5 Broad Categories of Alternative Investment Opportunities. 7 Major Differences Between HEDGE FUNDS Investing VERSUS MUTUAL FUNDS Investing.
WHAT ARE ALTERNATIVE INVESTMENTS?
Alternative investments is a term used to describe nontraditional asset classes. Traditional asset classes include stocks, bonds, commodities, and foreign exchange. Alternative investments include real estate funds, private equity, venture capital, managed futures funds, hedge funds, and sometimes products that invest in hard assets such as timber, land, or artwork.
The more established and better understood traditional asset classes are best described as having large global markets, significant pools of liquidity, and a high degree of price transparency, regulation, and established market microstructures. Mutual funds have been around in various shapes and sizes for well over 100 years, whereas alternatives and hedge funds, by even the broadest measures, started in the late 1960s and really only began to grow in the early 1990s.
Alternative investing is not a mature industry. Alternative investments are considered relatively young in terms of life cycle and track records. Hedge funds are perhaps the newest form of alternatives and as such may also be the least understood. Their business models are also not as stable, well developed, or mature as those associated with traditional investing or even earlier forms of alternatives, such as real estate and private equity. Today, there are over $10 trillion of investments in traditional stock and bond mutual funds in the United States and over $25 trillion globally, as compared to just over $2 trillion invested globally in hedge funds.
So what exactly constitutes an alternative as opposed to a traditional investment? There are a few broad categories that most professionals would agree make up the broad universe of alternative investment opportunities.
- Real estate investing includes funds that invest in commercial or residential real estate or mortgages that produce rental income, interest income, and capital appreciation. Most funds are organized in specific regions or by specific types of properties.
- Private equity investing includes funds that take equity ownership in existing private companies in the hope of streamlining or improving management, negotiating favorable leverage terms with banks, and improving performance so that the fund may ultimately profit from an initial public offering (IPO) of the company’s shares.
- Venture capital investing includes funds that provide day-one capital to fund new business ideas. These early-stage investors hope to profit by sale of the company to a strategic investor or perhaps to a private equity fund that ultimately will help the company go public.
- Managed futures investing includes funds that are specially dedicated to trading futures contracts based on directional or trend-following models. These funds are similar to hedge funds in many ways. They are different from hedge funds in that they are restricted to trading listed futures contracts and are regulated by the Commodity Futures Trading Commission (CFTC).
- Hedge fund investing includes private investment partnerships and funds that trade stocks, bonds, commodities, or derivatives using leverage, short selling, and other techniques designed to enhance performance and reduce the volatility of traditional asset classes and investments.
There are several common attributes shared among the various types of alternative investments that make them unique. Most alternative investments are run by expert management, are major investors in the funds they manage, get paid both management and performance or incentive fees, use leverage to enhance returns, are illiquid, provide limited transparency to investors, and are difficult to value.
Alternative investment managers are not managing money to beat a benchmark and as such are free to focus on narrow opportunities that need 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 analysts and 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 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 to 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 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 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.
The following summary of the unique features of alternative investments may be useful in trying to classify an investment as part of a traditional or alternative portfolio.
- Expert management means that the manager of the pool of investments has significant experience in a relatively narrow market segment, industry, or area of investing. This level of skill and focus can allow the manager to identify unique value or opportunities not readily seen by the investor community at large and, as such, generate significant outperformance for investors.
- Manager co-investment means that the manager and many of the partners or employees of the management company are also investors in the fund. This further serves to align the interests of the investors with those of the manager.
- Performance fees mean that the manager is 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 aligns the interest of the manager with that of the investor.
- Leverage means that the fund borrows money 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.
- Illiquidity means that an investor must lock up money in the fund for an extended period and can generally not sell the fund immediately to generate a return of capital.
- Limited transparency means that a fund does not disclose its investments to its investors on a daily basis and, further, that it may restrict the amount of periodic information provided to investors related to positions, strategy, leverage, or risk.
- Hard to value means that the investment or the underlying instruments owned in the portfolio may not be listed on any exchange and require an over-the-counter (OTC) quotation or price, a model price, or an independent valuation to determine the value.
HEDGE FUNDS VERSUS MUTUAL FUNDS
A mutual fund is a highly regulated, collective investment vehicle managed by a professional investment manager. It aggregates smaller investors into larger pools that create economies of scale and efficiency related to research, commissions, and diversification. Mutual funds have been available to investors in a wide range of asset classes since the mid-1970s and became increasingly popular in the 1980s and 1990s as a result of retail attention, product deregulation, and solid returns. Mutual funds generally cannot use leverage or short selling and generally cannot use most derivatives.
