Financial Resource

Alternatives like private equity, commodities and real estate may be somewhat familiar to investors. Others, like hedge funds, managed futures, and “distressed” securities are more recent and may not be as well-known. Alternatives are not for investors who have had no previous experience with them, or who are accustomed to making less complex investment decisions.

It’s critical that investors analyze the complexities of the investment’s structure and strategy; evaluate the business or other expertise of the investment’s owner or manager, and obtain and interpret any available performance or other information about the investment There may also be higher costs associated with determining the suitability of an alternative investment.

TYPES OF ALTERNATIVES

Alternative investments can be placed into three groups by the primary role that they usually play in portfolios:

Investments that provide exposure to markets other than the traditional stock, bond and cash equivalents;

Investments that provide exposure to specialized investment strategies run by an outside management company. Hedge funds and managed futures might fall into this category;

Investments that combine features of the prior two groups, like private equity funds and managed futures.

Let’s take a brief look at the major types of alternative asset classes:

Commodities

Investors can gain direct exposure to commodities in spot (cash markets) or in markets for deferred delivery (futures and forwards markets). Direct investment entails cash market purchase of physical commodities – agricultural products, metals and crude oil – or exposure to changes in spot market values via derivative investments, such as futures. Only investment in commodities via the cash and derivatives markets constitutes alternative investing.

Indirect commodity investment involves acquiring indirect claims on commodities, such as equity (stock) in companies specializing in commodity production. Because cash market purchases involve actual possession and storage of the physical commodities and incur carrying costs (financing, insurance and transportation) and storage costs, investors have generally preferred indirect commodity investments.

Private Equity

The term private equity refers to a stock that is bought or sold via a private placement rather than through conventional public trading. To qualify as private placements, securities are generally offered for sale to accredited investors (institutions or high net-worth investors). Private equity investments can be made face to face with the company needing financing or indirectly through private equity funds. Unlike conventional investments, private equity securities are not registered with a regulatory agency.

Hedge Funds

There is no precise or universally accepted definition of a hedge fund. However they are usually described as pooled investment vehicles that may employ various investment strategies. Although generally regarded as loosely regulated, a trend toward greater regulatory oversight of hedge funds is under way in the U.S.

London is the leading center for Europe’s hedge fund managers, with three-quarters (about 0 billion) of European hedge fund investments at the end of 2008. Asia, and more specifically, China, is taking on a more important role as a source of funds for the global hedge fund industry. Major offshore hedge fund centers include Cayman Islands, Dublin (Ireland), Luxembourg, the British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of the world’s hedge funds, with nearly half the industry’s estimated .225 trillion in assets under management.

Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore locations. Typical rules concern restrictions on the availability of hedge funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.

Hedge funds can use more complex investment strategies and are often classified according to investment style. The five most widely used hedge fund strategies are: equity market-neutral, equity hedge, merger arbitrage, convertible arbitrage, and global macro. (See sidebar, The 5 Most Common Hedge Fund Investment Strategies.)

Managed Futures

These private pooled investment vehicles can invest in the cash, spot and derivatives markets and have the ability to use leverage (borrowed money) in a wide variety of trading strategies. Similar to hedge funds, managed futures programs are actively managed and are structured as limited partnerships open only to accredited investors. The managers take positions based on expected profit potential.

Distressed Securities

These are securities of companies that are in financial distress or near bankruptcy. Investment strategies using distressed securities exploit the fact that many investors are unable to hold below investment grade securities because of investment policy or regulatory restrictions. Also, comparatively few analysts cover distressed securities markets and bankruptcies, resulting in unresearched investment opportunities for knowledgeable investors willing to do their homework.

(SIDEBAR)

The 5 Most Common Hedge Fund Investment Strategies

These investment strategies are the ones most often used in managing a hedge fund.

Equity Hedge

In these strategies, fund managers hold both long and short positions mainly in stocks and stock derivatives (options). An equity hedge fund may be global, industry or country-specific, hedging against downturns in stock markets by taking a long position or shorting stocks or stock indexes that the fund managers believe are overvalued.

Equity Market-Neutral

An investment strategy in which the investor seeks to obtain the same return regardless of the performance of the broader market. There is no single way of executing a market neutral strategy, but it usually involves taking a combination of a long (ownership) position and a short position (the investor borrows and sells a security but has not yet replaced it with an equal number of shares). For example, an investor could take a long position on one market index while also taking a short position on a similar index.

Merger Arbitrage or Risk Arbitrage

An investment strategy that is meant to generate gains with little or no risk. When a publicly traded company is acquired, the acquiring company makes a tender offerto the current shareholders, inviting them to sell their stock at a price usually above the quoted price on the market. As soon as the tender offer is announced, arbitragers will rush in and purchase the security on the open market then turn around and sell it directly to the acquiring company for the higher price.

Convertible Arbitrage

The purpose of convertible arbitrage is to take advantage of a market situation where investors believe that the securities are priced lower they are worth. It involves two simultaneous moves on investments: taking a long position on a company’s convertible security,* while at the same time taking a short position on the company’s stock.

*Any type of security that can be exchanged for other types of securities issued by the same company – for example, bonds issued by a company that are convertible into shares of common stock.

Global Macro

Macro fund managers anticipate such events and shifts and profit by investing in financial instruments whose prices are most directly influenced by these trends. Macro funds participate in all major markets (stocks, bonds, currencies, commodities) though not always at the same time, and often use borrowed funds and financial derivatives to enhance the profit potential of market moves.

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