Level 1 CFA® Exam:
Alternative Investments – Basics
In this lesson, we're going to introduce the topic of alternative investments. We're going to describe the basic categories of alternative investments and compare them with traditional investments. We're also going to show the benefits of using alternative investments as components of an investment portfolio.
Defining Alternative Investments
Alternative investments, as their name suggests, serve as a kind of alternative to financial instruments used in a traditional model of investment. It's safe to say that they have non-standard features that make them very different from stocks, bonds, or cash. And so, in terms of alternative investments, all elements connected with investment strategies, methods of valuation, or fees are different from those involved in traditional investments.
A few examples of alternative investments are hedge funds, private equity, real estate, commodities, or assets such as spirits, stamps, furniture, art, or even patents. Alternative investments usually involve using derivatives, low-liquidity assets, leverage, or short selling.
One of the basic features of alternative investments is the fact that they are less common than traditional ones, which has its consequences. First of all, alternative investments have lower liquidity and the transactions are less transparent. What's more, the fact that they are less popular makes access to historical return data or volatility of prices restricted. As a result, alternative investments call for highly specialized investors. Alternative investments are also subject to different legal and tax regulations.
Differences between Alternative and Traditional Investments
There are many differences between alternative and traditional investments such as:
- alternative investments have lower liquidity,
- transactions on alternative investments are less transparent,
- alternative investments are less regulated,
- for alternative investments, access to data on historical returns and volatility is restricted, so they call for highly specialized investors,
- higher fees in the case of alternative investments,
- concentrated portfolios in the case of alternative investments,
- there’s a relatively low correlation between the rates of return on both types of investments,
- there are restrictions on redemptions like a lock-up period or long notice period,
- alternative investments are subject to different legal and tax regulations.
Benefits & Risks of Alternative Investments in the Context of Portfolio Management
What are the benefits and risks of alternative investments?
The basic benefit of investing in alternative assets is the fact that they are an alternative to conventional investments, such as stocks or bonds. The small degree of similarity between traditional and alternative investments translates in the long run into a low correlation between the rates of return on both types of investments, which largely decreases the risk of a portfolio composed of both alternative and traditional investments.
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Categories of Alternative Investments – Overview for CFA Candidates
star content check off when doneWe can distinguish 3 main groups of alternative investments:
- private capital,
- real assets, and
- hedge funds.
Private Capital
Private equity investments are equity investments in both public and private companies to take over their shares. One of the categories of private equity investments is venture capital, which invests in startups and early-stage companies.
Private equity (but not venture capital funds) can take the form of leveraged buyouts (LBO), where the purchase of shares in companies is financed through loans or, less commonly, through management buyouts where the managers of the acquired company become investors. Private equity also includes investments in financially unstable companies that are to be restructured (such a form of investment is also used by hedge funds).
Private debt can also be included in the category of private capital. Private debt can take different forms, e.g., direct lending, mezzanine loans, venture debt, or distressed debt.
Real Assets
Investments in real assets can be divided into the following categories:
- real estate,
- infrastructure,
- natural resources (commodities; agricultural land & timberland),
- other real assets.
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Hedge Funds
Hedge fund investments are mainly targeted at investors who expect high returns and have high risk tolerance. The term 'hedge fund' may be slightly misleading as hedge funds follow strategies that use not only the elements of hedging but most of all the elements of speculation. Such various investment strategies include using derivatives or illiquid assets, leverage, and short selling.
- Alternative investments have non-standard features that make them different from stocks, bonds, or cash.
- Alternative investments usually involve using derivatives, low-liquidity assets, leverage, or short selling.
- The small degree of similarity between traditional and alternative investments translates in the long run into a low correlation between the rates of return on both types of investments.
- We can distinguish 3 main groups of alternative investments: private capital, real assets, and hedge funds.
- Investments in real assets can be divided into the following categories: real estate, infrastructure, natural resources (commodities; agricultural land & timberland), and other real assets.
- Hedge fund investments are mainly targeted at investors who expect high returns and have high risk tolerance.