What you should know about Alternative Investments

This article gives a brief introduction to Alternative Investments. This is a very fascinating topic for me. I got interested in this asset class while studying for my CFA exams, this was by far my best course, I enjoyed studying it and yes, I scored very well on this topic. **ends background**

What does Alternative Investment mean? 

The CFA Institute defines “Alternative investments” as a label for a different group of investments that are distinguished from long-only, publicly traded investments in stocks, bonds, and cash (often referred to as traditional investments). If that sounds new to you, relax it's not so complex. Alternative Investments are investments other than traditional investments. In the Nigeria context, we mean investments other than your Zenith bank shares, FGN Sukuk bonds, Dollars/Pounds etc.

Alternative investments also include non-traditional approaches to investing within special vehicles, such as private equity funds, hedge funds, and some exchange-traded funds (ETFs). 

According to Preqin[1], the Asset Under Management - AUM of this industry has grown over the past 10 years: from $3.1trn in 2008 to more than $10.2trn in 2019. Preqin predicts that this figure will have reached a record $14trn by 2023. (AUM can be defined as the total market value of all alternative investments of a particular asset class managed within the industry)

How do you identify Alternative Investments?

Some characteristics of this asset class (alternative investment) are: 

• Less regulated and less transparent than traditional investments
• Difficult to value
• Illiquid (can not be converted to cash or its equivalent easily)

Why would you invest in Alternative Investments? 

Alternative Investments exhibit a low correlation with traditional investments, as a result, they provide diversification benefits to investors. This is important because the financial market has unsystematic risk i.e. risk that is unique to a particular company or industry e.g. Death of the CEO of Apple, Burnt down of an Amazon factory etc. This risk is reduced by investing in alternative investments.

J.P.Morgan Asset Management[2] also say that alternative investments bring AID (Alpha, Income and Diversification) to the traditional asset portfolio. 

What are the types of Alternative Investments?

Here are seven(7) types[3] of the alternative investments everyone should know: 

1. Private Equity

Private equity refers to capital investment made into private companies i.e. Companies not listed on a public exchange, such as the Nigerian Exchange[4]. Private equity encompasses a variety of strategies, including:

• Venture capital, which focuses on startup and early-stage ventures
• Growth capital, which helps more mature companies expand or restructure
• Buyouts, when a company or one of its divisions is purchased outright

2. Private Debt

A Harvard Business Review (HBR) post[5] describes Private debt as investments that are not financed by banks (i.e., a bank loan) or traded on an open market. The “private” part of the term is important—it refers to the investment instrument itself, rather than the borrower of the debt, as both public and private companies can borrow via private debt.

Private debt is leveraged when companies need additional capital to grow their businesses. The companies that issue the capital are called private debt funds, and they typically make money in two ways: through interest payments and the repayment of the initial loan.

3. Hedge Funds

A post from the Harvard Business Review (HBR) post[6] explains Hedge funds as investment funds that trade relatively liquid assets and employ various investing strategies to earn a high return on their investment. Hedge fund managers can specialize in a variety of skills to execute their strategies, such as long-short equity, market neutral, volatility arbitrage, and quantitative strategies.

Hedge funds are exclusive, available only to institutional investors, such as endowments, pension funds, and mutual funds, and high-net-worth individuals.

4. Real Estate

This can refer to the purchase of residential homes or the building of commercial offices or many types of real assets. Major examples include land, offices, multifamily residential dwellings, retail and industrial properties, residential homes and hotels.

Investors in real estate receive current cash flow from tenants paying rent—and their initial investment. The increase in the long-term value of the asset is called capital appreciation.

Valuation of real estate can also be a bit tricky here as with other real assets. However, the most recognized real estate valuation methods include income capitalization, discounted cash flow, and sales comparable, with each having its pros and cons. 

5. Commodities

Commodities are mostly natural resources, such as agricultural products, oil, natural gas, and precious metals. Commodities tend to move inversely with inflation, as a result, they are considered a hedge against inflation.

Investment in commodities can be made by buying the physical commodity, shares of natural resources or commodity-related companies, or commodity derivatives.

6. Collectables

Collectables include a wide range of items, from rare wines to vintage cars to baseball cards. Investing in collectables means purchasing and maintaining physical items with the hope the value of the assets will appreciate over time.

These investments are risky due to the high costs of acquisition, a lack of dividends or other income until they're sold, and potential destruction of the assets if not stored or cared for properly.

7. Structured Products

A Harvard Business Review (HBR) post[7] describes Structured products as products that usually involve fixed income markets—those that pay investors dividend payments like government or corporate bonds—and derivatives, or securities whose value comes from an underlying asset or group of assets like stocks, bonds, or market indices. Examples of structured products include credit default swaps (CDS) and collateralized debt obligations (CDO). Structured products can be complex and they played a role in the 2009 financial crisis. 

This wraps our introduction to Alternative Investment and its importance. There is still a lot to unravel in this asset class and I look forward to sharing them with you.

References

  [1] https://www.preqin.com/academy/lesson-1-alternative-assets/past-present-future-of-the-alternative-assets-industry

[2] https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/portfolio-insights/global-alts-outlook.pdf

[3] https://online.hbs.edu/blog/post/types-of-alternative-investments

[4] https://ngxgroup.com/exchange/trade/equities/listed-companies/

[5] https://online.hbs.edu/blog/post/types-of-alternative-investments

[6] https://online.hbs.edu/blog/post/types-of-alternative-investments

[7] https://online.hbs.edu/blog/post/types-of-alternative-investments