Alternative Investing

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Meryl Nash
9 years ago
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1 BigFuture s Guide to Alternative Investing TRACT LEARNING: Asset Allocation Module 2

2 Alternative Investing: Use of the term alternative investments has increased over recent years, although it remains ill defined. An investment is usually considered alternative if it doesn t fit into any of the major asset classes; i.e., listed equities, property, bonds, and cash. Examples of alternative investments are hedge funds, leveraged funds and/or infrastructure funds. Investors in some countries would call property an alternative investment, whereas most Australians would call property a major asset class. Hedge funds often have an objective to make a positive return even when the major asset classes decline. Sub-categories of hedge funds include event driven, relative value, directional, multistrategy, long-short equities, convertible arbitrage and special opportunity funds (see Appendix for details). Because hedge funds aim to make a positive return every year, they are sometimes called absolute return funds. Making a positive return, no matter what the financial environment is for the major asset classes, is one of the attractions for investors to include hedge funds in their investment portfolio. Note that, just because delivering absolute returns is the objective of many hedge funds, doesn t mean they actually deliver on this objective! Hedge funds are often sold as part of a private partnership. The legal structure can be complicated. Hedge funds are more lightly regulated than retail funds and many hedge funds cannot be sold directly to retail investors. In addition, the minimum investment amount is often large; too large for a retail investor. Hedge funds typically have much higher fees than those paid for funds investing in the traditional major asset classes, and almost always include a significant performance fee. Hedge funds justify the higher fees because all the funds are invested to make an active return. An active return is the return made from a manager s insight or skills. Traditional asset classes have lower fees, but the fund s return can be broken down into systematic return, the return from the general movement of the asset class which is outside the control of the fund manager, and the active return resulting from the manager picking those securities that will out perform the general movement of the asset class. Leveraged funds can be hedge funds, property funds, infrastructure funds or traditional asset funds with debt. It is any fund that borrows money with the aim to make higher returns than if the investment strategy had no debt. For example, an ASX equities fund could borrow from a bank and invest more in equities than the investors initial amount. If the share market increases, the return of the fund will increase even more. However, the fund return will be reduced by the interest cost paid on the debt. Should the share market fall, the fund will fall even more, plus the fund must still pay the interest on its debt. 1.

3 Continued: Illiquid funds are any fund that purchases assets that are not easily sold back to the market. Investors in illiquid often earn a liquidity risk premium. This extra amount is to compensate an investor for the fact investors cannot easily get their money back nor easily reduce the investment risk should markets decline. Some overseas investors would treat direct property investment as an alternative asset. Property is illiquid as it is difficult to quickly sell. Property often has bank debt (i.e., a mortgage) attached to the asset. Illiquid funds also include infrastructure funds, some credit funds and private equity. Private equity is a very common illiquid fund. Like hedge funds, private equity funds are often structured as a limited partnership. Investors are required to remain in the fund for a period of time before they can get their money back. This is called a lock up period. Private equity funds invest in numerous types of investments including companies that are just starting out with a new idea (frequently call venture capital funds), companies that could grow quickly with additional capital, or where a company s management team sees more value in buying the company (management buy-out funds). Why are alternative investments included in a portfolio? Investors include alternative investments in their portfolios because they expect to make a return commensurate with the amount of risk they are taking. In some cases the returns could be uncorrelated with the risks with the major asset classes in their portfolio, which provides additional benefits through diversification. Even if the return from an alternative investment is below that of another asset class with equal amount of risk, it may still make financial sense to invest some money into alternative investments. This is because adding an asset class that is not subject to the same influences as the major asset classes could lower the total risk of the portfolio and thereby improve the return efficiency. 2.

4 Summary: Alternative investment funds are growing in popularity as investors seek returns that are not correlated to traditional asset classes. Alternative investments may have complicated legal structures, be illiquid, and have high fee structures. In many cases alternative investments are much more complex investment options and retail investors cannot easily access them. For retail, and even professional investors, having access to expert advice as to what alternative fund to invest in is critical. Some alternative funds such as property, infrastructure, private equity, hedge funds and credit funds are becoming increasingly popular in superannuation funds. Appendix : types of alternative investments 3.

5 Continued: Visit Us At: BigFuture.com.au 4.

6 GENERAL ADVICE WARNING Any advice on this website is of a general nature only and has been prepared without taking into account your objectives, financial situation or needs. Before you act on any advice on this website, please consider whether the advice is appropriate for you having regard to your objectives, financial situation and needs. It may be prudent for you to seek appropriate licensed financial advice before making any decision. The content is provided by BigFuture Pty Ltd.

Learn about alternative investments. Investor education

Learn about alternative investments Investor education Special investment instruments may help enhance a portfolio Once the exclusive domain of the ultrawealthy, alternative investments are beginning