Part A: Foundations
Introduction to alternative investments
Key takeaways
- Alternative investments differ from conventional ones on four dimensions: they are generally illiquid, lightly regulated, driven by manager skill and illiquidity premia rather than broad market beta, and valued infrequently by appraisal or model.
- Their defining features are illiquidity, low correlation with traditional assets, greater use of leverage, higher fees, lighter regulatory oversight and heavier reliance on manager skill.
- They are held through their own structures: limited partnership interests or fund shares, privately negotiated trading, management plus incentive fees, and layers such as funds of funds and co-investment vehicles.
- Investors hold them for four goals: diversification, return enhancement, inflation protection and access to opportunities public markets do not offer.
- Illiquidity is the one property that explains most of the rest, from higher fees to infrequent valuation and the illiquidity premium.
Alternative investments were first introduced in CIFA Introduction to Finance and Investment, under alternative investment markets, as a residual category outside traditional equities and bonds; this paper develops that category into its own full discipline, starting with what actually distinguishes it.
Alternative versus conventional investments
| Conventional investments | Alternative investments | |
|---|---|---|
| Liquidity | Generally liquid, traded on organised securities exchanges (covered in CIFA Regulation of Financial Markets) | Generally illiquid, often with long lock-up periods |
| Regulation and disclosure | Heavily regulated, standardised disclosure (see CIFA Regulation of Financial Markets) | Lighter regulation, often available only to sophisticated or institutional investors |
| Return drivers | Broad market beta and identifiable factor exposures (covered in CIFA Portfolio Management, under capital market theory) | Often manager-specific skill (alpha), illiquidity premia, and less easily diversified idiosyncratic risk |
| Valuation | Frequent, market-based pricing | Infrequent, appraisal or model-based pricing (see appraisal smoothing, in the chapter on real assets) |
Historical evolution
Alternative investments grew from a niche activity of a small number of specialised institutional and high-net-worth investors into a mainstream allocation for pension funds, endowments and sovereign wealth funds (the investor types covered in CIFA Portfolio Management), driven by the search for diversification and return sources uncorrelated with traditional public markets, particularly following periods of poor traditional-market performance that exposed the limits of a purely stocks-and-bonds portfolio.
Defining features
- Illiquidity, often with multi-year lock-up periods and limited redemption windows
- Lower correlation with traditional asset classes, the primary diversification rationale (echoing the diversification case in CIFA Portfolio Management)
- Greater use of leverage than most traditional strategies
- Higher fees, typically a management fee plus a performance-based incentive fee (see the chapter on hedge funds)
- Less regulatory oversight and disclosure than conventional securities (see CIFA Regulation of Financial Markets)
- Greater reliance on manager skill and less on identifiable, replicable market exposure
Alternative investment structures
Goals of alternative investing
- Diversification: adding return sources with low correlation to traditional holdings (see Defining features, above)
- Return enhancement: pursuing the illiquidity premium and manager-skill-driven alpha not available in efficient public markets
- Inflation protection: particularly through real assets and commodities (each covered in its own chapters)
- Access to unique opportunities: private companies, specific real assets, and strategies unavailable through public markets alone
Self-check
(a) Distinguish alternative from conventional investments on four dimensions: liquidity, regulation, return drivers and valuation. (4 marks)
(b) State four features of alternative investments and, for each, one consequence it has for the investor. (4 marks)
(c) A pension fund's trustees ask why the scheme should hold alternatives at all. Give four goals of alternative investing. (4 marks)
(d) Explain what is meant by an institutional structure such as a fund of funds and why an allocator might accept its extra layer of fees. (3 marks)
Show worked answer
(a) Liquidity: conventional assets trade on organised markets and can be sold quickly; alternatives are illiquid with multi-year lock-ups. Regulation: conventional securities face heavy, standardised disclosure; alternatives are lightly regulated and open only to sophisticated investors. Return drivers: conventional returns come from market beta and identifiable factors; alternative returns depend on manager skill, illiquidity premia and idiosyncratic risk. Valuation: conventional assets are marked to market frequently; alternatives are appraised or modelled infrequently.
(b) Illiquidity, so capital may be locked up for years; low correlation with traditional assets, so the portfolio diversifies; heavy use of leverage, so returns and losses are amplified; high fees (management plus incentive), so gross performance must clear a higher bar before the investor benefits. Reliance on manager skill and light regulation are also acceptable.
(c) Diversification through low-correlation return sources; return enhancement through the illiquidity premium and skill-based alpha; inflation protection through real assets and commodities; access to unique opportunities such as private companies and specific real assets.
(d) A fund of funds pools investor capital across many underlying hedge or private equity funds. An allocator accepts the extra fee layer for manager selection expertise, due diligence it could not conduct itself, diversification across managers, and access to funds closed to small direct investors.
Exam tip
Illiquidity is the single feature that most directly explains almost everything else distinctive about alternative investments: higher fees, infrequent valuation and the illiquidity premium as a return source. Anchor unfamiliar questions back to this one property first.