What is Investing?

Investing is the act of allocating funds to an asset or committing capital to

an endeavor (a business, project, real estate, etc.), with the expectation of
generating an income or profit. In colloquial terms, investing can also mean
putting in time or effort - not just money - into something with a long-term benefit,
such as an education.

Understanding Investing

The expectation of a return in the form of income or price appreciation

with statistical significance is the core premise of investing. The spectrum of
assets in which one can invest and earn a return is a very wide one. Risk and
return go hand-in-hand in investing; low risk generally means low expected
returns, while higher returns are usually accompanied by higher risk. At the
low-risk end of the spectrum are basic investments such as Certificates of
Deposit; bonds or fixed-income instruments are higher up on the risk scale, while
stocks or equities are regarded as riskier still, with commodities and derivatives
generally considered to be among the riskiest investments. One can also invest
in something as mundane as land or real estate, while those with a taste for the
esoteric - and deep pockets - could invest in fine art and antiques.

Risk and return expectations can vary widely within the same asset class.
For example, a blue chip that trades on the New York Stock Exchange will have
a very different risk-return profile from a micro-cap that trades on a small
exchange.

The returns generated by an asset depend on the type of asset. For

instance, many stocks pay quarterly dividends, bonds generally pay interest
every quarter, and real estate provides rental income. In many jurisdictions,
different types of income are taxed at different rates.

In addition to regular income such as a dividend or interest, price

appreciation is an important component of return. Total return from an investment
can thus be regarded as the sum of income and capital appreciation.

Types of investments

While the universe of investments is a vast one, here are the most
common types of investments:

Stocks​ - A buyer of a company's stock becomes a fractional owner of that

company. Owners of a company's stock are known as its shareholders and can
participate in its growth and success through appreciation in the stock price and
regular dividends paid out of the company's profits.

Bonds​ ​- Bonds are debt obligations of entities such as governments,

municipalities and corporations. Buying a bond implies that you hold a share of
an entity's debt and are entitled to receive periodic interest payments and the
return of the bond's face value when it matures.

Funds​ ​- Funds are pooled instruments managed by investment managers that

enable investors to invest in stocks, bonds, preferred shares, commodities etc.
The two most common types of funds are mutual funds and exchange-traded
funds or ETFs. Mutual funds do not trade on an exchange and are valued at the
end of the trading day; ETFs trade on stock exchanges and like stocks, are
valued constantly throughout the trading day. Mutual funds and ETFs can either
passively track indices such as the S&P 500 or the Dow Jones Industrial Average
or can be actively managed by fund managers.

Investment trusts​: Trusts are another type of pooled investment, with Real
Estate Investment Trusts (REITs) the most popular in this category. REITs invest
in commercial or residential properties and pay regular distributions to their
investors from the rental income received from these properties. REITs trade on
stock exchanges and thus offer their investors the advantage of instant liquidity.

Options and Derivatives​ ​- Derivatives are financial instruments that derive

their value from another instrument such as a stock or index. An option is a
popular derivative that gives the buyer the right but not the obligation to buy or
sell a security at a fixed price within a specific time. Derivatives usually
employ leverage, making them a high-risk, high-reward proposition.

Commodities​ - Commodities include metals, oil, grain and animal products, as

well as financial instruments and currencies. They can either be traded through
commodity futures - which are agreements to buy or sell a specific quantity of a
commodity at a specified price on a particular future date - or ETFs. Commodities
can be used for hedging risk or for speculative purposes.

Alternative Investments​ ​- This is a catch-all category that includes hedge

funds and private equity. Hedge funds are so called because they can hedge
their investment bets by going long and short stocks and other investments.
Private equity enables companies to raise capital without going public. Hedge
funds and private equity were typically only available to affluent investors
deemed "accredited investors" who met certain income and net worth
requirements. However, in recent years, alternative investments have been
introduced in fund formats that are accessible to retail investors.

What is an Alternative Investment?

An alternative investment is a financial asset that does not fall into one of
the conventional investment categories. Conventional categories include stocks,
bonds, and cash. Most alternative investment assets are held by institutional
investors or accredited, high-net-worth individuals because of their complex
nature, lack of regulation, and degree of risk.

“Diversify! Diversify! Diversify!” is the mantra on every investment advisor’s

lips and we could not agree more on this. However, diversification has varied
connotations across classes of investors. While regular investors are happy to
be diversified through plain equities, bonds, and mutual funds, the High Net
Worth individuals and institutions want diversification with a tiara of exclusivity.
This is where Alternative Investments find their place.

Why Alternative Investments are Preferred?

Now the question arises, if these are investments with an air of ambiguity,
why would high net worth investors want to have them in their portfolios and how
would it benefit them?

Alternative investments as a domain are still evolving and maturing. While

it is mainly considered to be a prerogative of the High Net Worth investors, there
are also retail investors who are showing keen interest in them. After the financial
crisis in 2008, where even the best of the diversified portfolios was swayed by
extreme volatility, alternative investments proved their worth.

The major reasons why they score brownie points over traditional investments
are:

A low correlation with markets:

Low correlations to traditional asset classes like equity markets and fixed
income markets act as a major advantage for alternative investments. These
asset classes usually have a correlation between -1 to 0 which makes them less
susceptible to systematic risk or market-oriented risk elements. However, a
catch in this scene is the upside is also capped due to a low correlation with the
market.

