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Investments Alternative Investments

Cash, bonds and stocks are considered to be traditional investments as they have historically been the tree main avenues of business, before the whole array of alternative investments came into the picture.

Cash, bonds and stocks are considered to be traditional investments as they have historically been the tree main avenues of business, before the whole array of alternative investments came into the picture. Moreover, as alternative instruments are often more complex, are relatively illiquid and have limited regulations on them, investments in them are confined to high net worth investors and institutional investors. More common of all the various alternative investment strategies, and thus the more popular, are hedge funds, private equity, limited partnerships, venture capital, managed funds and real estate investment trusts. Investments in art, wine and businesses of value may also fall in the ‘alternative investments’ category.

A common underlying theme with all alternative investments happens to be a good scope for portfolio diversification, due to their marginal correlations with other, more traditional investments. If you compare the returns of any investments from the standard asset classes with the returns of alternative investments, the correlations is negligibly small. Due to this important revelation, large private endowments, pension funds and other large institutional funds have now begun to allocate small portions of less than ten percent of their entire portfolios towards alternative investments like hedge funds.

However, on the flip side, many alternative investments have typically high minimum investment requirement and fee schedules that often compare to those of ETFs and mutual funds. The fact that alternative investments deal with fewer regulations also means that they have no compulsions to publish and performance related data that can be verified by potential investors. Though most alternative investments are out of reach for small retail investors, they can still pick up some other investment opportunities in the form of managed funds and REITS in the commodities and real estate markets.

REITs or Real Estate Investment Trusts

A REIT or a Real Estate Investment Trusts is a tax status that is given to a company or corporation that invests in real estate to either reduce or to completely eliminate corporate income taxes. REITS are compulsorily required by law to distribute at least 90 percent of their incomes in return for this, and these may or may not be taxable in the investor’s hands. Just as mutual funds provide a platform for investments in stocks, similarly the REITs were designed to give similar impetus to real estate investments. In the US, REIT is actually a company that has ownership as well as operational rights to real estate that is capable of producing incomes. Some Real Estate Investment Trusts may also finance or fund real estate deals.

REITS can be both publicly as well as privately held, just like any other corporations. Just like normal common stock, the shares of a public REIT may be listed on any public stock exchanges and may be classified as equity stock, mortgage stocks or as hybrid stocks.

There are three key variables that must be looked at when one is looking to gauge the important statistics of a REIT and they are: 1) The Net Asset Value or NAV 2) The Adjusted Funds from Operations AFFO and 3) The CAD or Cash Available for Distribution. The economic slowdown and the worldwide financial crisis are both posing serious threats to the REITs with their share values freefalling anywhere between fifty to seventy percent in many cases.

There are certain stipulations that must be followed by a REIT in order for it to qualify for the tax advantages as a pass through entity and they are as listed below:

  • A board of directors or a board of trustees must professionally manage the REIT.
  • The REIT must be structured as an association, trust or corporation.
  • The REIT must either have transferable shares or have transferable certificates of interest.
  • The REIT must be taxable as a domestic corporation.
  • The REIT must be owned jointly by at least a 100 people.
  • The REIT cannot be an insurance company or a financial institution.
  • Out of the REITs total income, at least 95 percent must be derives from property income pertaining to dividends, interest, etc.
  • The REIT must pay at least 90 percent of its total taxable income as dividend.
  • The REIT must hold the 5/50 rule true; i.e. 5 or fewer individuals cannot hold any more than 50 percent of the REITs stakes during the second half of each tax year.
  • The REIT must have real estate investments of at least 75 percent of its total investment assets.
  • At least 75 percent of the REIT’s gross income must come from rents or mortgage interests.
  • A maximum of 20 percent of its assets can consist of stocks in other taxable or otherwise, REIT subsidiaries.

Hedge Funds

Hedge funds are investment funds that are open to very limited or selective range of investors, who have the regulator’s permissions to undertake numerous investment and trading activities that do not fall into the preview or other investment funds. There is a performance fee that is given to the hedge fund’s investment manager for his management efforts. Each individual hedge fund has a different underlying strategy that not only determines the types of investments that are made in it but also determine the investment methods. The investment class of hedge funds dabbles in all investment types, namely debt, commodities as well as common stock. Just as the name suggests, a hedge fund tries to minimize its potential losses by hedging the risks undertaken in the principal markets by hedging tactics such as short selling in other parallel markets. Still, the words hedge funds are now being used to define even those funds that may not actually hedge their investments risks and may actually use techniques such as short selling to increase it instead in order to increase return expectations.

