settlements, farmland, weather derivatives, or collectables such as artwork, comic books, vintage automobiles, and rare coins (even Bitcoins). Most of these exotic and collectable investments still lack a minimum level of liquidity or price transparency, and are subject to greater fraud risk or are very difficult to value. These investments tend to remain in the domain of pure speculators, hobbyists, and those who are equal parts product enthusiasts and investors.
Most of the established and exotic alternative investments share at least a few common attributes or qualities. Most, if not all, alternative investment managers are experts in their area of investment, are major investors in the fund they manage, and get paid both a management and an incentive fee. Many also use leverage to enhance returns; some create portfolios that are illiquid at times; most only provide limited transparency to investors; and some alternative investments can be difficult to value.
When thinking about an alternative investment, here are seven things to consider:
1. Expert management. Does the manager of the investments have significant experience in a specific market segment, industry, or area of investment? This extra level of skill and focus can allow the manager to identify unique values or opportunities not readily seen by the investor community at large.
2. Manager co-investment. Do the manager and many of the partners or employees of the management company have a significant investment in the fund? This serves to align the interests of the investors with those of the manager.
3. Performance fees. Does the manager get paid a percentage of the profits of the investments, in addition to any flat fees for managing the fund? The widespread use of an incentive fee is based on the principle that it further aligns the interest of the manager with that of the investor.
4. Leverage. How much money or securities does the fund borrow to make investments? The use of a fund’s investor capital, plus leverage obtained from banks or derivatives, allows the fund to magnify gains or losses from each investment and achieve higher rates of return.
5. Illiquidity. How long do investors need to lock up money in the fund before they can sell or redeem? Many times funds require investors to lock up their money for an extended period of time before they can redeem their investment.
6. Limited transparency. Does the fund disclose its investments to its investors on a daily basis? Many times a manager may restrict the amount of periodic information provided to investors related to positions, strategy, leverage, or risk.
7. Hard to value. Can the investment or the underlying instruments owned in the portfolio be valued on an exchange or do they require an over-the-counter (OTC) quotation or price, a model price, or an independent valuation to determine the value? An illiquid market, third-party valuations, or the use of model price for an instrument can lead to more subjective portfolio pricing and less accurate fund valuations.
Alternative investment managers are usually trying to generate an absolute return and not managing money to beat a benchmark. This gives them the freedom to focus on narrow opportunities, with significant barriers to entry, requiring a high level of expertise. A commercial real estate fund might employ a property manager who is an expert on shopping malls in Chicago. A private equity fund may focus on infrastructure projects or telecommunications and may employ former industry executives and engineers to evaluate potential investments. A hedge fund that invests in equities related to the biotech industry may have doctors on staff who work as consultants or research analysts who recommend companies to the portfolio manager.
Most professional managers who start a private equity or hedge fund also invest the majority of their personal net worth in the fund. Managers do this to align interests and to signal confidence to investors that they believe in what they are doing and that they are not merely managing other people’s money.
Managers of alternative investments usually command a performance fee in addition to a fixed fee for managing assets. Managers getting an incentive or performance fee share in the upside when they produce positive results and generally do not get paid when they produce negative results. The effect of the performance fee is to give the manager a tangible incentive to generate the highest possible absolute level of return and to minimize variation and volatility over a complete business cycle.
Alternative investments are generally less regulated than traditional investments. This opens the door to the use of leverage, short selling, and derivatives on a much grander scale. Leverage is a powerful tool for magnifying winning outcomes and enhancing returns. Short selling is another form of leverage that particularly applies to managed futures and hedge funds and allows managers to make money when prices fall and magnify outcomes. It also enables them to mitigate volatility and reduce risk. Derivatives can be used by real estate funds to hedge interest rate risk or by hedge funds to place bets on the market.
Managers of alternatives can be quite secretive and at times even a bit paranoid about disclosure. They routinely do not provide much information to their investors and, rather, expect investors to rely on incentives and co-investment to align interests rather than active monitoring of positions. Some institutions struggle with the limited transparency that many alternative investments offer. Managers are also terribly afraid of their strategies being leaked and replicated if they provide too many details.
Hedge funds use a wide range of legal entities and domiciles to gather assets from investors. Each entity is designed for a specific purpose and a specific type of investor. Domestic funds in the United States tend to be organized as limited partnerships or limited liability companies, and investors tend to be individuals. Offshore funds are generally organized in tax or regulatory advantaged locations such as Cayman Islands, Bermuda, Luxembourg, or Ireland. These funds cater to certain types of U.S. not-for-profit investors and international investors. Other structures, such as mutual funds, are designed for retail investors or institutions who want more regulation and surveillance of the structures offered. Regardless of the structure used, each fund must also appoint a manager to make decisions and run the day-to-day operations, either as the general partner or under a contract established by the fund board between the fund and the manager.
Strutures and Domiciles
A hedge fund is a specific type of alternative investment. It is a legal entity, not an asset class per se. Generally, hedge funds are commingled vehicles that allow many investors who qualify to be aggregated and invested as a single pool of capital. A hedge fund is generally lightly regulated and combines leverage, short selling, and derivatives with active security selection, macro views, and advance portfolio construction methods to generate returns and manage risk.
Traditionally, hedge funds were limited in the structures they used to gather assets. They were generally organized as either onshore funds or offshore funds. Onshore funds are funds organized in the United States as either partnerships or limited liability companies. Offshore funds are investment companies organized outside the United States, typically in a tax haven such as the Cayman Islands or Luxembourg. Today, hedge fund strategies are also available to retail investors and are offered as mutual funds or UCITS (Undertakings for Collective Investing in Tradable Securities) products.
Onshore funds are U.S. entities that are formed as limited partnerships (LP) or limited liability companies (LLC). Onshore funds are typically formed in Delaware and managed by a general partner (GP). The managing member or manager typically manages an LLC. Investors in an LP are limited partners, and investors in an LLC are simply members. The GP or managing members are responsible for portfolio trading and take actions on behalf of the fund.
Offshore funds are most typically offered to qualified U.S. taxable investors or investors located outside the United States. The vehicle used is normally a listed portfolio company. Funds are typically formed in jurisdictions that do not impose tax on fund income (e.g., Cayman Islands, Bermuda, British Virgin Islands). A board of directors is required to govern the company and appoint a professional investment manager to manage the portfolio. The manager is responsible for portfolio trading and takes actions on behalf of the fund.
Mutual funds are a type of U.S. investment company created under the Investment Company