Gravel road

• [TERM]: Alternative Investment
• [RELATED_TERM]: Publicly Traded Securities
• [TERM_CATEGORY]: Investment Management

What Is an Alternative Investment?

An alternative investment refers to any financial asset that falls outside the traditional categories of stocks, bonds, and cash. This broad classification within Investment Management encompasses a diverse range of assets and strategies, often characterized by lower correlation with traditional markets, unique risk-return profiles, and typically reduced liquidity. Alternative investments aim to enhance portfolio diversification by introducing different return drivers and potentially higher yields, which can be attractive to institutional investors and sophisticated individuals.

History and Origin

While the concept of investing in non-traditional assets has ancient roots, the modern era of alternative investments began to take shape with significant developments in the 19th and 20th centuries. Early examples include private capital financing infrastructure projects, such as the construction of the U.S. Transcontinental Railroad in 1852, which involved private funding alongside government bonds²³, ²⁴, ²⁵. However, a pivotal moment arrived in 1949 with the establishment of the first hedge fund by Alfred Winslow Jones. This fund pioneered a long/short strategy designed to mitigate market volatility, along with a fee structure that included a performance fee²¹, ²². The subsequent decades saw the rise of other alternative asset classes like private equity and venture capital, driven by evolving financial landscapes and the pursuit of new opportunities¹⁹, ²⁰.

Key Takeaways

• Alternative investments are assets outside of traditional stocks, bonds, and cash.
• They often offer portfolio diversification benefits due to lower correlation with public markets.
• Common examples include hedge funds, private equity, real estate, and commodities.
• Alternative investments typically come with reduced liquidity and may have higher fees compared to traditional assets.
• They have become increasingly accessible beyond institutional investors, though often with higher minimums.

Formula and Calculation

Unlike traditional assets, many alternative investments do not have a single, universally applied formula for valuation due to their unique structures and the illiquid nature of their underlying assets. However, for certain types, such as real estate or private equity, various valuation methodologies are employed. For instance, a common approach for valuing a private company in a private equity investment might involve discounted cash flow (DCF) analysis.

The Discounted Cash Flow (DCF) formula for a business valuation is:

Where:

• (PV) = Present Value
• (CF_t) = Cash flow in year (t)
• (r) = Discount Rate (often the weighted average cost of capital or a desired rate of return)
• (n) = Number of years in the projection period
• (TV) = Terminal Value (the estimated value of the business beyond the projection period)

This calculation helps investors assess the potential return from an alternative investment over its holding period. When evaluating such investments, understanding the Discount Rate and the projected Cash Flow is crucial.

Interpreting the Alternative Investment

Interpreting an alternative investment requires a different lens than evaluating publicly traded securities. Since many alternative investments are not marked-to-market daily, their reported valuations may be less volatile, but this does not necessarily indicate lower inherent Market Volatility. Instead, it reflects the infrequent appraisal of illiquid assets¹⁸. Investors typically focus on the long-term Return potential, the strategic role the alternative plays in overall Asset Allocation, and its contribution to true portfolio diversification. The "vintage year" of an alternative fund can also be significant, as it indicates the market conditions prevailing when the fund made its initial investments¹⁷.

Hypothetical Example

Consider an investor, Sarah, who seeks to diversify her portfolio beyond traditional stocks and bonds. She decides to allocate a portion of her capital to a private equity fund that specializes in growth-stage technology companies. Sarah commits $100,000 to the fund, which has a 10-year lock-up period. The fund manager invests in several private companies over the next few years. Instead of daily price movements like public stocks, Sarah receives quarterly updates on the fund's estimated net asset value, reflecting the performance of the underlying private holdings. After eight years, one of the fund's major holdings goes public through an Initial Public Offering (IPO)), generating a significant gain for the fund. Two years later, the fund liquidates its remaining assets and distributes the proceeds to its investors, including Sarah, providing her with a substantial return on her initial $100,000 commitment, demonstrating the long-term nature of private capital investments.

Practical Applications

Alternative investments are extensively used across various financial landscapes, particularly by Institutional Investors such as pension funds, endowments, and sovereign wealth funds. They are employed to:

• Diversify Portfolios: By including assets with low correlation to traditional stocks and bonds, alternatives can help reduce overall portfolio risk and enhance diversification¹⁶.
• Seek Higher Returns: Certain alternative strategies, particularly in private equity and venture capital, have historically demonstrated the potential for higher returns compared to public markets, partly due to an illiquidity premium¹⁴, ¹⁵.
• Access Private Market Growth: As more companies choose to stay private longer or never list publicly, alternative investments provide a means to access growth opportunities in private markets¹¹, ¹², ¹³. The asset class, including private credit and real assets, has seen substantial growth, doubling in size in recent years¹⁰. BlackRock anticipates private markets growing from $13 trillion today to over $20 trillion by 2030, driven by increased investment activity and demand for long-term capital⁹.

Limitations and Criticisms

Despite their benefits, alternative investments come with notable limitations and criticisms. A primary concern is their inherent Illiquidity. Many alternative assets cannot be easily converted to cash without significant discounts or long lock-up periods, sometimes extending for a decade or more⁷, ⁸. This can pose a challenge for investors needing quick access to capital⁶.

Another criticism revolves around transparency and valuation. Since many alternative investments are not publicly priced, determining a fair market value can be difficult, and valuations may be subjective⁴, ⁵. This lack of transparency can make it challenging for investors to fully assess underlying risks and compare performance across different funds³. Furthermore, alternative investments typically involve higher fees, including management fees and performance fees, which can erode investor returns. Investors must carefully consider the complexity, costs, taxes, and liquidity before committing to these investments². As one perspective notes, "the appeal of alternative investments is the hope that they have a low correlation with traditional investments which would help stabilize portfolio returns. But they don't work this way in practice"¹.

Alternative Investment vs. Publicly Traded Securities

The distinction between an alternative investment and publicly traded securities lies primarily in their accessibility, liquidity, and regulatory environment.

The primary confusion arises because some alternative strategies might invest in public securities, but they do so using non-traditional methods such as short selling or leverage, which differentiates them from direct ownership of Publicly Traded Securities.

FAQs

What is the main benefit of alternative investments?

The primary benefit of alternative investments is their potential to offer portfolio diversification, as they often have a low correlation with traditional asset classes like stocks and bonds. This can help reduce overall portfolio risk and potentially improve risk-adjusted returns.

Are alternative investments only for wealthy investors?

Historically, alternative investments were largely reserved for High-Net-Worth Individuals and institutional investors due to high minimum investment requirements and complex regulatory frameworks. However, new structures and funds are making some alternative strategies more accessible to a broader range of investors, though often still with higher minimums than traditional investments.

What are some common types of alternative investments?

Common types include Hedge Funds, Private Equity, Venture Capital, Real Estate, Commodities, and infrastructure. Each category encompasses various strategies and underlying assets.