Alternative Investments. Hossein Kazemi

returns is often an important characteristic in differentiating alternative investments from traditional investments.

      Alternative investments may be viewed as being likely to have return characteristics that are different from stocks and bonds, as demonstrated by their lack of correlation with stocks and bonds. The distinctions between traditional and alternative investments are also indicated by several common return characteristics found among alternative investments that either are not found in traditional investments or are found to a different degree. The following three sections discuss the most important potential return characteristic distinctions.

      1.4.2 Illiquidity

      Traditional investments have the institutional structure of tending to be frequently traded in financial markets with substantial volume and a high number of participants. Therefore, their returns tend to be based on liquid prices observed from reasonably frequent trades at reasonable levels of volume. Many alternative investments are illiquid. In this context, illiquidity means that the investment trades infrequently or with low volume (i.e., thinly). Illiquidity implies that returns are difficult to observe due to lack of trading, and that realized returns may be affected by the trading decisions of just a few participants. Other assets, often termed lumpy assets, are assets that can be bought and sold only in specific quantities, such as a large real estate project. Thin trading causes a more uncertain relationship between the most recently observed price and the likely price of the next transaction. Generally, illiquid assets tend to fall under the alternative investment classification, whereas traditional assets tend to be liquid assets.

      The risk of illiquid assets may be compensated for by higher returns. An illiquid asset can be difficult or expensive to sell, as thin volume or lockup provisions prevent the immediate sale of the asset at a price close to its potential sales value. The urgent sale of an illiquid asset can therefore be at a price that is considerably lower than the value that could be obtained from a long-term comprehensive search for a buyer. Given the difficulties of selling and valuing illiquid investments, many investors demand a risk premium, or a price discount, for investing in illiquid assets. While some investors may avoid illiquid investments at all costs, others specifically increase their allocation to illiquid investments in order to earn this risk premium.

      1.4.3 Inefficiency

      The prices of most traditional investments are determined in markets with relatively high degrees of competition and therefore with relatively high efficiency. In this context, competition is described as numerous well-informed traders able to take long and short positions with relatively low transaction costs and with high speed. Efficiency refers to the tendency of market prices to reflect all available information. Efficient market theory asserts that arbitrage opportunities and superior risk-adjusted returns are more likely to be identified in markets that are less competitively traded and less efficient. (Market efficiency is detailed in Chapter 6.) Many alternative investments have the institutional structure of trading at inefficient prices. Inefficiency refers to the deviation of actual prices from valuations that would be anticipated in an efficient market. Informationally inefficient markets are less competitive, with fewer investors, higher transaction costs, and/or an inability to take both long and short positions. Accordingly, alternative investments may be more likely than traditional investments to offer returns based on pricing inefficiencies.

      1.4.4 Non-Normality

      To some extent, the returns of almost all investments, especially the short-term returns on traditional investments, can be approximated as being normally distributed. The normal distribution is the commonly discussed bell-shaped distribution, with its peaked center and its symmetric and diminishing tails. The return distributions of most investment opportunities become nearer to the shape of the normal distribution as the time interval of the return computation nears zero and as the probability and magnitude of jumps or large moves over a short period of time decrease. However, over longer time intervals, the returns of many alternative investments exhibit non-normality, in that they cannot be accurately approximated using the standard bell curve. The non-normality of medium- and long-term returns is a potentially important characteristic of many alternative investments.

      What structures cause non-normality of returns? First and foremost, many alternative investments are structured so that they are infrequently traded; therefore, their market returns are measured over longer periods of time. These longer time intervals combine with other aspects of alternative investment returns to make alternative investments especially prone to return distributions that are poorly approximated using the normal distribution. These irregular return distributions may arise from several sources, including (1) securities structuring, such as with a derivative product that is nonlinearly related to its underlying security or with an equity in a highly leveraged firm, and (2) trading structures, such as an active investment management strategy alternating rapidly between long and short positions.

      Non-normality of returns introduces a host of complexities and lessens the effectiveness of using methods based on the assumption of normally distributed returns. Many alternative investments have especially non-normal returns compared to traditional investments; therefore, the category of alternative investments is often associated with non-normality of returns.

      1.5 Investments Are Distinguished by Methods of Analysis

      The previous section outlined return characteristics of alternative investments that distinguished them from traditional investments: diversifying, illiquid, inefficient, and non-normal. Alternative investments can also be distinguished from traditional investments through the methods used to analyze, measure, and manage their returns and risks. As in the previous case, the reasons for the difference lie in the underlying structures: Alternative investments have distinct regulatory, securities, trading, compensation, and institutional structures that necessitate distinct methods of analysis.

      Public equity returns are extensively examined using both theoretical analysis and empirical analysis. Theoretical models, such as the capital asset pricing model, and empirical models, such as the Fama-French three-factor model, detailed in Chapter 6, are examples of the extensive and highly developed methods used in public equity return analysis. Analogously, theories and empirical studies of the term structure of interest rates and credit spreads arm traditional fixed-income investors with tools for predicting returns and managing risks. But alternative investments do not tend to have an extensive history of well-established analysis, and in many cases the methods of analysis used for traditional investments are not appropriate for these investments due to their structural differences.

      Alternative investing requires alternative methods of analysis. In summary, a potential definition of an alternative investment is any investment for which traditional investment methods are clearly inadequate. There are four main types of methods that form the core of alternative investment return analysis.

      1.5.1 Return Computation Methods

      Return analysis of publicly traded stocks and bonds is relatively straightforward, given the transparency in regularly observable market prices, dividends, and interest payments. Returns to some alternative investments, especially illiquid investments, can be problematic. One major issue is that in many cases, a reliable value of the investment can be determined only at limited points in time. In the extreme, such as in most private equity deals, there may be no reliable measure of investment value at any point in time other than at termination, when the investment's value is the amount of the final liquidating cash flow. This institutional structure of infrequent trading drives the need for different return computation methods.

      Return computation methods for alternative investments are driven by their structures and can include such concepts as internal rate of return (IRR), the computation of which over multiple time periods uses the size and timing of the intervening cash flows rather than the intervening market values. Also, return computation methods for many alternative investments may take into account the effects of leverage. While traditional investments typically require the full cash outlay of the investment's market value, many alternative contracts can be entered into with no outlay other than possibly the posting of collateral or margin or, as in the case of private equity, commitments to make a series of cash contributions over time. In the case