Alternative Investments: What Are They and How to Invest Successfully
What is an Alternative Investment?
Alternative investments provide different financial assets from traditional investments like stocks and bonds. When someone mentions “investing,” what typically comes to mind is putting money into the stock market and waiting for stock prices to rise. However, alternative investments refer to investing in areas other than conventional assets such as stocks, bonds, and cash. Different alternative investment vehicles such as real estate investment trusts, private equity, hedge funds, and mutual funds offer diverse investment strategies in pursuit of returns above the market average and allow investors to choose vehicles that suit their risk appetite. Also, alternative investments require expenses like management fees and performance fees since they are managed by fund managers. Although some alternatives have low or no qualifications to investing, most alternative investments require a high minimum investment amount, typically over $10,000. In fact, a large number of alternative investors are ultra-high-net-worth or institutional investors. Why choose alternative investments; who wants them?
People who invest their money into markets have different risk tolerances and risk appetite. Alternative investments offer different approaches to investing across markets and vehicles so that investors can utilize their money with strategies other than long-only equity and bonds. Generally, investors seek absolute return or relative return. Investors who invest in traditional assets will expect relative returns, which result in less losses compared to the performance of the market in a bear market and more gains compared to the performance of the market in a bull market. On the other hand, alternative investments offer absolute returns which are expected to make positive returns throughout their investment horizon either in bear or bull markets. Alternative investments hedge against risk because they have little or no correlation to traditional assets, so they are more attractive to investors looking to diversify their portfolios.
What Strategies do Alternatives Use?
To deliver those desired returns to investors, alternative investment vehicles offer a number of effective investment solutions with different strategies. Alternative investments include private equity and hedge funds, and they provide different solutions. Private equity is a type of alternative investment in which one can invest and own part of a company that is not publicly traded. Private equity has many sub-sectors, such as venture capital, leveraged buyouts, mezzanine capital and distressed investing. Each sub sector has different performance drivers at different stages of a company’s life cycle. There are two types of private equity that are more commonly known: venture capital and leveraged buyouts. Venture capital firms provides capital to startups or companies that are in early stage growth and own some portion of the company in which they invest. This type of investment does not provide constant income to the investors, but offers high capital gains. Since investors lend capital to companies in their early stages and expect future growth, VCs are very risky and require investors to be thorough and informed during the decision-making process. On the other hand, in a leveraged buyout, a private equity firm acquires a business using leveraged loans, which are secured by the target company’s assets, and sells the business several years after the acquisition. LBOs have some risks of bankruptcy due to leveraged loans, but they will create value for a variety of parties if successfully done.
Another interesting and well-known method of alternative investing is by investing in hedge funds. A hedge fund is an investment pool operated by fund managers with specific strategies and goals. Hedge funds commonly offer a solution by employing a combination of different strategies. There are a variety of hedge funds styles and investors may choose a hedge fund manager or managers based on their risk appetite and preferred fund style.
Global Macro is one of the most famous styles of hedge funds. Global Macro generally looks into a broad range of markets and asset classes all over the world and seeks inefficiencies in markets. Geopolitical uncertainties, tensions among countries, and debt sustainability may matter to Global Macro hedge funds to make an investment decision, since those uncertainties may cause inefficiencies in markets. Global Macro hedge funds have the ability to take long or short positions in any global market using any financial instruments. Global Macro can be very opportunistic, but also, of course, can be very risky.
Similarly, event-driven style is referred to as Special Situations and it is also a high risk-bearing investment strategy. This type of hedge fund looks for special situations or corporate events that cause price inefficiencies and makes profits from those corporate events. Corporate events can include mergers, restructuring, reorganizations, spin-offs, bankruptcies, divestitures, and legal situations. The risk of this type of strategy can be significant. Many corporate events can be extremely complex and require many steps to be fully completed.
Overall, alternative investments can offer a good diversification to investors’ portfolio with non-market correlated positive returns. To succeed in alternative investments, picking good alternative investment managers who are capable of producing absolute returns throughout the economic cycle is the key for investors to succeed in investments.