A strong tool for diversification:

Alternative investments by virtue of their lower correlation coefficient offer

better diversification benefits with enhanced returns. These assets perfectly
complement the traditional investments and when a stock or bond
underperforms, a hedge fund or private equity firm can cushion the extent of
losses over the long term. One can add or replace alternative assets based on
individual investment goals and risk appetite.

Active management:

As compared to the passive indexed investment, alternative investment

calls for active management of funds. The complex nature of the assets, volatility
and elevated risk level of these investments required constant monitoring and
recalibration of investment strategies as needed. Moreover, the wealthy investors
for whom high management fees are not a concern would definitely want to reap
the benefits of high-end expertise.

There are various types of Alternative investments. Few are

well-structured, while few follow distinctiveness of the investors. Let us try to
understand the structure and underlying philosophies behind these asset types.

Types of Alternative investments:

Private Equity

Not all equities are listed on stock exchanges. Private Equity refers to
funds that institutional investors or high net worth investors directly place in
private companies or in the process of the buyout of public companies. Usually,
these private companies then utilize the capital for their organic and inorganic
growth. It can be for expanding their footprint, increasing the marketing
operations, technological advancement or making strategic acquisitions.

Mostly the investors lack the expertise to select companies that suit their
investment goals, thus they prefer investing through Private Equity Firms rather
than the direct mode. These firms raise funds from high net worth investors,
endowments, insurance companies, pension funds, etc.

Compensation
Limited Partner General Partner
Structure

They are the institutional The General Partners are The General Partners
or high net worth the ones responsible for receive management
individuals who invest in managing the fees as well as a share of
these funds investments in the fund profits on the investment.
 This is known as Carried
Interest and ranges
between 8% to 30%

The private equity industry was out of regulatory supervision since its birth
in the 1940s, however, after the 2008 financial crisis, it falls under the purview of
the Dodd-Frank Wall Street Reform and Consumer Protection Act. In recent
times, there is an increased call for transparency and the US Securities and
Exchange Commission (SEC) has started collecting data on private equity firms.

When it comes to judging the performance of Private Equity, measures like

IRR (Internal Rate of Return) were widely used, but it has certain limitations. IRR
did not address the reinvestment element for interim cash flows or negative
flows. Thus, evolved the Modified IRR. A more practical and holistic tool than the
traditional IRR, the modified IRR or MIRR is the main measure to quantify the
Private Equity performance these days.

Hedge Funds

Mutual Funds are quite popular, but Hedge Funds, its distant cousin, still
belongs to a lesser-known territory. This is an alternative investment vehicle,
which only caters to investors with ultra-deep pockets. As per US laws, hedge
funds should cater only to “accredited” investors. This implies that they must
possess a net worth of more than $1 million and also earn a minimum annual
income. According to the World Economic Forum (WEF), Hedge funds have
more than $3 trillion assets under management (AUM), which represents 40% of
total alternative investments.

So why are they called Hedge Funds in the first place?

These funds derived this name due to their core idea to generate a
consistent return and preserve capital, instead of focusing on the magnitude of
returns.

With minimal correlation to equity markets, most hedge funds have been
able to diversify portfolio risks and reduce volatility.

Hedge funds are also the pool of underlying assets but they differ
from Mutual Funds on a number of grounds. They are not regulated as Mutual
Funds and hence have the leeway to invest in a broader range of securities.
Hedge funds are best known for investments in risky assets and derivatives.
When it comes to investment techniques, hedge funds prefer to take a more
high-end complex approach calibrated to varying levels of risk and return. Many
of them also resort to “Leveraged” investment, which means using borrowed
money for investment.

One factor that distinguishes Hedge Funds from other alternative

investments is its liquidity quotient. These funds can take as low as a few
minutes for sell-off due to increased exposure to liquid securities.

Venture capital

We live in the age of entrepreneurship. New ideas and technological

advancements have led to the proliferation of start-up ventures across the globe.
But ideas aren’t enough for a firm to survive. To sustain, a firm needs capital.
Venture Capital is an alternative asset class that invests equity capital in private
start-ups and shows exceptional potential for growth.

Doesn’t it sound familiar to Private Equity? No, it doesn’t. Private Equity

invests equity capital into mature companies, while Venture Capital is mainly for
startups.

Venture Capital usually invests at seed and early-stage businesses while

some invest at the expansion stage. The investment horizon is typically between
3-7 years and venture capitalists expect returns to the tune of >8x-10x the
invested capital. This high rate of return is a natural outcome owing to the risk
quotient associated with the investment. While some ideas might appear
lackluster in the inception stage, who knows, they may turn out to be the next
Facebook or Apple? Investors who have the caliber to shoulder this level of risk
and believe in the underlying potential of the idea are the ideal venture
capitalists.

With the growth in entrepreneurship, this is the time for Venture Capital to
thrive. From 2013 to 2015, the deals have grown 54% YoY. Geographically,
Venture Capital investments are concentrated mostly in the US, followed by
Europe and China.