Typically, hedge fund investments are only open to select investors who are either investment professionals or are independently wealthy. This essentially affords them an exemption from the laws governing short selling, leverages, derivative contracts, liquidity interests and fee structures in many jurisdictions. If you go through the offer documentation of a hedge fund, you will find several statements that commit the hedge fund’s motivations to a particular investment strategy, type and even leverage level. This gives investors an early idea of what the hedge fund is all about. The billions of dollars comprising the net asset value of a hedge fund can already run into billions without it being multiplied by the hedge fund’s leverage. Hence, most hedge funds operate in specialty or niche markets such as high-yield rating derivatives and distressed debt instruments.

The fund manager of a hedge fund typically has two forms of remuneration, namely a management fee as well as an incentive performance fee. Normally, a hedge fund manager charges something called as ‘2 and 20’ fees, which means that the management fee for the fund is 2 percent of the fund’s annual net asset value and the performance based incentive is 20 percent of the fund’s profits. While 2 percent management fee is the standard figure, management fees can range between 1 and 4 percent per annum. Even the performance fee may be higher if the manager is reputed and highly regarded.

Advantages of Hedge Funds

Contrary to the name ‘hedge funds’, an investment in a hedge fund may actually be a riskier investment that investing in any other regulated fund. Still, investing in hedge funds does have the following advantages:

  • Correlation is Low:Hedge funds actually have very low or negligible correlation with bonds and stocks. What this means is that including a hedge fund investment into your investment portfolio can improve the overall risk-adjusted portfolio performance as the asset classes do not correlate and hence lower overall risk.
  • Fund Management Expertise:As hedge fund managers may have higher advantages when it comes to informational resources, market research data, etc. they utilize these additional resources into their management and generate returns that are much higher when compared to the returns of different asset classes.
  • Absolute Returns:Numerous hedge funds offer investment products that not only guarantee a certain percentage return per year but they also offer to yield absolute returns. This makes them good additions to complex risky portfolios.

Disadvantages or Risks of Hedge Funds

The following characteristics of hedge funds need to be analyzed in detail before one chooses to make a risky ‘hedge fund’ investment:

  • Leverage of Debt:A hedge fund typically borrows some money for investment, which is in excess to all the money invested into the fund by all of its investors. Some hedge funds may even borrow sums that are many times larger than the initial investment made into them. When investing in a hedge fund, it is essential to know its leverage status as in case of losses; it is the creditors who have the first share in the hedge fund value. With an over-leveraged hedge fund, even a small loss of say 10 percent of the value of investments in the hedge fund can wipe out the whole 100 percent of its total value as the creditors start calling in their loans.
  • Short Selling Strategies: Unless a short selling position is in direct response to a corresponding long position, losses that can result from an open short sell can theoretically be bottomless. Due to this nature of risk with short selling, it is important to know whether a hedge fund uses the short selling tool to reduce risk (as a hedging strategy) or it uses it as an investment strategy. If the markets work against a hedge fund’s investment strategy, short selling can leave them with excessively high losses. Fortunately, very few ordinary hedge funds will actually play around with short selling as an investment strategy and most use it strictly to hedge.
  • Risk Appetite:Due to the nature of hedge funds, they are often more likely to pick up investments that carry above normal degrees of risk, such as distressed securities, high yield bonds, collateralized debt instruments that are based on sub-prime mortgages, etc. It is important to assess yours as well as the hedge fund’s risk appetite and find a good enough match before choosing one to make an investment.
  • No Transparency: By nature hedge funds are highly secretive, simply because they are not bound to make periodic public disclosures by law. Hence, as an outside investor, it because infinitely more difficult to assess the hedge funds, trading strategies, its portfolio diversification and even other important factors that can affect the investment decision.
  • No Regulation: Financial regulators are not as strict on hedge funds as they are on other regulated funds. What this means is that hedge funds carry far higher risks in terms of undisclosed structural risks than other normal funds do.

