Hedge Fund Investing (eBook)

Chapter 1

What Are Alternative Investments and Hedge Funds?

Introduction

A newcomer to hedge fund investing can easily get overwhelmed by the complex terminology and unique characteristics associated with this type of investing. There is a lot to know and not always a lot of time to learn it. This chapter is meant to present the basics of hedge fund investing (including defining alternative investments) by discussing the characteristics and structures of hedge funds on a standalone basis and relative to mutual funds. The chapter is intended to be a means of providing an introduction to some performance and risk measurement terminology and phrases. This chapter also lays the foundation for the rest of the book. Let’s get started.

What Are Alternative Investments?

“Alternative investments” is a term used to describe investments in nontraditional asset classes. Traditional asset classes include stocks and bonds and sometimes commodities, as well as foreign exchange. Alternative investments include hard assets, collectables, real estate funds, private equity, venture capital, managed futures funds, hedge funds and sometimes structured products like collateralized debt and loan obligations. Every institution seems to have its own set of rules for what is and is not an alternative investment.

Investors obtain alternative exposure by investing in vehicles such as private limited partnerships and alternative mutual funds. Alternatives may offer attractive portfolio benefits to investors, although on a stand-alone basis they can be more volatile or less liquid than traditional investments.

The more established and better understood traditional asset classes can be described as having large global markets, significant pools of liquidity, a high degree of price transparency and regulation, along with well-established market microstructures. Stocks and bonds have been available to investors for centuries. Even mutual funds have existed in various shapes and sizes for well over 100 years. By even the broadest measures, on the other hand, alternatives and hedge funds began as recently as the late 1960s and really only began to grow in the early 1990s.

By its 2020 peak, the market value of publicly traded equity had reached almost $100 trillion. The current value of the public bond market is near $150 trillion. In the beginning of 2020, prior to the market crash and recovery, the combination of these two asset classes was over $250 trillion. At the end of 2019, there were more than $20 trillion of investments in traditional stock and bond mutual funds in the United States and over $30 trillion globally. This compares to about $3.2 trillion invested globally in hedge funds at the end of 2019. 1

Alternative investing is a far less mature industry that traditional asset management or mutual fund investing. Alternative investments are considered relatively young in terms of life cycle and track records. Hedge funds are perhaps the newest form of alternatives and as such, may also be the least understood. Their business models are not as stable, well-developed or mature as those associated with traditional investing or even earlier forms of alternatives, such as real estate and private equity.

So, what exactly constitutes an alternative as opposed to a traditional investment? There are a few broad categories that most professionals would agree make up the universe of alternative investment opportunities.

• Real estate investing includes direct investments or funds that invest in commercial or residential real estate or mortgages that produce rental income, interest income and capital appreciation. Most funds are organized in specific regions or by specific types of properties.
• Private equity investing includes direct investment or funds that take equity ownership in existing private companies in the hope of streamlining or improving management, negotiating favorable leverage terms with banks and improving performance so that the fund may ultimately profit from an initial public offering of the company’s shares.
• Venture capital investing includes direct investment or funds that provide day-one capital to fund new business ideas. These early-stage investors hope to profit by sale of the company to a strategic investor or perhaps to a private equity fund that ultimately will help the company go public.
• Hedge fund investing includes investments in either private investment partnerships, mutual funds or Undertakings for Collective Investing in Tradable Securities (UCITS) that trade stocks, bonds, commodities or derivatives using leverage, short selling and other techniques designed to enhance performance and reduce the volatility of traditional asset classes and investments.

All alternative investment managers are experts in their area of investment and are typically large investors in the fund they manage. These managers get paid both a management and an incentive fee for their work. Many also use leverage to enhance returns, while some create portfolios that are very illiquid at times, and most only provide limited transparency to investors. Some alternative investments can be difficult to value.

When thinking about an alternative investment, here are many things to consider:

• The need for expert management. Does the manager of the investments have significant experience in a specific market segment, industry or area of investment? This extra level of skill and focus can allow the manager to identify unique values or opportunities not readily seen by the investor community at large.
• The existence of manager co-investment can serve to align manager and investor interests. Does the manager and many of the partners or employees of the management company have a significant investment in the fund? This serves to align the interests of the investors with those of the manager.
• The use of performance fees can serve to incentivize manager behavior. Does the manager get paid a percentage of the profits from the investments, in addition to any flat fees for managing the fund? The widespread use of an incentive fee is based on the principle that it further aligns the interest of the manager with that of the investor.
• There are both a positive and negative consequences associated with leverage. How much money or securities does the fund borrow to make investments? The use of a fund’s investor capital, plus leverage obtained from banks or derivatives, allows the fund to magnify gains or losses from each investment and achieve higher rates of return.
• The portfolio positions may be illiquid. How long does an investor need to lock-up money in the fund before they can sell or redeem? Many times, funds require investors to lock-up their money for an extended period of time before being they can redeem their investment.
• There is often limited transparency provided to investors. Does the fund disclose its investments to its investors on a daily basis? Many times, a manager may restrict the amount of periodic information provided to investors related to positions, strategy, leverage or risk.
• It may be difficult to value many investments. Can the investment or the underlying instruments owned in the portfolio be valued on an exchange or do they require an over-the-counter quotation or price, a model price or an independent valuation to determine the value? An illiquid market, third party valuations or the use of model price for an instrument can lead to more subjective portfolio pricing and less accurate fund valuations.

Alternative investment managers are usually trying to generate an absolute return and not managing money to beat a benchmark. This gives them the freedom to focus on narrow opportunities with significant barriers to entry, thus requiring a high level of expertise. A commercial real estate fund might employ a property manager who is an expert on shopping malls in Chicago. A private equity fund may focus on infrastructure projects or telecommunications and may employ former industry executives and engineers to evaluate potential investments. A hedge fund that invests in equities related to the biotech industry may have doctors on staff that work as consultants or research analysts who recommend companies to the portfolio manager.

Many professional managers who start a private equity or hedge fund also invest the majority of their personal net worth in the fund. Managers do this to align interests and to signal confidence to investors that they believe in what they are doing and that they are not merely managing other people’s money.

Managers of alternative investments usually command a performance fee in addition to a fixed fee for managing assets. Managers getting an incentive or performance fee share in the upside when they produce positive results and generally do not get paid when they produce negative results. The effect of the performance fee is to give the manager a tangible incentive to generate the highest possible absolute level of return and to minimize variation and volatility over a complete business cycle.

Alternative investments are generally less regulated than traditional investments. This opens the door to...