Investing in new ventures involves a high degree of risk peppered with

uncertainty. There are high possibilities of negative outcomes and this justifies
the risk quotient. Each stage of Venture Capital investment presents a new risk,
however, the returns generated are directly proportional to the quantum of risk,
and that’s what lures the Venture Capitalists.
Real assets

Not all investments are towards businesses or pools of funds. Some of

them are towards real assets like precious metals or natural resources. Investing
money in gold, silver or other precious metal has been there since times
immemorial. They have always been known to be the best hedge against market
movements and currency fluctuations due to their inverse relationship with the
US Dollar. Investors can invest in gold through gold coins, bullions, or indirectly
through sector traded funds or exchange-traded funds.

Real estate is also one of the avenues that have caught the fancy of
investors for long. Investing in plots, houses and reaping rental yields or
commercial assets are some of the direct ways of investing in real estate. Indirect
ways through which retail investors can park their money in real estate are
through Real estate investment trusts (REITs). Once again, the low
co-relationship between equity markets and real estate has branded real estate
as an ideal hedge against inflation.

Collectibles like wine, art, stamps or vintage cars

For those who thought stamps, artwork and vintage wine are just
prestigious souvenirs, think again! Hidden in these connoisseurs are astute
investors who know the real value of these collectibles.

Classic cars like 1950 Ferrari 166 Inter Vignale Coupe and Ferrari 250
GTO Berlinetta tops the list, while investment-grade wines like Bordeaux come a
close second. Coins, art, and stamps are some of the other luxury investments
that also preferred options.
The History of Alternative Investing :

It provides a general overview of the investments typically held by

institutional investors, such as banks, pension funds, endowments, and
insurance companies. Throughout much of the 20th century, each institutional
quality investment was evaluated primarily on the safety of its income and
principal and tended to be evaluated on a standalone basis. Beginning in the
1950s and 1960s, modern portfolio theory established the mechanics and
advantages of diversification. Modern portfolio theory evaluates risk on a portfolio
basis—formalizing the idea that much risk can be diversified away by holding a
broad mix of available investments. In the 1980s and 1990s, the appropriateness
of investments for institutions increasingly began to be evaluated on a portfolio
basis. The change in law and investment practices from evaluating risk on a
standalone basis to a portfolio-as-a-whole basis is evidenced in Exhibit 1.2.
Beginning in the 1980s, inclusion of such assets as small-company stocks,
low-quality corporate bonds, and alternative assets became more common
among financial institutions, such as banks, pension funds, endowment funds,
and insurance companies. Evaluated on a standalone basis, many of these
assets had little or no reliable income and were at risk for loss of the original
investment. But when held in a portfolio, these relatively high-risk investments
could lower the total risk of the portfolio because of their ability to provide
improved diversification. Exhibit 1.2 indicates that institutions usually did not hold
common stocks prior to 1920. Most institutional-quality investments more than
100 years ago were those secured by tangible assets, such as real estate.
The underlying determinants of economic performance are changing with
increasing speed. Take, for instance, the composition of the major stocks in the
United States. In early 1901, the Dow Jones Industrial Average included 12
stocks: 10 common stocks and 2 preferred stocks. Almost every 1 of the 12
stocks was a commodity producer (copper, sugar, tobacco, paper, lead, coal,
leather, rubber, and steel). By 1960, the top seven Fortune 500 firms in the
United States were General Motors Company, Standard Oil Company of New
Jersey, Ford Motor Company, General Electric, US Steel, Mobil, and Gulf Oil.
The list included three oil companies and one steel company as well as two
automobile manufacturers and one electrical equipment manufacturer. Now, top
firms are dominated by services and technology. The top five US firms in terms
of market capitalization in 2017 were Apple Inc., Alphabet Inc., Microsoft
Corporation, Amazon.com Inc., and Berkshire Hathaway Inc. Facebook, Inc.,
was seventh in mid-2017 with a market capitalization of more than $500 billion,
no inventory, and fixed assets of only about $10 billion. Clearly, it is inappropriate
to view traditional assets as solid and alternative assets as speculative.
Investments closely tied to commodity prices are now viewed as alternative
investments, yet they constituted most of the industrial investment opportunities
in 1900. With such dramatic and increasingly rapid changes in the components of
an economy, it is difficult to conclude that conservative and traditional investment
principles consist of maintaining unchanging investment practices. In effect,
sticking with traditional investment practices moves the risk and diversification of
a portfolio through time as the economy underlying the investment opportunities
shifts. It is only through a dynamic approach to asset allocation (one that adjusts
to new industries, securities, and other economic changes) that a portfolio can
maintain good principles of diversification.
 Exhibit 1.2. Popular Institutional-Quality Assets, 1890–Present

1890–1920 Government debt, real estate, mortgages, preferred stock

1920–1950 Add high-quality corporate bonds, domestic equities, agricultural

debt 1950–1980 Add average-quality corporate bonds, international equities

1980–Present Add high-yield debt, small stocks, structured products, private

equity, hedge funds, real assets.

Investment structure:

The legal structures used by alternative investment funds differ

significantly from most traditional fund arrangements (mutual funds in the US,
unit trusts in the United Kingdom, and UCITS funds in Europe), even though both
entail a fund investing on behalf of an investor. This results in different and
unique fee structures, investment lifespans, degrees of freedom with regard to
the investment mandate, cash flow patterns, liquidity and investor constraints,
and performance metrics. Figure 10 provides an overview of the key differences
between alternative investment funds and traditional funds, such as mutual
funds.