Some of the most notable hedge fund firms are as listed below:

  • Bridgewater Associates
  • Fortress Investment Group
  • Amaranth Advisors
  • Citadel Investment Group
  • Man Group
  • D.E. Shaw
  • Marshall Wace
  • GLG Partners
  • Soros Fund Management
  • Renaissance Technologies

Managed Futures Account

The industry of managed futures offers professional money managers the option to make direct investments in world currencies, equity, interest rates, agricultural markets, energy markets and metal industries through the use of instruments such as options, forwards and futures. On specific terms, managed futures involve taking positions in futures contracts, options on futures contracts and Government securities. Though these decisions are most taken on the basis of technical analysis, some may even involve the use of some fundamental research. As the markets that managed futures trade in are not traditional investment markets and as they have historically recorded low correlations with bonds and stocks, the inclusion of managed futures in an investment portfolio gives scope for fair diversification. Staying in line with the modern portfolio theory, the low correlations actually help to reduce overall portfolio volatility and variance without negatively impacting on the returns. This is simply because managed futures source their returns from completely different sources and hence they can not only outperform stocks and bonds but they may even give out positive returns where they don’t.

Private Equity

Private equity is an independent class of investment assets in which investments are made in equity securities of companies that are not publicly traded on open stock exchanges. In other words, what this means is that, to make investments in private equity, you must either involve some capital into an already operational private company or acquire an already existing private company. Due to the large figures involved, capital for private equity is mostly garnered from high net worth individual investors or institutional investors. There are various different styles of private equity and even the types are so varied that the terms ‘private equity’ may not necessary mean the same thing as you cross international borders. The more common investment strategies in private equity can be seen as venture capital, mezzanine capital, distressed investments, leveraged buyouts, etc. Typically, a leveraged buyout involves a private equity firm making a bid for an existing firm by buying out majority stake in it. The greatest distinction between this and a venture capital or growth capital investment is that the latter two invest in emerging or young markets without obtaining any majority control of the company in which they invest.

There are several types of private equity investments and some of them are as listed below:

  • LBO or Leveraged Buy Out:This investment involves making a transaction to buy out a whole company, a small business unit or even just a business asset from an existing set of current shareholders, usually with the use of debt or leverage. These types of transactions usually involve mature or established companies that are able to generate their own operating cash flows.
  • Venture Capital:This type of private equity investment is made in recent or new companies that are either in their launch, early development or business expansion phases of their life cycles. Venture capital investment mostly involves putting money into yet untested ventures, such as a new application or technology, new and unproven products or untried marketing concepts.
  • Growth Capital:Growth capital, as the name suggests, is making investments in mature companies that are looking for an influx of capital in order to meet expansion, restructuring or acquisition needs. The idea behind the financing is to pursue planned business endeavors that require the financing and not to change the control or ownership of the business.
  • Distressed Investments and Investments in Special Situations:When a company is in financial distress, it can look out for equity and debt investments in order to change the distress situation.

One of the sub-categories under this type of investment is the ‘distressed-to-control’ strategy wherein an individual gets some debt securities in order to gain control of the company’s equity once a corporate restructuring is done. This strategy is also known as a ‘loan-to-own’ strategy.

Another sub-category known as the ‘special situations’ category or ‘turnaround’ category involves an investor making both equity as well as debt investments as a part of rescue financing so that the distressed company can meet its operational as well as financial needs.

  • Mezzanine Capital:Mezzanine level financing means financing through preferred equities or subordinated debt that form the lowermost strata in the company’s capital structure after common stock.
  • Secondaries:These are investments that are made in already existing private investment avenues such as private equity fund interests or direct private investment portfolios through purchases from institutional investors that already have them.
  • Other Investment Strategies: The following investment strategies can also be defined as private equity investments and can alternatively be termed as close adjacent market investments:

Real Estate Investment: Certain investors consider real estate to be a separate and independent asset class on its own. These typically risky investments are often backed with leverage.

Infrastructure: These investments are ordinarily made as part of privatization initiatives by Government entities and they mostly go towards financing public works such as toll roads, bridges and the likes.

