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Investment - Introduction to Alternative Investments
If a public company needs funds to invest in a project, say to establish a new manufacturing facility or to extend its operations abroad, it may turn to the financial markets and issue the forms of debt and equity instruments mentioned in the earlier modules of this course.
But what if an entrepreneur wants money to start a great new business? Or what if a small firm needs cash to grow, but it is not established enough to seek an initial public offering? The entrepreneur and the young company do not have the functioning track record needed to offer debt or equity securities to the public. In addition, although they may seek loans from banks, the amount of money they may borrow is frequently limited. Banks typically do not finance new and young enterprises since the risk of not getting the money back is considerable.
So, entrepreneurs or young enterprises may resort to the venture capital industry to receive the money they need.
Venture capitalists concentrate in investing new and fledgling firms. They give entrepreneurs and fledgling enterprises with both the funding and the skills to begin and build their businesses and to develop track records of successful operations.
Venture capital is a form of private equity, which is itself a type of alternative investment. From an investor’s point of view, alternative investments are diversified and often comprise the following:
Investments in private enterprises — that is, companies that are not listed on a stock exchange are known as private equity investments.
Direct or indirect investments in land and buildings are defined as real estate.
Investments in physical things, such as precious and base metals (e.g., gold, copper), energy products (e.g., oil), and agricultural products that are typically eaten (e.g., maize, livestock, wheat) or used in the creation of goods (e.g., lumber, cotton, sugar), are known as commodities.
Private equity, real estate, and commodities are all considered alternative investments since they represent an option to investing only in ‘traditional’ asset classes, such as debt and equity instruments. Although alternative investments have acquired importance in the 21st century, they are not new; in fact, real estate and commodities are among the oldest sorts of investments.
As we will discuss shortly, alternative investments are an opportunity to potentially enhance returns and obtain diversification benefits; recall that diversification is the practice of combining different types of assets or securities in a portfolio to reduce risk, without sacrificing expected returns. The hunt for higher returns and reduced risk explains why alternative investments have become a vital component of the portfolios of many investors, both institutional and individual, who regard private equity, real estate, and/or commodities as potential to deliver both.
Why Invest in Alternatives?
In addition to the issues connected to the COVID pandemic crisis that started in 2020 and increasing geopolitical risks, investors are ready for increased volatility, higher inflation, and upward pressure on interest rates. Against this context, investors are increasingly seeking to private markets and other alternative assets to accomplish their investment return targets. Real estate and private equity are the asset classes with the greatest portfolio allocations by institutional investors. For example, in 2021, 80% and 73% of institutional investors who allocate to alternatives responding to Nuveen’s EQuilibrium survey, placed a portion of their portfolios in real estate and private equity, respectively (see the image below). Private credit is also a significant asset class for such investors, demonstrating the highest year-over-year growth in current allocation.
The numerous sorts of alternative investments can look utterly unconnected to one other. But they have potential common advantages, and they also share similar constraints.
Advantages
They may help boost profits and minimize risk by providing diversification benefits.
Limitations
Typically, they are less regulated, less transparent, less liquid, and more difficult to value than debt and equity investments.
Advantages of Alternative Investments
Investors add alternative investments to their portfolios for two key reasons:
To enhance returns
To reduce risk by getting diversity benefits
Enhancing Returns
The following tables illustrate historical returns for various asset classes. The first and second tables illustrate that throughout the past 25-year period, investments in US private equity and North American real estate (as proxied by real estate investment trusts, or REITS), respectively, have outpaced investments in US equities securities. But you should not extrapolate from these outcomes that alternative investments always offer higher returns than traditional asset classes.
During the global financial crisis of 2008–2009, many investors suffered losses on their private equity and real estate investments, and some losses were larger than those on traditional assets, such as publicly listed securities.
Reducing Risk
Investors rarely allocate all their money to one form of asset or security. Instead, they diversify their portfolios by investing in assets and securities that act differently from each other. How investments act relative to each other leads us back to the concept of correlation, as you learnt about in Module 1, Quantitative Concepts.