Investor constraints

Most governments only permit wealthy individuals and institutional

investors (such as pension funds, sovereign wealth funds, and endowments and
foundations) to invest in alternative investments. The belief is that such investors
are better able to understand and manage the complex, often high risk, and
illiquid nature of alternative investments.

Investment lifespan​:

Most types of alternative investments utilize closed-end fund structures

that have a fixed lifespan (typically 10-15 years). All of the value of the
investment is returned to investors within this timeframe, who must then identify
new investment opportunities to reinvest the capital in. Hedge funds are a
noteworthy exception, as they usually offer open ended funds, which are similar
in style to traditional fund structures, in that the capital is automatically reinvested
with the fund unless the investor requests that the capital be returned to them.

Investment mandate:

The legal structure that alternative investment funds use is quite flexible
relative to traditional funds. Alternative investors usually have broad investment
mandates, which allows them to employ a diverse range of strategies and pursue
a wide range of investments. Moreover, they are not constrained by legal barriers
imposed on traditional funds that limit their ability to use debt (leverage), short
sell securities, invest in illiquid securities, or use derivatives when seeking to
execute on their strategies.
Sources of capital :

Sources of capital for the industry have evolved over time, simultaneously
supporting the rise of alternative investment and leading to changes in the
industry itself. The capital base has steadily shifted from small scale long-term
investors (e.g. wealthy individuals) to the large institutional investors (e.g.
pension funds) that provide most of the capital today. Below we discuss both the
different sets of drivers, as well as a number of specific types of investors.

Investment drivers​: Three sets of drivers underpin investment demand for

alternative investments, with each seeking a distinct set of attributes that
alternatives can offer (Figure 22). Different classes of investors are usually
aligned with one of these three groups.

Long-term investors​: Long-term investors have theoretically infinite horizons.

They range in size from large sovereign wealth funds to high-net worth
individuals, family offices, endowments, and foundations. Long-term investors
are attracted by the above average returns that are often possible when investing
in long-term and illiquid investments.

Liability driven investors​: Liability driven investors have moderately long

investment horizons (10-15 years) and a need to pay out cash on an on-going
basis in the short-term.45, 46 Pension funds, are the key investors in this
category, as they need to generate returns over the lifetime of a beneficiary, as
well as cash to payout to those in retirement. They are attracted to the prospect
of high expected returns, the ability to deploy large amounts of capital efficiently,
and the inflation-linked and cash flow generating attributes that alternatives can
offer. Insurance companies would normally be included as well, but legal
limitations on investing in alternatives leads them to behave more like
diversification driven investors.

Diversification driven investors​: Diversification driven investors are seeking to

diversify their portfolios. This set of investors includes asset managers,
corporations, banks, insurance companies, and government agencies. These
investors allocate to alternatives because it improves the overall returns and the
risk return profile of their broader portfolio. Historically, these investors have had
relatively and absolutely small allocations to alternative investment, though
collectively they provide a meaningful share of capital to the industry.
PERFORMANCE OF SEVERAL ALTERNATIVE INVESTMENTS:

Hedge funds

Overview​: Hedge funds manage more than $3 trillion (40% of all alternative
capital), which makes them a large and important part of the industry.
Geographically, the industry is highly concentrated. Most of the capital is
managed in the US (70%) and Europe (21%), with managers in the New York
area (50%) and London (18%) overseeing two-thirds of all global capital.6, 7
Still, hedge funds make investments across the globe and in all sectors of the
economy. Overall, there are more than 8,000 hedge funds,8 with the top 25
managing 29%9, 10 of all assets under management.

Business model​:

Hedge funds usually acquire minority stakes in securities with the goal of
generating outperformance for a given level of risk, no matter the economic
environment. Unlike venture capital and private equity buyouts, hedge funds
employ a wide variety of strategies in an attempt to generate their target returns
(Figure 14). Depending on the strategy employed, they may invest in different
parts of the capital structure (equity, different levels of debt) or purchase (or
short) a range of securities (stocks, bonds, loans, structured products,
derivatives, commodities, currencies, etc.) to meet their investment objectives.
Hedge funds usually use a mix of equity from investors and borrowed funds to
acquire securities, with the amount of debt used varying widely. The strategy
employed influences the holding period, which can be as short as microseconds
or longer than a year.
Investment attributes​:

Investors continue to allocate more capital to hedge funds for a number of

reasons. According to a recent survey, the number one objective for institutional
investors investing in hedge funds is for funds to produce returns that are
uncorrelated to equity. The degree to which hedge funds are able to meet this
objective varies widely, with different strategies and funds producing correlations
with traditional stocks ranging from 20-35% for futures, fixed arbitrage and global
macro funds, to 70-80% for long/short or emerging equity funds. Investors also
value the fact that the reduced correlation of hedge funds with equity markets
diversified their investment portfolio and reduces the volatility in it. Finally, the
ability to generate risk-adjusted absolute returns in any market is prized by
investors,
Private equity buyouts:

​Overview​: Private equity buyout firms have been a large and high profile part of
alternative investing since the 1980s. The asset class is the second largest
segment within alternative investing, with private equity buyout firms managing
$1.4 trillion. Firms invest in dozens of countries across the globe, though
companies in the US (50%) and Europe (26%) receive a disproportionate share
of the capital.15 They invest across a wide range of industries and in companies
ranging from small businesses to Fortune 500 companies worth billions. Globally,
there are approximately 1,000 firms, with the 25 largest managing 41% of the
total assets under management.16

​Business model​: Most private equity buyout firms focus on the private
acquisition, ownership, and eventual sale of equity stakes in existing businesses.
They usually acquire the entire company or at least a controlling stake, though
some firms specialize in making minority investments in companies. Debt, often
in the form of leveraged loans of high yield bonds, usually accounts for 50-70%
of the Overview of different types of alternative investments purchase price.
After acquiring a company, firms will often seek to upgrade management and
governance, improve the operations, and grow the business for a period of 3-6
years . It will then seek to sell the business to a company, another alternative
investment fund, or list it on a public exchange.

