managed Futures Funds

Emerging Markets Funds
Emerging Sectors Funds

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Managed Futures Fund are pools in which fund managers take bets on
directional moves in the positions they hold (long or short) usually in a single
asset class, such as currency, fixed income, or commodities and tend to use
many actively traded futures contracts.

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Emerging–markets funds primarily take bets on all types of

securities in emerging markets. The securities in these economies
are usually less efficient and less liquid than those in the developed
markets thus allowing for greater arbitrage potential. But as there
typically is not an organized lending market for securities, it is
difficult to sell short or leverage most positions. Emerging markets
represent growth but they also tend to be more volatile and subject
to political and currency risks.

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Emerging-sectors funds primarily take bets on all types of securities in

emerging sectors and technologies. These securities are usually subject
to a good deal of growth although there is a corresponding level of
volatility. As emerging sectors are by definition new, there is little
historical data to guide investment.

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 Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Merger and acquisition arbitrage funds bet on the price difference between the
stock price of a company just before merger or acquisition goes through and the
acquisition strike price. Before the effective date of a merger, the stock of the
acquired company will typically sell at a discount to its acquisition value as
officially announced. A hedge fund manager simultaneously buys stock in a
company being acquired and sells short stock in the acquirer.

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Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications

Funds of funds have been created to allow easier access to hedge funds by small
investors. An FoF has access to a large potential investor base (albeit each may
invest a much small amount; that is the point) but has enough funds to invest in
a variety of hedge funds thus providing retailing, access, diversification, and
expertise to those who otherwise may not be able to enjoy these in the context
of multiple hedge funds.

There are drawbacks with FoFs. They have fees of their own on top of the base
hedge fund fees, their performance will be diversified (diluted) if not all funds
perform. Also, as funds in FoFs are selected based on past performance, they
may be already passe by the time they make it into a FoF.

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 Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Sources and Indices
There are literally thousands of hedge funds around. To be able to operate as a true
hedge fund, they are not allowed (by the SEC) to advertise for the purpose of investor
solicitation. However, there are several firms, banks, index providers and even
educational institutions that provide indices in which these funds can “volunteer”.
These include:

Specialist firms: Hedge Fund Research, Van Hedge, Hennessee, Greenwich

Banks: Credit Suisse/Tremont, ABN AMRO EurekaHedge
Index providers: MSCI, S&P, FTSE
Educational Institutions: CISDM (Umass), EDHEC (school in France)

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 Derivatives
The previous pages show us that we no longer live and invest in the simple world of
stocks and bonds. Many new instruments have emerged, several – if not most – of which
no longer represents a direct investment in an asset but ones that offer a return based
on the return of another underlying asset. These are called derivatives.

Derivative: A financial instrument that offers a return based on the return of some
other underlying asset.

Derivatives are called thus as their value is derived

from the return of the underlying asset

A derivative is a contract that initiates

on a certain date and terminates on a
later date. Often (but not always) the
payoff is determined on the expiration
date

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 Derivatives
Types of Derivatives
There are two distinct but ultimately related markets for derivatives. Derivatives may be:
Exchange traded contracts: which have
standard terms and features and are
traded on an organized trading
facility/exchange such as a futures
exchange or an options exchange.
Over-the-counter contracts: which are
transactions created by two parties
but not traded on an exchange and
usually representing a “private” deal
vis a vis an underlying. This could be a
wide array of deals including
purchasing of insurance.
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 Derivatives
Forms of Derivatives
There are two distinct forms of derivatives. Derivatives may be:

Forward commitments: which are Contingent claims: which are

agreements between two parties in
which one party agrees to buy from
the other party an underlying asset at
a future date at a price established at
the start.
derivatives in which the payoff occurs
if a specific event occurs. We generally
call these types of claims as options.

