What are Alternative Investments you ask? The short definition is that they are any investment not includes in a traditional portfolio of Stocks, Bonds and Cash. Alternative Investments include Real Estate, Commodities, Hedge Funds, Alpha only funds, Currencies and others.
Alternative Investments usually have higher risk, lower liquidity and higher average returns. Because of their risks they were usually only available to Accredited Investors, those with high net worth and high incomes. In the past few years these walls have been crumbling and Alternative Investments are increasingly available to all investors.
Real Estate
- Rental Properties - My friends Richard and Mike own a series of apartments that they rent out for income. They manage the properties themselves and have to keep them rented, deal with tenant problems and provide maintenance on the properties. Craig owns the buildings his wife's business uses to help treat troubled teens. Her company deals with all the property issues.
- REITs - My parents own Developers Diversified Realty a REIT (Real Estate Investment Trust) that pays them regular income and has appreciated nicely through the years. I own an EFT (Exchange Traded Fund) that is an index of REIT companies.
Commodities
- Futures - Producers of commodities such as mining and agricultural companies have long used futures contracts to hedge their price risk on the sales of their products. Investors have taken advantage of the market producers created to invest in commodities. Because of their nature, futures contracts act like leveraged positions and have significant volatility.
- Funds - fund companies have begun to buy and sell futures for investors so that they can get professional management and so that it is available to unaccredited investors. There is still significant risk.
- Precious Metals - People buy precious metals outright in bars or coins. They often custody the bars with a metals dealer and custody the coins in their own homes or safety deposit boxes. You do not have an income on the metals except for any capital gain or loss you may incur when you sell. You have to pay custody fees if you store them out of your home. Some people buy stock in mining companies as a proxy for holding the physical metals. There are precious metal funds and also ETFs.
- Currencies - I'm lumping currencies in with commodities even though they could have their own segment. You trade currency pairs, buying the one you think is going to become more expensive against the one you think is going to become cheaper. If you thought the JPY (Japanese Yen) was going to go up against the USD (US Dollar) you would buy Yen by selling dollars. You can buy currencies spot (what you do when you go on vacation and buy it to spend immediately,) forward (exchange of funds at a rate set today for some certain date in the future) or in the future markets (a set contract that defines size, date, etc.).
Hedge Funds
- Long/Short - An analyst will have companies they like and companies they don't like. Traditionally they could only buy companies they likes and sell them when they stopped liking them. We call this a long only strategy. This strategy however limits the portfolio manager from delivering to the client more than 60% of the Information Ratio available. Allowing the manager to sell the companies he doesn't like short increases the return available.
- Market Neutral - In a market neutral fund, the manager takes two highly correlated stocks and buys the one he likes and sells the one he dislikes. Because they are highly correlated, when one goes up the other will too. If the analysis is right, the one you bought will go up more than the one you sold. There are different flavors of market neutral funds. Most try to be beta neutral, picking stocks that rise and fall the same amount versus the overall market. They may also be dollar neutral by using the amount of the sale to fund the amount of the buy. Finally, they can be sector neutral with the stocks coming from the same sector. Doing these things eliminates the systemic risk of the market and exposes you purely to the manager's skill in picking stocks.
- Arbitrage - Tries to identify mismatches in prices in securities in different markets or time periods. For instance, I may wish to buy Ford stock. I can buy it in the US, Canada or Europe. The price in dollars may be minutely different from the price in CAD or EUR. An arbitrager would buy in the cheap market and sell in the expensive until the price reached equilibrium in the various markets.
- Event Driven - tries to profit by trading in securities after any of company events, market events, or exogenous events like 9/11, the Indonesian tsunami, etc. They may buy up bankrupt companies, turnaround companies, good companies in bad sectors, etc.
Pure Alpha
- Pure alpha is like a market neutral strategy. You are attempting to eliminate all market risk and be left with the manager's skill in delivering alpha. You might find alpha in any of 20 or 30 different market segments.
- Alpha transport - where you combine the alpha you generate with beta from another market. You get the market return of the beta with the added alpha from various other markets.
I hope this helps. Input is welcome. Yell if I've misrepresented you or your industry or left significant Alternative Investments out.
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