Investment attributes: Investors find private equity buyouts attractive for a

number of reasons. First, they expect relatively high returns. Some 37% expect
private equity funds to outperform public equity by +4.1% and another 49%
expect it to outperform by +2.1-4.0%. Historically, this has been true, with global
private equity buyout returns yielding an average of 18.8% per year from 1986 to
2002 and 11.9% from 2003 to 2012.Second, the asset class tends to be illiquid
and long-term, which provides an opportunity to capture return premia associated
with each. Third, private equity returns offer a partial inflation hedge, as the
revenues of the companies they invest in are linked to the rate of inflation.
Fourth, historically investors had valued the fact that private equity buyout returns
were significantly uncorrelated with those of other asset classes, but this
diversification benefit has eroded significantly as it has grown.
Venture capital

Overview:

Venture capital is the best known alternative asset class and can trace its
history back to 1946. Today, venture capital firms manage more than $400
billion in assets under management.30 Geographically, investments and
firms are highly concentrated in a handful of countries, with the US alone
attracting nearly 70% of global investments (Figure 17). Investments are
concentrated in industries and sub-sectors that rely on the development of
new technologies, with information technology, biotechnology, internet
related media and consumer, and energy companies receiving a large
share of all annual investments. Most firms specialize in just one or two life
stages of a company, with most focusing on either seed and early stage
businesses or late and expansion stage companies. There are nearly 1,500
venture capital firms globally, with the top 25 firms managing 25% of the
global assets under management.

Top countries for total venture capital invested

Share of total venture capital invested 2006-2013, $ billions

Business Model

Venture capital firms focus on investing equity in privately owned start-up

companies, particularly those that are developing innovative new solutions,
products, and processes and have the potential to grow rapidly.33, 34
Given the high failure rate of start-up companies, the business model is
predicated on the hope that a few investments will deliver exceptionally
high returns (>10x invested capital) in order to offset for the many other
investments where some or all of the equity invested is lost. Most
investments range from less than $1 million for a seed stage deal to $10
million for a late stage deal. Venture capital firms expect the capital to be
invested for 3-7 years, depending on which life stage of the company they
invest at, before they seek to sell the investment to a company (known as a
trade sale) or list it for an IPO on an exchange.
Distribution of exits for US venture capital deals by type

Investment Attributes

Investors are primarily attracted to venture capital for the prospect of

receiving outsized returns relative to traditional public equity. The
expectation of high returns is justified due to the high level of risk
associated with investing in young companies with unproven products,
business models, or management teams (or all three), with the hope of
profiting from the creation of the next Google, Facebook, or Uber. Such
investments are high risk, illiquid, and long-tenured. Historically, the asset
class as a whole was able to deliver on these expectations, with returns
averaging as high as 100% during the dotcom boom.37 However, following
the dotcom crash, returns hovered around 0% for nearly a decade and only
recently returned to the 15-30% range in the late 2000s.
Other Types of Alternative Investments

Overview

The attractiveness and success of the alternative investment structure has

led investors to apply it to a range of investments beyond the core asset
classes described above. Some asset classes are unique to alternative
investing. Examples of this include secondary funds and growth equity
funds. Other funds apply the alternative fund structure to traditional
investments. Examples of this include private equity infrastructure funds,
private equity real estate funds, and private debt funds (including
mezzanine, distressed debt, direct lending).

Collectively, non-core alternative investment funds manage $2.07 trillion,

with four asset classes accounting for 85% of this (Figure 19).39 The
geographic focus varies by asset class, but the majority of capital is
invested in developed countries. These funds invest in all industries of the
global economy and in every part of the capital structure. The size of the
target company or security also varies widely, from growth stage
companies to multi-billion dollar real estate portfolios or infrastructure
projects. There are well over 1,000 non-core funds and each asset class
has a diversity of funds of varying sizes and specialties.
Share of non-core alternative Investment-classes

Business Model

Non-core alternative investors use a variety of business models, but most

use closed-end fund structures and seek to exit an investment through a
trade or secondary sale after holding it for 3-7 years.

Private equity real estate and private equity infrastructure use the private
equity buyout model. They acquire controlling equity stakes in assets, use
a large amount of debt as part of the deal structure, and often seek to
increase the value of the asset by investing in improvements, upgrades,
cost reduction measures, or growth initiatives. Similarly, growth equity is
akin to very late stage venture capital, as firms seek to acquire minority
stakes in small companies with strong growth prospects. The final primary
non-core area is that of private debt funds, which are composed of
mezzanine, distressed debt, and direct lending funds. These funds either
extend credit directly to companies or acquire debt securities issued by a
company. The fund manager can be a relatively passive owner of a
portfolio of such securities or actively engaged in advising on the business
strategy and operations of the underlying company itself.

