Alternative investments and the CFA

Published on September 30, 2020   14 min
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One increasingly popular area of the financial markets that many students and financial professionals are very interested in focuses on alternative investments. Today, I'd like to talk to you about the basics behind what we call alternative investments, and in particular, talk to you about some of the areas you might be wanting to focus on if you're going to take the CFA exam. Let's get started, shall we?
When we think about traditional assets out there, we're typically thinking about stocks and bonds or equities and fixed-income securities. There's a lot of benefits or advantages to these traditional assets. We have large global markets, lots of liquidity, easy price transparency, there are regulated markets where we can be pretty confident we're getting a reasonable price, it's easy to get in and out of them, and we have both opportunities for individual investors as well as professionally managed mutual funds. But there's an alternative to these traditional assets.
That alternative is what we're talking about today. Alternative assets are loosely defined, there's lots of different examples that could fit in. But the main ones that people talk about are real assets, private equity, hedge funds, and then a less common set of alternative alternatives. When we think about real assets, we're really referring here to, perhaps most commonly, real estate, but also things like land, timber, commodities, stuff like that. This could be anything from an industrial warehouse, as an example, to a high rise apartment building, to a forest that we're going to cut logs down from periodically. That's real assets. We also have private equity. Private equity includes venture capital, that is funds that go out and try to find high-growth early-stage companies and invest in them, but it also includes leveraged buyout funds, mezzanine funds, distressed funds, and a variety of other strategies. There's lots of famous big-name private equity firms out there, Blackstone, Apollo, Carlyle, KKR, etc. These funds have been very successful over time for investors, and so they've grown tremendously. Third, we have what we refer to as hedge funds. Hedge funds still invest in common equities, that it is stocks, but they use alternative investment strategies. Some of the big hedge funds that are well-known out there would include Bridgewater as an example, AQR, Renaissance Technologies, Two Sigma, and others. Hedge funds could invest in anything from commodities to foreign currencies, to stocks, etc. They can basically invest in anything they want. What makes them an alternative is the fact that they use complex strategies in order to make those investments on behalf of their investors. Regardless of the type of alternatives we're talking about, they usually share certain characteristics. In particular, number 1, they're generally fairly illiquid, and as a result, they're difficult to value. We don't know exactly how much our hedge fund stake is worth. We don't know exactly how much our forest in the middle of Montana is worth, for instance. We hope that the value is going to go up over time, but we don't really know at any moment exactly what it's worth. We have limited price transparency. In addition, alternative assets are usually restricted to wealthy investors and larger institutional investors. The reason for that is because they're considered to be riskier. They might have higher returns, but they're considered to be riskier and so the government, regulators don't generally want to let ordinary people take a risk on that because it's presumed to be too risky. The average individual can't necessarily afford to lose their money on that kind of a risky investment. Because these are restricted to certain groups of investors, they're typically less regulated. Then finally, managers of alternative asset funds typically receive management fees and performance fees from the investors in those funds. If I put money into a hedge fund, I'll typically pay what we refer to as a 2 and 20 fee, two percent of my assets every year plus 20 percent of profits. These funds can be quite expensive, but if the fund performs well, it can also be very profitable. Now given these drawbacks, why do people invest in hedge funds and other alternative assets? Let's talk about that.