Alternative investments can protect you
August 15, 2008
As you probably already know, today’s investment landscape includes more than just stocks, bonds and mutual funds- it also includes investments such as private equity, real estate and hedge funds and managed futures, among others. These types of investment, known collectively as alternative investments, are not new, but they’re growing in popularity as investors begin to better understand how they work and what potential benefits they may provide.
Like mutual funds, alternative investments pool capital from different investors into a commingled fund. (meaning all investors share the same fund manager and asset allocation strategy) to make investments. Unlike mutual funds, however, these funds are generally structured as private, nonregistered investment funds and investors must meet certain net- worth or net- investment Ðasset requirements. Depending on their country of residence and tax status, investors contribute to onshore (U.S. based) or offshore (based outside the U.S.) versions of alternative funds. Alternative investments typically have high investment minimums and liquidity may be limited.
Although they invest in the same markets as traditional funds, alternative funds use strategies that are vastly different. For instance, alternative managers may use short selling, leverage and derivatives to hedge risk and maximize return. What’s more, alternative investment may provide diversification benefits because of their low-to-moderate correlation to traditional investments- and each other. (Correlation refers to the degree to which two investment are expected to move in the same direction at the same time)
Alternative funds can also invest through other funds. So-called “funds of funds” distribute investment among other fund manager, who in turn invest the capital directly. Funds of funds often allow investors to invest in a broader array of funds than they would otherwise be able to because of impediments such as high minimums and limited access to single-manager funds. Investing funds of funds also can help spread the risk of investing in a single-manager fund.
While the performance of traditional funds depends primarily on market returns, the performance of alternative funds depends largely on manager skill. That’s why alternatives are known as “absolute return” investments- managers aim to reach a target return, regardless of the direction of the market. (With traditional or “relative return” investments, managers aim to match or beat a relative benchmark such as the Standard & Poor’s 500 index.)
Some examples of alternative investments are listed below.
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Private equity: Negotiated private investments in (most often) nonpublic companies at different stages of maturity. The objective is to resell at a higher price in the future.
Hedge funds: Private investment funds that invest primarily in the global equity and fixed income markets. Hedge funds typically use sophisticated trading strategies that involve leverage and derivative instruments.
Real estate: Negotiated private investments in real estate assets with the objective of generating current income and/or reselling at a higher value in the future.
Structured/fixed income products: Pools of fixed income securities purchased with equity from investors and leveraged with the objective of generating spread income (the difference between income and cost) for investors.
Managed futures: Investments in global markets including futures, options and forwards on traditional commodities, financial instruments and currencies.
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