Investment Attributes

Investment attributes vary widely for non-core asset classes, but investors
value several in particular. They value the inflation linked and relatively
non-correlated returns that investments in real estate and infrastructure
generate, as well the ability to efficiently deploy large sums of capital in
such deals. The ability to generate relatively high returns when investing in
growth funds is also prized by many investors.

Alternative Investment, Private debt funds and Shadow lending

Alternative investors have recently begun to expand into providing debt

(loans or bonds) to businesses, an area traditionally dominated by banks.
The disintermediation process is part of a broader global trend known as
shadow banking or shadow lending, whereby non-bank actors seek to
provide credit to companies. The growth in alternative investment related
shadow lending has been dramatic and the implications for investors,
regulators, and the system are still unknown.

The trend is driven by three factors. First, the post-crisis financial regulatory
reforms have led banks to reduce their lending activities, particularly to
small and medium sized businesses. Second, the demand for credit from
businesses has not fallen to the same degree, leading to unmet demand.
Third, the demand by institutional investors for debt that yields more than
government debt remains robust. Overall, the non-bank financial actors
including alternative investors, are expected to replace banks in providing a
projected $3 trillion of lending by 2018.

Alternative investors have long invested in certain types of debt, but the
scope of the market broadened in recent years. Historically, the private
debt market consisted of specialized funds that provided mezzanine debt,
which sits between equity and secured/ senior debt in the capital structure,
or distressed debt, which is owed by companies near bankruptcy. Following
the financial crisis, a third type of fund emerged. Known as direct lending
funds, these funds extend credit directly to businesses or acquire debt
issued by banks with the express purpose of selling it to investors (in the
past it would have been held by the bank).
The market for direct lending includes an array of core and noncore
alternative investors (Figure 21). Leading alternative investors, such as the
Blackstone Group, Apollo Global Management, the Carlyle Group, Pine
River, and BlueCrest Capital, have all expanded their product offerings to
include private debt funds. They are joined by a number of specialized
new firms.

The strong demand by institutional investors has enabled these funds to

expand their size rapidly. Collectively, some 531 private equity style debt
funds have been raised since 2009.42 Overall, total assets under
management have doubled since the financial crisis, from $213 billion in
assets under management in 2007 to $465 billion by June 2014,43 with
25% of that coming from direct lending funds. Hedge funds have also been
an important source of debt capital and now manage more than $600 billion
of debt focused funds.

The risks associated with shadow lending are not yet well known.
Regulators in the US, United Kingdom, and Europe have expressed their
concern that they could undermine the broader financial system if they take
on too much leverage, mismanage risk, or experience liquidity crises
stemming from a mismatch in what they borrow (short-term and liquid debt)
and what they lend (long-term and illiquid). They have responded by
studying the issue closely and examining whether shadow lenders should
be subject to some or all of the strict regulations that govern lending by
traditional banks.

While the universe of shadow lending is vast, it is worth noting that most
alternative investment debt funds do not use extensive amounts of
additional debt in order to extend or acquire business loans.

Overview of Key factors in the shadow lending system

Sources of Returns

At first glance, many of the asset classes that fall under the alternatives
umbrella seem to have little in common. However, all firms in the
alternatives universe rely on one or more of the attributes in the below
figure in order to generate their returns.

Below we take a look at these attributes in turn, noting that their importance
varies considerably depending on the asset class in question. For example,
leverage tends to be particularly important for private equity buyouts and
for some (but not all) hedge fund strategies, while investment selection is
the primary source of value venture capital and private equity buyout firms.

Sources of value for Alternative Investors

Relative Importance of Each Source of Value by Asset class

ALTERNATIVE INVESTMENTS ARE ON THE RISE

It would appear that the days of investment portfolios consisting

solely of equities and bonds are now steadily becoming a
thing of the past. There is now growing evidence to suggest that
allocating funds exclusively to such assets is failing to offer either the
necessary diversification or the intended returns that investors require
over the long-term. This is where alternative investments are proving
crucial, and they are being increasingly held in the portfolios of
institutional investors as well as high-net-worth individuals (HNWIs)
and ultra-high-net-worth individuals (UHNWIs).

But what exactly are alternative investments? They are generally

defined as those that do not fall under the typical classes of
financial assets, such as stocks, bonds and cash. This means that
the term alternative investments has ended up becoming a catch-all
term under which a number of products can be categorised, including:

● Hedge-fund–specific strategies, including relative value,

event-driven, macro and equity hedge,
● Private equity, such as venture capital, leveraged buyouts and
distressed investing,
● Commodities,
● Infrastructure,
● Mineral rights
● Derivatives, such as futures, options and swaps,
● Real estate, including REITs (real estate investment trusts),
direct and indirect ownership of property and lending
against property,
● Art and antiques,
● Intellectual property.
As such, there is a large diversity of products and strategies that
are classified under the alternatives umbrella. Leading global
asset-management firm BlackRock sees the sector as being divided
broadly into two main categories. Firstly, there are vehicles that invest
in non-traditional assets, such as infrastructure and real estate. And
secondly, there are investment strategies that can invest in traditional
assets but do so using non-traditional methods, such as short-selling
and leverage.

