Alternative Investments. Hossein Kazemi

use this view of structures to clarify, distinguish, and organize our understanding of alternative investments. The following paragraphs provide an overview of the five primary structures related to alternative investments:

      1. Regulatory structure refers to the role of government, including both regulation and taxation, in influencing the nature of an investment. For example, hedge funds (but not their managers) are often less regulated and typically must be formed in particular ways to avoid higher levels of regulation. Taxation is another important feature of government influence that can motivate the existence of some investment products and plays a major role in the transformation of underlying asset cash flows into investment products.

      2. Securities structure refers to the structuring of cash flows through leverage and securitization. Securitization is the process of transforming asset ownership into tradable units. Cash flows may be securitized simply on a pass-through basis (i.e., a pro rata or pari passu basis). Cash flows can also be structured through partitioning into financial claims with different levels of risk or other characteristics, such as the timing or taxability of cash flows. The use of securities and security structuring transforms asset ownership into potentially distinct and diverse tradable investment opportunities. The nature of this transformation drives and shapes the nature of the resulting investments, the characteristics of the resulting returns, and the types of methods that are needed for investment analysis. On the other hand, lack of easily tradable ownership units can drive the selection and implementation of investment methods.

      3. Trading structure refers to the role of an investment vehicle's investment managers in developing and implementing trading strategies. A buy-and-hold management strategy will have a minor influence on underlying investment returns, while an aggressive, complex, fast-paced trading strategy can cause the ultimate cash flows from a fund to differ markedly from the cash flows of the underlying assets. The trading strategy embedded in an alternative asset such as a fixed-income arbitrage hedge fund is often the most important structure in determining the investment's characteristics.

      4. Compensation structure refers to the ways that organizational issues, especially compensation schemes, influence particular investments. Thus, in the case of a hedge fund, compensation structures would include the financial arrangements contained in the limited partnership formed by the investors and the entity used by the fund's managers. Such arrangements usually determine the exposure of the fund's investment managers to the financial risk of the investment, the fee structures used to compensate and reward managers, and the potential conflicts of interest between parties. Compensation structures within investments, especially alternative investments, have implications for the agency costs generated by owner-manager relationships.

      5. Institutional structure refers to the financial markets and financial institutions related to a particular investment, such as whether the investment is publicly traded. Public trading or listing of a security is an essential driver of an investment's nature. Other institutional structures can determine whether an investment is regularly traded, is held by individuals at the retail level, or tends to be traded and held by large financial institutions such as pension funds and foundations.

      1.3.2 Structures and the Four Alternative Investment Types

      It would be difficult to find a major investment that is not influenced or shaped in at least some small way by each of the five primary structures. However, many investments tend to be most heavily influenced by only a subset of those structures. This section provides a general indication of the five structures that most influence the four alternative asset types of this book.

      1. REAL ASSETS such as natural resources and commodities tend to have relatively fewer influences from structures, although the value and management of natural resources are often quite subject to regulations. Commodities are primarily driven by their securities structure, since they are usually traded using futures contracts, but tend not to be heavily influenced by other structures. Operationally focused real assets are dominated in size by land and real estate. The majority of land and real estate has the institutional structure of being privately held and traded. The use of securities in the structuring of cash flows and securitization has also been important in driving the nature of real estate investments. Infrastructure often includes heavy regulatory structures, while intellectual property often includes issues related to compensation structures.

      2. HEDGE FUNDS are primarily driven by the trading structure: the use of active, complex, and proprietary trading strategies. Hedge funds are also distinguished by regulatory structures (e.g., the use of offshore structures due to tax regulations) and compensation structures, including the use of performance-based investment management fees.

      3. PRIVATE EQUITY is clearly distinguished by the institutional structure that it is not publicly traded. Compensation, securities, and trading structures also play nontrivial roles in shaping the nature of private equity.

      4. STRUCTURED PRODUCTS are clearly distinguished by the securities structure. However, structured products are also typically moderately influenced by institutional, regulatory, and compensation structures.

      1.3.3 Limits on Categorization

      Structures are an essential concept in understanding the nature of an investment; however, they are not necessarily a defining feature of alternative investments. For example, can we view an investment as an alternative investment if it is substantially affected by a particular number of these aspects? The answer is no. Some alternative investments, such as timberland, have minimal influences from structures. Typically, the cash flows of the underlying timberland are not substantially altered by structures as they pass from the underlying real assets to the ultimate investor. On the other hand, investments such as equity derivatives and interest rate derivatives can be heavily structured and regulated and yet be considered in many cases to be traditional investments.

      The concept of the five structures is designed to help us understand and analyze investment products but not necessarily to define classes of securities. The context of these five structures can help identify an investment's distinguishing characteristics. Structures help explain why some investments offer different return characteristics than others and why some investments require different methods of analysis than others; these topics are covered in the next two sections.

      1.4 Investments Are Distinguished by Return Characteristics

      A popular way of distinguishing between traditional and alternative investments is by their return characteristics. Investment opportunities exhibiting returns that are substantially distinct from the returns of traditional stocks and bonds might be viewed as being alternative investments. Stock returns in this context refer to the returns of publicly traded equities; similarly, bond returns refer to the returns of publicly traded fixed-income securities.

      1.4.1 Diversification

      An investment opportunity with returns that are uncorrelated with or only slightly correlated with traditional investments is often viewed as an alternative investment. An attractive aspect of this lack of correlation is that it indicates the potential to diversify risk. In this context, many alternative investments are referred to as diversifiers. A diversifier is an investment with a primary purpose of contributing diversification benefits to its owner. Absolute return products are investment products viewed as having little or no return correlation with traditional assets, and have investment performance that is often analyzed on an absolute basis rather than relative to the performance of traditional investments. Diversification can lower risk without necessarily causing an offsetting reduction in expected return and is therefore generally viewed as a highly desirable method of generating improved risk-adjusted returns.

      Sometimes alternative assets are viewed as synonymous with diversifiers or absolute return products. But clearly most types of investments, such as private equity, REITs, and particular styles of hedge funds, have returns that are at least modestly correlated with public equities over medium- to long-term time horizons and are still viewed as alternative investments. Accordingly, this non-correlation-based view of alternative investments does not provide a precise demarcation between alternative and traditional investments. Nevertheless, having distinct