Chapter 1
Introduction to Alternatives

This chapter provides background information on the world of alternative investments, beginning with a definition of alternatives and some common characteristics that distinguish these assets from traditional investments in stocks, bonds, or cash.

Next, this chapter reviews the structure of alternative investment firms and funds, highlighting several important differences compared to traditional assets. We also discuss important techniques and attributes of alternative strategies, including leverage, short selling, hedging, and fees.

With that foundational understanding in place, we present a due diligence framework. Much as institutional investors conduct due diligence on potential investments, we will refer to different elements of this framework throughout the book to help the reader understand the various alternative strategies and the role they may play in investor portfolios.

Finally, we discuss in brief two issues of more than passing interest to investors in alternatives: regulations and performance measurement. Both of these topics are more complex than can be addressed in this book, so we will limit our material to a few of the most important differences between alternatives and traditional investment products.

1.1 What Are Alternatives?

Ask someone on the street about investing and the answer will likely refer to stocks or maybe bonds. Together with cash, these constitute the “traditional” financial assets and are accessible to individuals through direct purchase (buying shares of stock) or through funds (i.e., mutual funds in the United States, unit trusts in Europe). In many countries these assets are closely regulated to provide individual investors with certain protections against fraud and bad actors. Typical regulations require standardized disclosure of financial and other information, transparent pricing, and trading through regulated securities exchanges.

If stocks, bonds, and cash are “traditional investments,” what does the term “alternative investments” mean? The first word is the most important, “alternative”––somewhat obviously it means any investment that is not stocks, bonds, or cash—anything else is considered an alternative investment. Note that IPOs (initial public offerings) and SPACs (Special Purpose Acquisition Companies) are considered specialized examples of stocks in this book, as are nearly all ETFs (exchange‐traded funds).

Although some alternative investment strategies trade in exchange‐listed public assets—hedge funds being one example—many alternative asset classes involve investments in entities that are not traded on an exchange (“unlisted”); these are often referred to as belonging to the “private markets.” Private markets assets include ownership stakes in private companies (most commonly Venture Capital and Private Equity), some Real Estate and Infrastructure investments, and Impact Funds as examples. Beyond these investments in companies and projects, alternative investments also include commodities, collectibles, and a wide range of other assets that are not stocks, bonds, or cash.

Alternative investments often share other characteristics that may cause the investment to be riskier (or more expensive) than traditional investments, and as a result, the investor should do more due diligence before investing.

Table 1.1 presents the common features of alternative investments.

To aid understanding of why these features of alternative investments are important, let us describe a few of these characteristics, starting with “Liquidity restrictions.” The ability to buy or sell an asset without significantly influencing the price of the asset is referred to as “liquidity.” Investments in cash, stocks, or bonds, or even mutual funds or unit trusts, are straightforward to trade through a brokerage account. Many of these investments are relatively liquid. In contrast, most alternative investments do not trade on public exchanges, making them harder to buy and sell, and therefore they are described as being less liquid.

TABLE 1.1 Common features of alternative investments

Narrow manager specialization and potentially unconventional investment strategies Concentrated portfolios, potentially higher risk due to lower diversification Limited and potentially problematic historical risk and return data, making performance measurement more difficult Relatively low correlation of returns with those of traditional investments Absolute return targets High fees and/or performance‐based fees (“2 and 20”) Restrictions on redemptions (i.e., “lockups” and “gates”) Liquidity restrictions, often associated with a return premium as compensation Unique legal and tax considerations Less regulation and less transparency than traditional investments Not generally publicly traded—these are private investment vehicles High due diligence costs, and available for “sophisticated investors” only

Furthermore, many alternatives place restrictions on redemptions (sales), requiring a minimum holding period (also called a lockup) followed by a notice period before it is possible to redeem them. For example, private equity funds invest in unlisted companies that take considerable time to buy and sell, and typically require investors to commit to minimum holding periods of 7–10 years. Some managers investing in less liquid assets may also place “gates” on funds to control the pace of redemptions, or halt redemptions altogether in an extreme case like the Global Financial Crisis. One example of a gate could be a fund that only allows investors to sell one quarter of their holdings at any one time. Investors in alternatives should carefully consider the impact of these additional restrictions on liquidity from lockups and gates when deciding whether (and how much) to invest.

“Limited and potentially problematic historical risk and return data” is another common and important characteristic of alternative assets. Stocks and mutual funds trade on exchanges, creating a very detailed record of historical price information. Alternative investments, on the other hand, typically don't trade on exchanges, and, as a result, historical data may be limited in scope and detail (e.g., monthly or quarterly data only). In addition, price and performance data are often self‐reported by the manager—this is potentially problematic because you must trust that the manager is reporting the correct figures.

1.2 Investing in Alternatives

For reasons which will be explained throughout the book, institutions and wealthy individuals account for the majority of investments in alternative assets. These investors may have direct contact with alternative investment managers, or they may access and invest in these assets through intermediaries like private banks.

From the fund manager's perspective, raising money is one of the most important challenges to building a successful business. Like entrepreneurs in other industries, fund managers therefore tap into different distribution channels to find suitable investors for their fund. Institutions are often large enough to be able to make significant investments, and fund managers attend conferences and hire dedicated staff to reach these investors. Wealthy individuals, on the other hand, have relatively less capital to invest, so it can be more efficient to raise capital from wealthy individuals by partnering with a private bank.

From an investor's perspective, large institutional allocators may enjoy direct relationships with fund managers, which also means avoiding the additional layer of fees charged by intermediaries like private banks. The intermediaries provide benefits such as access to funds and additional due diligence on managers that may justify the additional fees for individual investors who would otherwise find it difficult to invest in these alternative funds.

1.2.1 The Market for Alternatives

One way that investors evaluate the attractiveness of different investments is through the relationship between return and risk. A 2021 study of private markets funds by Morgan Stanley shows historical return and risk for many major asset classes. Venture Capital and Buyout Funds (two of the major Private Equity strategies that will be described further in Chapter 2) stand out for their superior returns per unit of risk (Figure 1.1).

FIGURE 1.1 Performance of major asset classes, 1984–2015.

Source: Mauboussin and Callahan, 2020, Morgan Stanley.

Given this historically strong performance, perhaps it shouldn't be surprising that assets in alternative strategies have been growing faster than public markets. The industry uses “assets under management” (AUM) as a measure of the amount of capital being managed by investment firms. Looking back over the past 40 years of US data, the same Morgan Stanley report documents a tremendous rise in allocations to US Buyout funds.

When viewed in the context of the broader asset management industry, we see that investments in alternative assets are growing more quickly than the industry as a whole: a recent report by the Boston Consulting...