As such, there is a large diversity of products and strategies that

are classified under the alternatives umbrella. Leading global
asset-management firm BlackRock sees the sector as being divided
broadly into two main categories. Firstly, there are vehicles that
invest in non-traditional assets, such as infrastructure and real estate.
And secondly, there are investment strategies that can invest in
traditional assets but do so using non-traditional methods, such as
short-selling and leverage.

Given the diverse nature of alternatives, therefore, there can be

many reasons why investors seek to gain exposure to them.
Arguably, the most important reasons are that they offer a route to
gain sufficient diversification and thus reduce portfolio risk, and also
that they can often generate higher returns than an exclusively
traditional portfolio. And not just higher returns but often higher
absolute returns can be generated throughout the economic cycle,
instead of being measured against a market index.

But it may also be other more specific reasons that convince

investors to include alternative investments in their portfolios. It could be
just because the product is priced attractively at a specific point in time,
such as real estate, which in many regions of the world crashed to
historically low market valuations in the aftermath of the financial crisis. Or
the investor may have a specialised understanding of a particular sector,
such as a fine-art dealer, a wine connoisseur or a precious-metals
entrepreneur.

Then there are other less objective reasons for holding alternative
investments, which may or may not necessarily prove to be justified
in terms of maximising portfolio returns. For one, an investor may
simply enjoy the process of investing in alternatives more than stocks
and bonds. Identifying promising start-ups that end up becoming
successful, for example, can be incredibly satisfying for a
venture-capital investor, while the same can also be said for
underwriting one’s own mortgage on acquired real estate. And in
some rare instances, the mere opportunity for savvy investors to be
ostentatious in their decision-making can be enough to hold
alternatives in their portfolios, particularly among the HNWI and
UHNWI crowds.
Other reasons for holding alternative investments are likely to be
based on their unique characteristics, some of which are as
follows:

● A relatively illiquid profile,

● Availability in private markets (not just public markets),
● Low or no correlation with other assets,
● Active rather than passive shareholders (who can sometimes be
solo owners),
● Returns being driven mainly by alpha rather than beta (and
thus typically involving active return-seeking strategies),
● Higher dispersion of returns among investors,
● Markets often not as efficient, which in turn can offer up more
opportunities to exploit,
● Less regulation (such as crypto-currencies),
● Lower transparency,
● Less availability of historical risk and return data,
● Unconventional legal and tax implications.

With so many potential advantages to holding alternatives, therefore,

it is not surprising that investors are becoming increasingly drawn to
the sector. According to Dubai-based alternative-investment platform
and accelerator Dalma Capital, the alternative-investment industry
worldwide represents a whopping $10 trillion in assets under
management (AUM) and is forecast to grow rapidly to $14 trillion by
2023. “As we enter the late stages of economic and credit cycles,
investors increasingly consider alternative investment and uncorrelated
assets,” Dalma’s chief executive officer, Zachary Cefaratti, recently
observed. US asset-management company Fidante Partners,
meanwhile, recently noted that alternative investments reached a
record high of a 7.2-percent share of the global market by the end
of last year. The company also expects the annual growth rate of
alternative investments to average 15.7 percent over the next three
years.

And we can now see this growing interest playing out in the market.
J.P. Morgan, for instance, has become one of the latest
major players to boost their alternatives-sector credentials by
launching its Real Assets investment trust, which will invest in
alternative products, including infrastructure, real estate, transportation,
among others. According to its head of investment trusts, Simon
Crinage, J.P. Morgan has for some time had clients asking whether
it was possible to offer something in this space. “So we have known
for quite some time there is demand for a global real assets fund.”
And in May, BlackRock completed the acquisition of the end-to-end
alternative-investment management-software and solutions provider
eFront for $1.3 billion in cash. eFront currently serves more than 700
clients in 48 countries and enables comprehensive management of
the lifecycle of a range of alternative investments, including due
diligence and risk analysis. BlackRock’s chairman and chief executive
officer, Laurence Fink, said of the acquisition that it “provides a
unique opportunity to accelerate our positioning in both” technology
and illiquid alternatives.
Institutional investors seem to be particularly benefiting from such
forays into the alternatives space, with the likes of pension funds now
significantly increasing their exposures to the sector. According to
Fidante Partners, investments in publicly listed markets and high-yield
bonds dropped by 8.3 percent and 12.3 percent respectively last
year, while private-market interest grew by more than 11 percent, thus
making the biggest difference between public and private markets since
2011. Retail investors are not quite as vested in alternative
investments, however. BlackRock’s global head of alternative
investments, Edwin Conway, recently stated that institutional clients at
his company currently allocate an average of 25 percent of
their portfolios towards alternatives, which is expected to rise to
between 30 and 40 percent, whereas ordinary investors will increase
their alternatives allocation from 3 to 25 percent.

