Alternative Investments. Hossein Kazemi
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investment outlay, the return computations may use alternative concepts of valuation, such as notional principal amounts. In the case of multiple cash contribution commitments, IRR is used. Chapter 3 provides details regarding return computation methods that facilitate analysis of alternative investments.
1.5.2 Statistical Methods
The traditional assumption of near-normal returns for traditional investments offers numerous simplifications. First, the entire distribution of an investment with normally or near-normally distributed returns can be specified with only two parameters: (1) the mean of the distribution, and (2) the standard deviation, or variance, of the distribution. Much of traditional investment analysis is based on the representation of an investment's return distribution using only the mean and standard deviation. Further, numerous statistics, tests, tables, and software functions are readily available to facilitate the analysis of a normally distributed variable.
But as indicated previously in this chapter, many alternative investments exhibit especially non-normally distributed returns over medium- and long-term time intervals. Non-normality is usually addressed through the analysis of higher moments of the return distributions, such as skewness and kurtosis. Accordingly, the analysis of alternative investments typically requires familiarity with statistical methods designed to address this non-normality caused by institutional structures like thin trading, securities structures like tranching, and trading structures like alternating risk exposures. An example of a specialized method is in risk management: While a normal distribution is symmetrical, the distributions of some alternative investments can be highly asymmetrical and therefore require specialized risk measures that specifically focus on the downside risks. Chapter 5 introduces some of these methods.
1.5.3 Valuation Methods
Fundamental and technical methods for pricing traditional securities and potentially identifying mispriced securities constitute a moderately important part of the methods used in traditional investments. In traditional investments, fundamental equity valuation tends to focus on relatively healthy corporations engaged in manufacturing products or providing services, and tends to use methods such as financial statement analysis and ratio analysis. Many hedge fund managers use the same general fundamental and technical methods in attempting to identify mispriced stocks and bonds. However, hedge fund managers may also use methods specific to alternative investments, such as those used in highly active trading strategies and strategies based on identifying relative mispricings. For example, a quantitative equity manager might use a complex statistical model to identify a pair of relatively overpriced and underpriced stocks that respond to similar risk factors and are believed to be likely to converge in relative value over the next day or two. Additionally, alternative investing tends to focus on the evaluation of fund managers, while traditional investing tends to focus more on the valuation of securities.
Methods for valuing some types of alternative investments are quite distinct from the traditional methods used for valuing stocks and bonds. Here are several examples:
■ Alternative investment management may include analyzing active and rapid trading that focuses on shorter-term price fluctuations than are common in traditional investment management.
■ Alternative investment analysis often requires addressing challenges imposed by the inability to observe transaction-based prices on a frequent and regular basis. The challenges in illiquid markets relate to determining data for comparison (i.e., benchmarking), since reliable market values are not continuously available.
■ Alternative investments such as real estate, private equity, and structured products tend to have unique cash flow forecasting challenges.
■ Alternative investments such as some real estate and private equity funds use appraisal methods that are estimates of the current value of the asset, which may differ from the price that the asset would achieve if marketed to other investors.
These specialized pricing and valuation methods are driven by the structures that determine the characteristics of alternative investments.
1.5.4 Portfolio Management Methods
Finally, issues such as illiquidity, non-normal returns, and increased potential for inefficient pricing introduce complexities for portfolio management techniques. Most of the methods used in traditional portfolio management rely on assumptions such as the ability to transact quickly, relatively low transaction costs, and often the ability to confine an analysis to the mean and variance of the portfolio's return.
In contrast, portfolio management of alternative investments often requires the application of techniques designed to address such issues as the non-normality of returns and barriers to continuous portfolio adjustments. Non-normality techniques may involve skewness and kurtosis, as opposed to just the mean and variance. In traditional investments, the ability to transact quickly and at low cost often allows for the use of short-term time horizons, since the portfolio manager can quickly adjust positions as conditions change. The inability to trade some alternative investments like private equity quickly and at low cost adds complexity to the portfolio management process, such as liquidity management, and mandates understanding of specialized methods. Finally, alternative investment portfolio management tends to focus more on the potential for assets to generate superior returns.
1.6 Investments Are Distinguished by Other Factors
Three other issues help form the complex differentiation between alternative and traditional investments: information asymmetries, incomplete markets, and innovation.
Information asymmetries refer to the extent to which market participants possess different data and knowledge. In traditional investments, most securities are regulated and are required to disclose substantial information to the public. Many alternative investments are private placements, and therefore the potential for large information asymmetries is greater. These information asymmetries raise substantial issues for financial analysis and portfolio management.
Incomplete markets refer to markets with insufficient distinct investment opportunities. The lack of distinct investment opportunities prevents market participants from implementing an investment strategy that satisfies their exact preferences, such as their preferences regarding risk exposures. In an ideal world, securities could be costlessly created to meet every investor need. For example, an investor may desire an insurance contract that contains a specific clause regarding payouts, but regulations may make such clauses illegal. Or perhaps a contract with regard to a potential risk may be subject to unacceptable moral hazard. Moral hazard is that risk that the behavior of one or more parties will change after entering into a contract. As a result of this inability to contract efficiently, the investor might be unable to diversify perfectly. Trading structures in some alternative investments, such as large minimum investment sizes, can be viewed as exacerbating the problem of incomplete markets and the investment challenges that accompany them.
Finally, substantial degrees of innovation permeate the world of alternative investments, from the nascent enterprises of venture capital to the pioneering structures implemented in financial derivatives. The new and rapidly changing nature of alternative investments raises issues regarding methods of financial analysis and portfolio management that distinguish the study of alternative investments from the study of traditional investments.
1.7 Goals of Alternative Investing
Having defined what alternative investments are from a variety of perspectives, we introduce the questions of how and why people pursue alternative investing. Understanding the goals of alternative investing is essential; the following sections provide an introduction to the most important of these goals.
1.7.1 Active Management
Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return. Alternative investment analysis typically focuses on evaluating active managers and their systems of active management, since most alternative investments are actively managed. Active management is the converse of passive investing. Passive investing tends to focus on buying and holding securities in an effort to match the risk and return