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 Derivatives
Forms of Derivatives
Forward Commitments
Forward commitments come in three categories:

Forward contracts or Forwards: This is a Futures contracts: which are a variation of a

forward commitment in which the two forward commitment that is a public,
parties “privately” design and therefore exchange-traded, standardized transaction
customize the deal. The underlying could be the protection re the default on which is
anything from a pizza to Pizza Hut Inc. guaranteed by the exchange. Futures are
available on a wide range of commodities,
Swaps: which are a variation of a forward currencies, stocks, funds, etc.
contract (actually it is simply a series of
forward contracts) in which the parties agree
to swap a series of future cash flows.
Generally at least one cash flow’s value is
determined by a later outcome

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 Derivatives
Forms of Derivatives
Contingent Claims
Warrants
Options are by far the largest category of contingent claims. Other forms of contingent
claims (all having option-like features) are:

Warrants: are issued by the firm whose stock (sometimes bonds) serves as the
underlying. At the time of issue, a warrant entitles the holder to purchase one share of
the stock for the appropriate exercise price. Further stock splits may alter the
proportion, always reflecting the original offer. The major differences between warrants
and call options are that:
Warrants have longer expiry than call options,
sometimes they are perpetual;
Warrants are dilutive, when a warrant is exercise,
the company must issue new stock;
Most warrants are over-the-counter

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 Derivatives
Forms of Derivatives
Contingent Claims
Callable/Putable Bonds
Callable/Putable bonds: A callable/putable bond gives the issuer/buyer the right to
redeem the bond for a pre-agreed price before the maturity or (in rare occasions)
under certain pre-specified conditions).

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 Derivatives
Forms of Derivatives
Contingent Claims
Convertible Bonds

Convertible bonds: Again, we have seen these before. A convertible bond is a bond that
carries the right at the holder’s option (the contingent claim) to convert it to another
security, often common stock.

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 Derivatives
Forms of Derivatives
Contingent Claims
Asset-backed Securities
Asset-backed Securities represent a claim on a pool of securities which may be
mortgages, automotive loans, bonds, and similar instruments. As borrowers always have
the option to pre-pay these loans when interest rates are favorable (re-finance), they
hold an option. The investor who buys into the pool of such loans, is in fact selling an
option.

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 Derivatives
Forms of Derivatives
Contingent Claims
Options
All contingent claims have an option (in the sense of a choice to take action) at their
core. As such one can consider them all as types of option instruments (some do).
A proper option however is usually a standardized, more often than not exchange
traded instrument that has a contract associated with it called a term sheet that at a
minimum specifies the following:

The underlying asset

The right(s) or exercise terms, (call/put)
Settlement terms (e.g. deliver the underlying or an equivalent value)
Expiration date
Strike price (the price of the underlying)
Option price (the premium payable/paid to hold the option)

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 Understanding Returns
• Investment returns are culmination of market return (Beta) &
excess returns (Alpha). Don’t extract Alpha from Beta.
• Beta is the risk/reward of a portfolio that is explained just by
being in a particular market.
• Alpha is excess return—that elusive edge that lets a
investment manager beat the market.
• Retail investors do not separate Alpha and Beta. When they
buy an active mutual fund, for instance, you’re buying a lot of
Beta and a little bit of Alpha. Index mutual funds and ETFs
help us in getting Beta market exposure inexpensively.
• Institutional investors decouple the two, separating their
decisions about Alpha from that of Beta. This helps them to
maximize returns, minimize costs and manage portfolio risks.
 Modern Investment Management
• Two fundamental revolutions:
– Creation of the first mutual funds in the 1930-40.
– Creation of the first index funds in the 1970s.
• The next revolution:
– Separation of Alpha and Beta are tremendously powerful
in managing risk and containing costs.
– Those that segregate true Alpha can provide investors
unique, uncorrelated sources of return.
– Uncovering hidden Beta (Alternative Beta) can be indexed
and turned into investable products such as hedge fund
replication funds, giving investors access to entire asset
classes that were previously inaccessible.
Drivers of Alpha & Beta
Absolute return strategies: where the hedge
fund manager is unchained from a stock-and-
bond index.
Market segmentation: allows fund managers
to identify sweet spots within a broad asset
class like collateralized debt market.
Concentrated portfolios: offers greater
opportunity for excess return. Eg: CGF & PEF
have only a few very concentrated positions in
their portfolio.
Nonlinear return distributions: exhibit option-
like payoffs with a “kinked” distribution or
may replicate an option payoff structure by
virtue of their trading strategy. Eg: merger
arbitrage, event-driven, fixed income
arbitrage, and managed futures.
 Rethinking Asset Allocation
Strategic Asset Allocation Equity Beta & Alpha Drivers
 Conclusion
• Think outside the benchmark.
• Recognize that alpha can be generated
across asset class boundaries.
• Consider the risk of failing to out perform
a peer group.
• Pursue alternative assets where you have
the greatest informational advantage.