When managed funds talk about their investments they usually focus on the mainstream asset classes such as Australian or overseas equities, government or corporate bonds, direct or listed property and cash. But for investments that are not so easy to classify we use the broad term of alternatives - they are an alternative to what is mainstream.
This doesn't make alternative assets high risk or speculative, although some can be. It just makes them harder to classify because by their nature they are different. After all, if they weren't we wouldn't need to call them an alternative asset. Another way to look at alternative assets is that they behave differently from the traditional asset classes and from each other. For the individual investor, accessing them can be more difficult as well. Alternative assets can behave differently for two reasons.
First is that the physical underlying assets are different if they are, for example, infrastructure assets like bridges, airports, public utilities companies, emerging market high-risk credit bonds, or equity in privately held companies. The second reason is that some alternative investment strategies don't focus on the underlying physical asset like mainstream investment strategies do, but rather on the investment process.
By this we mean that some alternative asset strategies emphasise complex trading strategies in highly liquid financial securities, such as futures and options across a variety of markets not limited to equities, currencies, fixed
income and commodities. As a result they can profit from relative values between different securities, not just from whether the asset goes up or down in price.
For these reasons it is best that investors access alternative assets through pooled investments. Alternative assets tend to have low liquidity, meaning they cannot be quickly redeemed for cash, can have high fees and are generally associated with higher levels of investment risk. But on the upside, skilled alternatives investment managers can achieve high profits for investors.
Hedge funds are specialist funds where the portfolio manager seeks to earn absolute returns rather than being bound by reference to an investable benchmark index. The underlying assets held in these funds and the trading strategies their investment managers use are often complex and may include trading financial instruments, investing in combinations of currencies, fixed income, commodities and precious metals.
Some hedge funds can be considered high risk because of their exotic trading strategies but some are low or moderate risk. Each hedge fund needs to be assessed on its merits because they are highly dependent on the skills and practices of the people running the fund.
Infrastructure includes investments in assets such as airports, toll roads, electricity or water utilities, and bridges. They are usually associated with a sort of monopoly power, which cannot easily be replicated. For example, each city usually has one major airport or only a small number of electricity providers. Reflecting this, they are usually subject to government regulation that guarantees their revenue and legislates price increases. Due to their illiquidity, durable nature and protected revenue, they are generally held for many years. Infrastructure is considered moderately risky.
Private equity is similar to investing in regular company shares except that the companies involved are privately held rather than being listed on the securities exchange. Private equity companies can include reasonably new companies still being prepared to be listed on a shares exchange or they can be previously listed public companies that were purchased by a private equity fund when the company was close to failing, the idea being to restructure the company and re-list it later for a large profit.
When a company is bought by private equity investors the new owners usually install their own management to restore the company and then sell it to new investors through either a trade sale or by listing it on the sharemarket. An investor may not know their overall investment return from a private equity investment until the company or portfolio of companies has been sold or listed on the sharemarket. As a result the private equity asset class is considered very high risk, requiring considerable expertise from the investment manager making these investments.
Venture capital is similar to private equity except it involves the financing of very young start-up companies that investors believe have high growth potential but no track record. The companies are usually from high-technology industries, such as information technology, clean technology such as in the renewable energy sector, or biotechnology. Venture capital funds provide funding and managerial expertise. On an individual basis they have a low rate of success, but this is potentially made up for by the companies that become spectacularly successful. Venture capital is considered high risk.
Precious metals such as gold, silver, platinum and palladium can be purchased for their intrinsic value and low correlation with traditional asset classes. They can be held physically in the form of ingots or through exchange traded funds.
Securities lending and short selling
A commonly cited example of alternative investing used by hedge funds is short selling. This is when a hedge fund manager believes a company's shares are about to sharply fall in value and sells them, even if they don't own any of the shares. To make the trade, the hedge fund manager has to borrow or rent the shares from another investment manager, superannuation fund or custodian so they can deliver the shares to the buyer at the agreed price. The hedge fund manager makes a profit if the price they sold the shares for is higher than the price of the shares when the time comes to return the borrowed securities. When a hedge fund manager engages in short selling they are betting a company's share price will plummet more than the buyer of the shares believes.
Short selling is extremely high risk and is heavily criticised because it encourages speculation in collapsing companies. However, if carefully executed, short selling trades can be highly profitable.