AUTHORS:

Donald R. Chambers, CAIA

Keith Black, CFA, CAIA

Nelson J. Lacey

 

Alternative Investments: A Primer for Investment Trustees provides an overview of alternative investing for investment trustees and others with substantial experience regarding traditional investments in stocks and bonds but limited experience regarding alternative investments. It begins by exploring the differences between institutional-quality alternative investments and traditional investments, going beyond the common approach of describing assets to an intuitive approach that describes their intrinsic differences. Alternative investments are placed in their long-term historical context, with a focus on their crucial distinguishing features—features that require management methods that differ markedly from traditional methods. 

Two “pillars of portfolio oversight” are the foundation of successful asset selection and allocation in alternative investing: empirical analysis and economics reasoning. Because alternative investing uses empirical and theoretical models that are only lightly covered in traditional investing (i.e., multifactor models, statistical analysis based on higher moments), this primer focuses on the extra knowledge required by portfolio overseers who are new to such investments. For example, Chapter 2 reviews terms commonly used in alternative investing but less commonly used in traditional investing (i.e., prime brokers, private placement memoranda, and undertakings for collective investment in transferable securities, or UCITS).

Nine of the primer’s 17 chapters cover the four major institutional-quality alternative investment categories: hedge funds, real assets, private equity, and structured products/derivatives.

Chapter 3 introduces hedge funds by reviewing the rationale for incorporating hedge funds in a portfolio, including their risks and potential sources of return. An asset’s source of return is an explanation of why the investment might be able to generate enhanced expected returns.

Hedge fund liquidity ranges from liquid alternatives (US Investment Companies Act of 1940 funds) to limited partnerships with restrictions on redemptions and potential lock-up periods. The primer’s introduction to hedge funds includes an overview of the management fees, incentive fees, hurdle rates, and high-water marks commonly found in private hedge funds. Particular attention is given to the call option–like nature of hedge fund incentive fees and the accompanying issue of moral hazard. The chapter concludes with a discussion of co-investment to mitigate conflicts of interest and a general discussion of hedge fund governance. 

• How many underlying funds provide optimal diversification? 
• Should the institution use a direct investment program or pooled approaches?
• What are the relative merits of multistrategy funds, funds of funds, and fund indexes?

Chapters 6, 7, and 8 focus on real assets and the key information that portfolio overseers should possess, such as illiquidity, valuation issues, the smoothing of reported returns, potential benefits of including real assets (e.g., sources of return, diversification), challenges with using internal rate of return, and methods of access. The primer provides clear reasoning for such propositions as intellectual property being a real asset. Although some of the literature does not recognize intellectual property as a real asset, the primer clarifies the distinction between real assets and tangible assets, explaining that tangible assets have physical form, while real assets are direct claims on resources. The counterpart to tangible assets is intangible assets; the counterpart to real assets is financial assets (which are indirect claims on resources). For example, although intellectual property is intangible, it is clearly a direct claim on resources. Understanding of this issue is critical because intellectual property as an asset class is soaring in economic importance. As cited in the primer’s first chapter, tangible assets such as land and gold dominated the world’s wealth in previous centuries. In the last 100 years, however, it is intangible wealth that has fueled explosive economic growth. The assets of many of the world’s largest firms (e.g., Facebook) are now composed almost entirely of intellectual property.

Private equity (including private debt) is a major segment of institutional-quality alternative investing and is addressed in Chapter 9. The chapter includes a discussion of the wide variety of types of private equity as well as access to private equity, the associated fees, the challenges of using and interpreting the internal rate of returns, the J-curve of private equity returns, and potential sources of returns. 

Financial derivatives and structured products are each covered in separate chapters (Chapters 10 and 11, respectively). The chapter on financial derivatives focuses on understanding the risks from a top-level perspective. This view includes a focus on the “Greeks” (e.g., delta, gamma) and the motivations for using options, futures, forwards, and swaps. The chapter on structured products focuses on the intuition and mechanics of collateralized debt obligations (CDOs), including discussions of tranching, cash-flow waterfalls, and the various types of CDOs.

Having introduced alternatives and covered the four major asset groups in the first 11 chapters, the primer, in its remaining chapters, primarily provides portfolio-related perspectives. Chapter 12 discusses tail risk and summarizes lessons to be learned from past fund failures, including flawed investment strategies, investment strategy drift, rogue traders, operations errors, and fraud. Appropriately, the next chapter discusses due diligence, that is, the ongoing duty of investment professionals to exercise care in avoiding harm to their clients. The due diligence discussion focuses on two aspects: (1) the decision of whether to perform various aspects of due diligence internally or through outsourcing, and (2) the particular issues regarding due diligence that have been identified as being especially problematic in the area of alternative investments. The key issues include (1) four important trends in due diligence, (2) three warning signals, and (3) five issues regarding compliance programs and the Code of Ethics (which all advisers registered with the US SEC are required to adopt). 

Chapters 14 and 15 turn to a discussion of returns, risk, benchmarking, return expectations, and performance attribution, focusing on those issues that are particularly important in alternative investments and relevant to asset overseers, and that tend to be relatively unfamiliar to professionals whose experience has been centered on traditional investments. For example, the first of the two chapters emphasizes the asymmetrical return distributions of many alternative investments and the potential errors from viewing returns as being roughly normally distributed. The primer provides an overview of the challenges of measuring and managing risks, including the potential for managers to “game” naive monitoring methods. Chapter 15 clarifies the often-misinterpreted concepts of alpha and beta as applied within alternative investing, and the crucial concepts of absolute and relative performance. The chapter also discusses benchmarks and asset pricing models, not in terms of their mathematical nuances but rather in terms of their usefulness in guiding how asset allocators develop realistic and logical understandings of return expectations for individual assets and portfolios.

The primer’s final two chapters conclude with discussions of portfolio construction approaches (e.g., risk budgeting, risk parity) and the case for investing in alternatives (including the endowment model). The discussion highlights asset allocation as the primary determinant of portfolio returns. Thoughtful and effective asset allocation is inextricably linked to concepts such as diversification, alpha versus beta, and sources of return. 

The key to the usefulness of these final chapters—as well as to the value of the primer as a whole—is the primer’s focus on the most important terms and concepts. These key terms and concepts are clearly presented to the primer’s intended audience: investment trustees seeking to extend their investment knowledge into the area of alternative assets and strategies.