An Introduction to Alternative Investments by Sameer Jain

This, from a friend of mine at AR Capital…

The alternative investments universe generally consists of investments outside
of publicly traded real estate, equity and debt. It includes investments ranging
from private commercial real estate, hedge funds and managed futures, liquid
alternatives to illiquid private equity funds, and real asset and natural resource
partnerships. Moreover, the alternative investments industry is rapidly evolving
– expanding and increasing its ability to provide durable investment strategies,
and therefore is attracting interest from a growing number of individual investors.
These programs are continuing to increase in popularity among the investment
community because, when added to an otherwise well-balanced, fully diversified
portfolio, they have the potential to provide greater risk-adjusted return, while
also adding diversity and flexibility for advisors/investors seeking to construct a
durable income-producing portfolio.

Alternative investment programs are generally not required to register under the
Investment Company Act of 1940. When offered as public, non-traded investment
funds, they are not listed on an exchange, placing limits on the investors eligible
to access them. Until recently, these private alternative investment programs were
largely available only to high net worth and institutional investors (though now they
continue to make up an increasingly larger part of the average investor’s portfolio).
A distinct feature of alternative investments is their absolute performance objective.
In other words, they do not merely seek to outperform a benchmark but rather
aspire to produce positive returns under varying market conditions. In order to
achieve their absolute performance objective, alternative investment solutions tend
to use leverage to increase returns as well as depend upon on investing skill rather
than just market exposure to create value. Historically, alternative investments
have exhibited relatively low correlation with traditional financial market indices
over long periods of time. Typically they also exhibit reduced liquidity relative to
traditional investments, with monthly to multi-year lock-ups. Alternative program
managers typically charge higher fees, which may include performance fees.
We believe that in order to act in their client’s best interest, advisors should consider
taking the large dispersion of performance across program sponsors into account,
in addition to evaluating the degree of each program’s performance persistence.
Therefore, even more so than for traditional investments, program manager selection
is of critical importance.

Alternative investments tend to fall into four broad subtypes – commercial real
estate, private equity, hedge funds (with a variant liquid alternatives/ alternative
mutual funds), and managed futures – all of which differ from traditional
investments in a variety of ways.

Commercial real estate investing includes making equity or debt investments in
multi-family residential, land, office, industrial, retail, hotel properties and other
more specialized assets. A significant advantage of commercial real estate is that
investors can gain access to this segment through a number of different vehicles
and structures that provide different types of opportunity at different points in
the business cycle. It is important to remember that the commercial real estate
market does not necessarily move in tandem with the residential housing market.
It is driven more by economic factors such as economic growth, job creation,
consumption and inflation.
These investments may utilize anywhere from 30% to 75% leverage, while
traditional investments typically do not rely on leverage. Historically, commercial
real estate has had a relatively low correlation with financial market indices.
Over the long term, commercial real estate has also been less volatile when
compared to traditional investments such as equities and fixed income. Also,
real estate is a physical asset and is relatively illiquid, as opposed to traditional
investments which are financial assets and are highly liquid. Lastly, real estate
is typically considered a better inflation hedge than traditional investments.
This is because as inflation rises, the value of real estate usually increases in
tandem, whereas traditional investments such as stocks are usually hurt by
adverse inflation surprises.