7 Common Characteristics of Alternative Investments
Besides being increasingly popular in the last decades, alternative investments have proved to have significant benefits for long-term portfolios of various types of investors. Nevertheless, in order to successfully invest in alternative assets and take advantage of their often high returns, controlled risk, and diversification benefits, you should know the common characteristics of alternative investments and what they mean to your investment management process. Many of these unique features present investors with new challenges, unknown in the world of traditional stocks and bonds.
Characteristic 1: Diversity of Alternative Investments
There are several key characteristics which apply across the whole alternative investments universe, but the first common characteristic that comes to mind is the great diversity of alternative assets.
Hedge funds, commodities, private equity, or real estate are all called alternatives, but their liquidity, return patterns, risks, and ways to invest in them are very different. As a result, the below listed characteristics rarely apply universally and to the same extent to all alternative asset classes.
Characteristic 2: Non-normal Returns and Non-linear Returns
Returns of alternative investments often follow distributions which are non-normal. There can be high positive or negative skewness (probabilities and sizes of profits and losses are very different). Alternative assets tend to record extreme returns (on both positive and negative side) more frequently than traditional asset classes. You can see a few examples on what makes alternative investments’ returns non-normal.
Characteristic 3: Most Alternative Assets Have Low Liquidity
Many types of alternative assets have low liquidity. However, there are vast differences between individual alternative asset classes – and even within them. Private equity, real estate, and infrastructure investments have been among the most complicated from the liquidity perspective. These assets usually trade outside the public markets and finding a buyer can be extremely challenging. Liquidity of hedge funds varies – many of them impose lock-up periods and notice periods on withdrawals.
One exception from the low liquidity rule is commodities. Commodity futures, ETFs, or “pure play” commodity stocks are all publicly traded and easy to sell whenever the market is open.
Characteristic 4: Alternative Assets Are Difficult to Value
As a result of their unique return characteristics and illiquidity, the valuation of alternative assets can be tricky. For those assets which trade outside the public markets, it is difficult to figure out fair market prices, as details of transactions are often kept private.
Therefore, private equity and real estate are often valued based on appraisals and theoretical models, which may be subjective and prone to biases (or even conflict of interest when returns are deliberately smoothed). You can read more about the challenges of alternative investments valuation and performance measurement.
Characteristic 5: Weaknesses of Alternative Investment Benchmarks
The difficulty of collecting market price data and the frequent subjectivity of valuation makes it also very challenging to create benchmark indices for real estate or private equity. Though several good quality benchmarks have been introduced in the last years, you should always study the underlying methodology and rules for creating an index before using it in your investment management process.
Similarly, there are numerous hedge fund index providers, but understanding how data is collected and how a particular index is constructed is crucial for using the index effectively. There are several biases which hedge fund indices commonly have, including survivorship bias, self-selection bias, or backfill bias.
Characteristic 6: Alternative Assets Are Not Available to Everybody
Hedge funds and private equity are known to be the rich guys’ game and not easily available to small investors. This is partly due to legal restrictions, as these funds may only be marketed and sold to so called qualified investors (defined by law as having net worth exceeding a specified amount). It makes sense in a way that these investments and their risk exposures are usually more complicated to understand – the law assumes that rich people have more experience with investing and risk taking (this assumption is often wrong).
On the other hand, some types of alternative assets are more widely available. Exposure to commodities, for example, can easily be created using ETFs, commodity futures, or shares in mining companies. You can trade some of these with as little as 40 dollars. Even with other alternative asset classes, the trend in the last years has been towards making them more available to retail investors. You can read more here: Alternative Investments Accessibility: Are Hedge Funds Only for the Rich?
Characteristic 7: Due Diligence Is Both Necessary and Costly
Before making an investment decision which involves alternative assets, you often need to spend a lot of time on research and due diligence. Due diligence is typically more time consuming and more costly with alternative investments due to several factors:
- Complexity of alternative funds’ holdings and exposures. Alternative funds often use derivatives, leverage, and less traditional securities. It is therefore more difficult to analyze their holdings and risk exposures.
- Diversity of alternative investments. There are thousands of ways how a hedge fund can trade. There are thousands of little factors to look at when buying property. With every new investment you face new unique features which you must understand and analyze before making the investment decision.
- Secrecy of fund managers and lack of transparency. The information you need is not just simply available. Even when they need to explain their trading strategy to persuade a potential investor, fund managers are often reluctant to disclose too much in fear of losing their edge.