As a reminder, if two assets or securities do not have a correlation of +1 (that is, if they are less than fully positively correlated), then combining the two assets or securities in a portfolio provides diversification benefits and hence decreases risk in the portfolio. In other words, the risk to the portfolio after incorporating these two assets or securities is lower than the weighted sum of the risks of the two assets or securities when they are assessed separately.
Because there is a generally low connection between different forms of alternative investments, and also between alternative investments and other asset classes (such stocks and bonds), adding private equity, real estate, and commodities to portfolios helps investors decrease risk. As previously mentioned, during periods of financial crisis, returns on diverse investments may become more connected and the benefits of diversification may be lessened.
Limitations of Alternative Investments
Although alternative investments have the potential to boost returns and minimize risk, they also have limitations. Typically, alternative investments are less regulated and less transparent than regular investments, illiquid, and difficult to appraise.
Because alternative investments are less regulated and less transparent than traditional investments, such as stock and debt instruments, individual individuals are less likely to invest in them. Institutional investors may regard this as an opportunity to take advantage of market inefficiencies.
In addition, most alternative investments are illiquid – that is, they are impossible to sell fast without accepting a drastically discounted price. For example, it is considerably easier to sell shares of a public corporation listed on a stock exchange than to sell shares in a private firm, a piece of land, or a building. Some institutional investors, depending on their cash flow needs, may be ready and able to keep investments for long periods, therefore liquidity may be less critical for them than for individuals or institutional investors that have liquidity limits.
Alternative investments are especially difficult to value because data availability to assess how much they are worth is restricted. Purchases and sales of start-up enterprises, land, or buildings are unusual, thus valuation is tough and is generally based on an evaluation. An appraisal is an assessment or estimation of the value of an item and is subject to specific assumptions, which may not always be practical.
For example, a property may be estimated to be worth GBP100,000 based on its location, square footage, and price per square foot paid in similar deals. But if the property market slows down, the assumption regarding the price per square foot may be unduly optimistic and the value of the property could be less than projected.
If a public company needs funds to invest in a project, say to establish a new manufacturing facility or to extend its operations abroad, it may turn to the financial markets and issue the forms of debt and equity instruments mentioned in the earlier modules of this course.
But what if an entrepreneur wants money to start a great new business? Or what if a small firm needs cash to grow, but it is not established enough to seek an initial public offering? The entrepreneur and the young company do not have the functioning track record needed to offer debt or equity securities to the public. In addition, although they may seek loans from banks, the amount of money they may borrow is frequently limited. Banks typically do not finance new and young enterprises since the risk of not getting the money back is considerable.
So, entrepreneurs or young enterprises may resort to the venture capital industry to receive the money they need.
Venture capitalists concentrate in investing new and fledgling firms. They give entrepreneurs and fledgling enterprises with both the funding and the skills to begin and build their businesses and to develop track records of successful operations.
Venture capital is a form of private equity, which is itself a type of alternative investment. From an investor’s point of view, alternative investments are diversified and often comprise the following:
Investments in private enterprises — that is, companies that are not listed on a stock exchange are known as private equity investments.
Direct or indirect investments in land and buildings are defined as real estate.
Investments in physical things, such as precious and base metals (e.g., gold, copper), energy products (e.g., oil), and agricultural products that are typically eaten (e.g., maize, livestock, wheat) or used in the creation of goods (e.g., lumber, cotton, sugar), are known as commodities.
Private equity, real estate, and commodities are all considered alternative investments since they represent an option to investing only in ‘traditional’ asset classes, such as debt and equity instruments. Although alternative investments have acquired importance in the 21st century, they are not new; in fact, real estate and commodities are among the oldest sorts of investments.
As we will discuss shortly, alternative investments are an opportunity to potentially enhance returns and obtain diversification benefits; recall that diversification is the practice of combining different types of assets or securities in a portfolio to reduce risk, without sacrificing expected returns. The hunt for higher returns and reduced risk explains why alternative investments have become a vital component of the portfolios of many investors, both institutional and individual, who regard private equity, real estate, and/or commodities as potential to deliver both.