But while alternative investments may offer distinct advantages to an

investor such as potentially higher returns and greater portfolio
diversification, it is worth noting that they don’t guarantee them.
Indeed, investors should also be wary of the pitfalls associated with
various alternative products and understand their often unique risks.
With such considerations in mind, therefore, it is important to perform
the appropriate due diligence to determine whether the investment
strategy can be implemented as well as whether the necessary
infrastructure for managing such investments is in place (particularly
for institutional investors), such as risk management and compliance.
This may prove more challenging than in the case of traditional
investments, especially given the more unique risk-and-return profiles
exhibited by alternatives, not to mention the lower transparency,
liquidity and market efficiency associated with them.
Typical measures of risk and return (such as beta, mean return and
standard deviation) may not provide a sufficient assessment of
an alternative investment’s risk-and-return characteristics or indeed
may even be wholly unreliable or inappropriate. Returns may
also be correlated with some traditional investments, which
would only exacerbate an investor’s losses during periods of financial
downturns or crises. That said, some alternative investments such as
precious metals are often ideal during such periods as they tend to
be negatively correlated with other asset classes. With virtually every
asset tumbling during the 2008-09 financial crisis, for example, gold
proved to be one of the few winners during this time.

Ultimately, alternative investments can offer investors a much-needed

source of higher returns and risk diversification that are simply
non-existent in the world of traditional investing. And while interest in
this space is growing rapidly and the sector itself is continuously
evolving, investors should be fully aware of the often complex nature
and hidden risks associated with such products.
Conclusion

Alternative investments are a large, growing, and important part of the

economy and they affect everyone in one form or another. Consequently, it
is an industry that requires close attention not only from regulators, but also
from the general public. With this report we have attempted to break down
the complex workings and sometimes opaque history of alternative
investments. Three insights stand out:

1. Alternative investments have grown to become a critical component

of the global financial system. The industry provides liquidity, various
forms of capital (from long-term to high-risk) and is a source of
innovation. Alternative investors are also highly diverse, ranging from
high-risk venture capital to long-term private equity buyout funds. As
such, they are a key part of the engine that keeps capital moving
within the financial system and in the real world.
2. Alternative investors serve capital providers with higher returns and
greater diversification. Capital providers include pension funds,
sovereign wealth funds and foundations and endowments, all of
which serve the public good. Pension funds, for example, rely on
returns to close their funding gaps and secure the retirement of their
beneficiaries, while sovereign wealth funds invest on behalf of the
public in order to stabilize the economy and provide future benefits.
Most such institutions include alternatives in their portfolio to achieve
goals in the interest of their stakeholders.
3. The impact of alternative investments on the real economy is
substantial. Alternative investors have an effect on the economy in
numerous ways – and not all are unambiguously positive. At the
highest level, they seek to allocate capital towards its most
productive use and enforce discipline on its deployment. Often this
means funding innovative new products, increasing firm productivity,
or creating corporate governance structures that better align the
interests of executives and investors. All of these changes have the
 potential to improve the economy and society, but the process of
doing so may also result in adverse effects such as layoffs.

The industry cannot thrive or survive by itself, as it relies on the broader

financial system to provide much of the capital (e.g. debt capital) and
services that it requires to operate. Thus, the potential unintended
consequences of new financial regulations should be of significant concern
to policy makers. A review and analysis of this topic can be found in our
forthcoming report, Alternative Investments 2020: Regulatory Reform and
Alternative Investments.

It is also an industry that is quickly evolving in terms of its sources of capital

and the business models that it deploys. New trends, such as
institutionalization – the systematic upgrading of the architecture of both
investors and asset owners, and retailization – the growth of retail investors
as a source of capital, are altering business models and changing the
alternative landscape. A sister report in the World Economic Forum
Alternative Investments 2020 series, The Future of Alternative Investments,
will cover these shifts and what they mean for investors and asset owners
alike in greater depth.

At the societal level, capturing the benefits of alternative investments, while

managing their risks appropriately, requires a subtle understanding of the
complex machinery at work. Our aim for this report is to contribute to this
understanding and provide a primer and reference guide that can inform
policymakers and the public.

The Forum hopes to further meaningful debate on a highly important topic

for society, rather than provide set answers. In this spirit, we welcome any
feedback and constructive input.
 Every investment is inherently connected with risk. Its existence and
diversity among various types of investments is one of the driving
forces behind the development of the capital market. The risk has
also caused emergence and development of alternative investments.
Flourishment of this segment of the market has also been influenced
by periodical financial crises, which have been the driving force
behind the search for investments that would allow investment
portfolio diversification and would provide opportunities for profiting,
even during price declines on the market. Alternative investments
constitute an effective tool for risk diversification, however, they are
not suitable for all investors.

Institutional investors, including the banks, pension funds, large

companies as well as individual investors within the wealth management
sector, constitute a dominant group of the investors on the alternative
investments market. Investors considering such investments should
rely on their own preferences regarding the acceptable risk as well
as on the entities acting as the trustees of the investors’ assets.
Often, it is the experience gained during management of own
alternative investment portfolio, which allows verification and
assessment of the acceptable level of the risk, definition of the
maximum loss tolerance, and designation of achievable financial
targets.

The attempt to evaluate and forecast the alternative investments

market was conducted with caution. A different specificity, not only of
the investments themselves, but of the market on which these
investments are made, have been considered as well. Undoubtedly,
the lack of access to crucial statistical data has hindered the
inference considerably.
 References

● http://www3.weforum.org/docs/WEF_Alternative_Investments_2020_
An_Introduction_to_AI.pdf
● https://www.cfainstitute.org/-/media/documents/book/rf-publication/20
18/rf-v2018-n1-1.ashx