Power and Energy:This involves not just investment in particular assets but rather in a whole range of different companies that do business in the energy right from extraction or manufacturing, all the way to sale and distribution.

Merchant Banking: This involves private equity investments that are negotiated by financial institutions in unregistered securities of public as well as private companies.

Venture Capital

Venture capital or VC is the private equity capital that is provided to early-stage growing companies that have high potential for returns. The returns can be generated through IPOs or though the trade sale of the company once it has achieved what it had initially set out to achieve because VC investments are generally made in the form of cash investments that are later exchanged for company stock. Venture capitalists typically favor investments in high technology companies such as IT or biotech. Venture capital is usually arranged by dedicated investment companies, who pool in resources from other institutional investors or high net-worth individuals. Firms that provide venture capital have working teams to scout for opportunities. These teams either comprise of experts from a technical background or professional with deep industry experience and hence the field of venture capital is not easy to get into, unless of course you have some expertise of immense value.

Venture Capital Funds

Usually venture capital funds have a fixed 10-year life span though most of them allow for an extension of a few years to allow for the liquidity requirements of private companies. Venture capital funds have a 3 to 5 year investment cycle, post that the focus is rather on investment management and on follow-on investments rather than any new investments. In most funds, the investors make a fixed fund commitment that needs to be individually participated when a capital call is made for it.

Raising Capital

Raising capital is often one of the most difficult steps in the venture capital industry and it can take anywhere from a month to many years to raise the requisite amount of money from the limited partners for their fund. It is only when all the money for the fund is raised is the fund officially closed for its 10-year life term, though some terms may have partial closes when half the money has been raised. The year when a fund closes is termed as a ‘vintage year’ and it is this year that is used for classification of VC funds, especially for comparison purposes.

It may so happen that a fund may finish its capital before its life ends and due to the probability of this happening, large venture capital companies keep numerous overlapping funds at different development stages. This also helps the firms have specialist resources on task for the development of all firms. Though smaller firms may either fail or thrive by the time the fund cashes out, some firms may not still have the same technology and people. It is hence of vital important to constantly reassess the changes in industries as well as people in the companies that the fund already has interests in.

Management and Performance

The main skills set that is put at high value in a VC is the knack of identifying new age technologies with the potential to churn out highly lucrative returns at early stages itself. VCs also look at managerial roles in such companies where entrepreneurial skills can be put to good use along with the capital in order to realize even higher returns. The venture capitalist, either as a person or as an investment firm, is required to bring in both technical as well as managerial expertise along with the actual funds. A venture capital fund on the other hand is a pooled investment tool that invests third-party investors’ capital into ventures that are too risky for normal bank loans or share issues.

Compensation

As touched upon earlier, venture capitalists are compensated in what is known as a ‘2 and 20’ compensation arrangement in which there are two separate components for management fees as well as for the carried interest. Let us look into both of these components separately.

Management Fees: This annual fee is paid to the fund manager for the investment operations undertaken by him, for the fund. In general, the typical management fee equals about 2 percent of the committed capital but it may be higher for some reputed managers.

Carried Interest: This is a kind of performance incentive that is paid out of the fund’s profits. Though the usual carried interest is typically about 20 percent of the profits, it can range between 25 and 30 percent for some funds.

Limited Partnerships

This is a form of partnership that is quite like a general partnership except for the involvement of one or more limited partners along with the general partners (GPs). Here only one partner is required to be a general partner and all the GPs are just the same as conventional partners in the eyes of the law. In other words, all GPs have rights to use partnership property, have control in management, share proportionate portions in profit and have joint as well as several liabilities with regards to the partnership’s debts. As GPs act as agents in a general partnership they can even bind other partners in third party contracts in the course of ordinary business.

Partnership

Though they sound so similar, limited partnerships are indeed different from limited liability partnerships. According to the United States Uniform Limited Partnership Act, 402 (b), unless there is an actual authorization from the other partners, the act or acts of a general partner even in the ordinary course of business is not binding on the other partners of the limited partnership. Limited partners have limited liability with regards to the partnership's debts just like common shareholders in a corporation. The general partners are required to pay teh limited partners an amount simila to a dividend as return on their investments and the terms as well as percentages of this payment are usually defined in the partnership agreement.

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