Collective investment products originated in the Netherlands in the eighteenth century, became popular in England and France, and first appeared in the United States in the 1890s. The creation of the Massachusetts Investors’ Trust in Boston heralded the arrival of the modern mutual fund in 1924. The fund went public in 1928, eventually spawning the mutual fund firm known today as MFS Investment Management. State Street Investors started its mutual fund product line in 1924 under the stewardship of Richard Paine, Richard Saltonstall, and Paul Cabot. In 1928, Scudder, Stevens, and Clark launched the first no-load fund.
The creation of the Securities and Exchange Commission and the passage of the Securities Act of 1933 and 1934 provided safeguards to protect investors in mutual funds. Mutual funds were required to register with the SEC and provide disclosure in the form of a prospectus. The Investment Company Act of 1940 put in place additional regulations that required more disclosures and sought to minimize conflicts of interest. At the beginning of the 1950s, the number of open-end funds topped 100. In 1954, the financial markets overcame their 1929 peak, and the mutual fund industry began to grow in earnest, adding some 50 new funds over the course of the decade. The 1960s saw more than 100 new funds established and billions of dollars in new investment inflows. The bear market of the late 1960s resulted in a temporary outflow and a minor reversal of the trend in growth. Later, in the 1970s, Wells Fargo Bank established the first passively managed index fund product, a concept used by John Bogle to found the Vanguard Group.
Hedge funds emerged as an investment product in the late 1960s. Alfred Winslow Jones is considered to have been the first hedge fund manager, in that he used leverage and short selling to modify portfolio returns and was paid an incentive fee. Hedge funds, however, provide investors with investment opportunities that are very different from those available from traditional investments such as mutual funds. Hedge funds are also regulated and structured differently from mutual funds and thus have certain unique properties, although both operate using expert managers on behalf of passive investors. Hedge funds are designed to offer investors less volatility and lower correlation to traditional investment benchmarks such as the S&P 500 and the various corporate bond indices.
Hedge funds do share some common features of the more familiar mutual fund; however, they also have some very significant differences. There are seven major differences between a hedge fund and a mutual fund that are worth noting:
1. Performance measurement
Mutual fund success or failure is based on relative performance versus some benchmark or index. Performance is compared to a particular index that is considered suitable to capture passive returns from a particular asset class. Equity mutual funds are commonly benchmarked against an index such as the S&P 500. Hedge funds, on the other hand, are designed to generate positive returns in all market conditions and as such are referred to as absolute return investments that can generate mostly alpha for their investors.
The mutual fund industry is highly regulated in the United States, whereas regulation of the hedge fund industry is only just beginning to emerge in many markets, including the United States. A mutual fund’s design, terms, liquidity, performance calculations, and other features are prescribed by regulation. In addition, they are generally restricted from many types of transactions, including the use of short selling and derivatives. Hedge funds, by contrast, are only lightly regulated and therefore much less restricted. They are allowed to short-sell securities, use leverage, add derivatives to their portfolios, and use many techniques designed to enhance performance or reduce volatility.
3. Compensation model
Mutual funds are generally rewarded and compensated by a fixed management fee based on a percent of assets under management. The fee generally varies by asset class, with money markets and fixed income earning the lowest fees and active equity or credit strategies earning the highest. Hedge funds are generally compensated with both a fixed management fee and a variable performance fee based on the funds results.
4. Protection against declining markets
Mutual funds are generally not designed to protect investors against declining markets, as they normally need to stay close to 100 percent invested in a specific asset class. In some limited cases, they can use put options or short index futures for hedging. Hedge funds, however, are often able to protect against declining markets by utilizing various hedging strategies, short selling, and derivatives. Hedge funds are often able to generate positive returns in declining markets.
5. Correlation to traditional asset classes
The performance of most mutual funds is dependent on the direction of the equity or bond markets. The performance of many hedge fund strategies has a low, perhaps even negative, correlation to the stock or bond market.
6. Leverage, short selling, and derivatives
Most mutual funds are restricted by regulation from the use of leverage, short selling, or derivatives. When permitted to do so, they can do so only in varying degrees and within strict limits. Even those that can use leverage, short selling, and derivatives often do not, as the firm may lack the expertise and training to do so effectively. Almost every hedge fund can use some combination of leverage, short selling, or derivatives to modify returns and lower volatility.
Most mutual funds offer daily liquidity. In cases where liquidity is restricted, investors most often can exit the fund by paying a penalty. Hedge fund investors usually can redeem only periodically, based on the strategy of the fund. Redemption is usually monthly or quarterly. In some cases it may extend to one or two years.
The author of the aboved writing: Kevin R. Mirabile