Alternative Investments: Concepts & Strategies

Posted on Jul 5, 2025 in Finance

Hedge Funds & Private Equity Fundamentals

  1. Service Providers:
    Prime brokers provide financing and trading; administrators manage pricing and reporting; custodians safeguard assets.

  2. Fee Structures:
    Hedge funds typically charge 1–2% management fees and 10–20% incentive fees, often on realized and unrealized gains, unlike mutual funds which charge only flat management fees.

  3. Illiquidity in Private Equity:
    Investors must deal with capital calls and cannot redeem easily. Secondary markets are thin, especially in downturns.

  4. Legal Structures:
    Most PE funds use limited partnerships: General Partners (GPs) manage, Limited Partners (LPs) invest with limited liability. LPs may join advisory boards but do not manage directly.

  5. Managerial Life Cycle:
    Fund managers show return persistence. Top-quartile performers often remain top. Institutions aim to invest early in successful manager life cycles.

Due Diligence & Diversification Strategies

  1. Due Diligence:
    Investment due diligence evaluates the strategy; operational due diligence checks governance, fraud risk, controls, and service providers.

  2. Diversification Methods:
    Direct investment (high control, high cost); fund of funds (low entry, high fees); multi-strategy funds (internal diversification, lower control).

  3. Risks Accepted:
    Hedge funds accept complexity, illiquidity, and event risk. These can yield excess returns if managed well.

Fee Mechanisms & Risk Concepts in Alternatives

  1. High-Water Marks & Clawbacks:
    High-water marks ensure incentive fees are paid only on new profits. Clawbacks apply mostly in PE to return past fees after losses.

  2. Incentive Fees Comparison:
    Hedge funds charge based on unrealized gains. Private Equity (PE) uses carried interest on realized profits, often with hurdle rates and clawbacks.

Performance Measurement & Real Assets

  1. IRR Limitations:
    Internal Rate of Return (IRR) is sensitive to cash flow timing and assumes reinvestment at the IRR itself. It can distort performance compared to time-weighted returns.

  2. Real Assets as Diversifiers:
    Assets like real estate and farmland show low correlation with equities, improving diversification.

  3. Illiquidity Premium:
    Illiquidity prevents quick exit, especially in crises. The premium compensates for these constraints.

Accessing & Valuing Real Assets

  1. Access to Real Assets:
    Through direct ownership, partnerships, funds, and derivatives like futures and swaps.

  2. Valuation by Appraisal:
    Appraisals cause “smoothing” — reported volatility and correlations are understated compared to market-based prices.

Specific Alternative Investment Types

  1. Raw Land:
    Raw land is like a call option on future development. Its value increases with potential uses and volatility. Modeled using real options and tree diagrams.

  2. Farmland Characteristics:
    Generates income from crops/livestock. Exposed to commodity price and land speculation risk.

Commodities & Derivatives in Investment

  1. Commodities as Investments:
    Accessed mainly via futures. Provide inflation protection, diversification, and potential alpha.

  2. Components of Commodity Returns:
    Total return = cash price change + roll yield + collateral return (from cash posted to futures).

Structured Products & Derivatives Explained

  1. Collateralized Debt Obligations (CDOs):
    CDOs repackage debt into tranches with different risks and returns. Used to create structured exposures.

  2. Tranching in CDOs:
    Senior tranches get paid first, are safest; equity tranches get paid last, are riskiest. Tranching redistributes default risk.

  3. Financial Derivatives Uses:
    Used for leverage (high exposure, low capital), completing markets (creating tailored exposures), and reducing transaction costs (versus cash markets).

  4. Options Positions:
    Long options have limited loss, high upside. Short options offer small premium gains but large potential losses. Like a lottery ticket versus an insurance writer.

  5. Forwards and Futures:
    Equivalent to long/short cash exposure, but use less capital. Cash efficient but lack dividends and may involve financing costs.

  6. Credit Default Swaps (CDS):
    CDS shift credit risk between parties. Buying CDS = buying protection. Selling CDS = taking on credit exposure. Used to build synthetic bond positions.

Advanced Risk Management Strategies

  1. Tail Risk:
    Extreme losses from unlikely events. Strategy drift — unmonitored changes in investment behavior — can increase tail risk unexpectedly.

  2. Managing Tail Risk:
    Use stress testing, limit leverage, and continuously monitor strategy alignment to avoid unrewarded tail risk.