What are the different types of alternative investments?
Alternative investments can be split into two types of assets: different ways to manage, and different types of assets. I’ve written before how all wealth really depends on the economy. A huge pile of gold or a robotic factory that churns out flying cars are both worthless if they’re stranded on Mars.
Alternatives are just different ways to tie in to the economy’s wealth. Within management-alternatives are private equity, angel investing, and venture capital investing. These are different ways to have equity ownership, and they focus on young companies or companies that are in unique circumstances, like distressed firms in turnaround situations. Because so many startups fail, execution here is critical. Fund managers need to be able to provide management support along with their cash.
Private equity focusses on more mature companies. It provides a different level of accountability to company executives than public ownership. If private investors are suspicious of a firm’s accounting, they can bring in their own accountants. If a privately owned firm’s management behaves badly in the morning, they can be fired in the afternoon. That’s one reason why there are fewer scandals involving private firms. They can be held to a higher standard.
Source: NY Fed
Hedge funds are a different breed of alternatives. They aren’t really a different type of asset, they’re a different type of fee structure. They typically have a higher management fee, and they also take a share of a portfolio’s gains. Hedge fund managers are also free to invest in all kinds of things, to concentrate their portfolios, to use leverage, to short different assets, and so on. The theory is that by providing more compensation – and more flexibility for fund managers – the best ideas will emerge. But sometimes, hedge funds run out of ideas. Then they end up doing silly things, like putting most of their money into one stock.
In the long run, these management alternatives depend on the stock market for many of their activities, whether it’s IPOs to get cash out of a startup, or market multiples to figure what the value of a company might be in a mezzanine-funding round. So it’s no surprise that correlations are pretty high, even if their performance is better.
Management alternatives aren’t really different assets, they’re different ways to invest in assets. Using different managers is like listening to a different musician perform a song you like. Sometimes you get an entirely different take on the music. But sometimes, it’s just a different rendition of the same old song.
Douglas R. Tengdin, CFA
Chief Investment Officer