Why Invest in Alternatives?
In addition to the issues connected to the COVID pandemic crisis that started in 2020 and increasing geopolitical risks, investors are ready for increased volatility, higher inflation, and upward pressure on interest rates. Against this context, investors are increasingly seeking to private markets and other alternative assets to accomplish their investment return targets. Real estate and private equity are the asset classes with the greatest portfolio allocations by institutional investors. For example, in 2021, 80% and 73% of institutional investors who allocate to alternatives responding to Nuveen’s EQuilibrium survey, placed a portion of their portfolios in real estate and private equity, respectively (see the image below). Private credit is also a significant asset class for such investors, demonstrating the highest year-over-year growth in current allocation.
The numerous sorts of alternative investments can look utterly unconnected to one other. But they have potential common advantages, and they also share similar constraints.
Advantages
They may help boost profits and minimize risk by providing diversification benefits.
Limitations
Typically, they are less regulated, less transparent, less liquid, and more difficult to value than debt and equity investments.
Advantages of Alternative Investments
Investors add alternative investments to their portfolios for two key reasons:
To enhance returns
To reduce risk by getting diversity benefits
Enhancing Returns
The following tables illustrate historical returns for various asset classes. The first and second tables illustrate that throughout the past 25-year period, investments in US private equity and North American real estate (as proxied by real estate investment trusts, or REITS), respectively, have outpaced investments in US equities securities. But you should not extrapolate from these outcomes that alternative investments always offer higher returns than traditional asset classes.
During the global financial crisis of 2008–2009, many investors suffered losses on their private equity and real estate investments, and some losses were larger than those on traditional assets, such as publicly listed securities.
Reducing Risk
Investors rarely allocate all their money to one form of asset or security. Instead, they diversify their portfolios by investing in assets and securities that act differently from each other. How investments act relative to each other leads us back to the concept of correlation, as you learnt about in Module 1, Quantitative Concepts.
As a reminder, if two assets or securities do not have a correlation of +1 (that is, if they are less than fully positively correlated), then combining the two assets or securities in a portfolio provides diversification benefits and hence decreases risk in the portfolio. In other words, the risk to the portfolio after incorporating these two assets or securities is lower than the weighted sum of the risks of the two assets or securities when they are assessed separately.
Because there is a generally low connection between different forms of alternative investments, and also between alternative investments and other asset classes (such stocks and bonds), adding private equity, real estate, and commodities to portfolios helps investors decrease risk. As previously mentioned, during periods of financial crisis, returns on diverse investments may become more connected and the benefits of diversification may be lessened.
Limitations of Alternative Investments
Although alternative investments have the potential to boost returns and minimize risk, they also have limitations. Typically, alternative investments are less regulated and less transparent than regular investments, illiquid, and difficult to appraise.
Because alternative investments are less regulated and less transparent than traditional investments, such as stock and debt instruments, individual individuals are less likely to invest in them. Institutional investors may regard this as an opportunity to take advantage of market inefficiencies.
In addition, most alternative investments are illiquid – that is, they are impossible to sell fast without accepting a drastically discounted price. For example, it is considerably easier to sell shares of a public corporation listed on a stock exchange than to sell shares in a private firm, a piece of land, or a building. Some institutional investors, depending on their cash flow needs, may be ready and able to keep investments for long periods, therefore liquidity may be less critical for them than for individuals or institutional investors that have liquidity limits.
Alternative investments are especially difficult to value because data availability to assess how much they are worth is restricted. Purchases and sales of start-up enterprises, land, or buildings are unusual, thus valuation is tough and is generally based on an evaluation. An appraisal is an assessment or estimation of the value of an item and is subject to specific assumptions, which may not always be practical.
For example, a property may be estimated to be worth GBP100,000 based on its location, square footage, and price per square foot paid in similar deals. But if the property market slows down, the assumption regarding the price per square foot may be unduly optimistic and the value of the property could be less than projected.
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