Alternative Investments. Hossein Kazemi
Capital Advisors. Dr. Chambers previously served as Director of Alternative Investments at Karpus Investment Management. He is a member of the editorial board of the Journal of Alternative Investments.
Dr. Mark J. P. Anson, CAIA, CFA, CPA, Ph.D., J.D, is a board member of CAIA and the President and Chief Investment Officer of the Bass Family Office – winner of the Family office of the Year award for 2014–2015. Dr. Anson previously served as President and Executive Director of Investment Services at Nuveen Investments Inc., Chief Executive Officer of both the British Telecom Pension Scheme and its wholly owned asset management company in London, Hermes Pension Management Limited, and Chief Investment Officer at California Public Employees' Retirement System. He has published over 100 research articles in professional journals, has won two Best Paper Awards, is the author of six financial textbooks, and sits on the editorial boards of several financial journals.
Dr. Keith H. Black, CAIA, is Managing Director of Curriculum and Exams at the CAIA Association. He was previously an Associate at Ennis Knupp and, before that, an Assistant Professor at Illinois Institute of Technology. He is a member of the editorial board of the Journal of Alternative Investments.
Dr. Hossein Kazemi is a senior adviser to the CAIA Association. He is the Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts, Amherst; Director of the Center for International Securities and Derivatives Markets; a cofounder of the CAIA Association; and Editor-in-Chief of the Journal of Alternative Investments– the official publication of the CAIA Association.
PART One
Introduction to Alternative Investments
Part 1 begins with an introduction to alternative investments and a description of the environment of alternative investing. Chapters 3 to 6 include primers on quantitative methods, statistics, and financial economics as they relate to alternative investments, as well as a chapter on measures of risk and return. The last three chapters of Part 1 discuss performance attribution, hypothesis testing of risk and return, and multivariate and nonlinear methods. The material is designed to provide a foundation for Parts 2 to 5, which detail each of the four main categories of alternative investments.
CHAPTER 1
What Is an Alternative Investment?
Definitions of what constitutes an alternative investment vary considerably. One reason for these differences lies in the purposes for which the definitions are being used. But definitions also vary because alternative investing is largely a new field for which consensus has not emerged, as well as a rapidly changing field for which consensus will probably always remain elusive.
Analyzing these various definitions provides a useful starting point to understanding alternative investments. So we begin this introductory chapter by examining commonly used methods of defining alternative investments.
1.1 Alternative Investments by Exclusion
Alternative investments are sometimes viewed as including any investment that is not simply a long position in traditional investments. Typically, traditional investments include publicly traded equities, fixed-income securities, and cash. For example, if a particular investment (such as private equity) is not commonly covered as equity in books on investing, then many people would view it as an alternative investment.
The alternative-investments-by-exclusion definition is overly broad for the purposes of the CAIA curriculum. First, the term investment covers a very broad spectrum. A good definition of an investment is that it is deferred consumption. Any net outlay of cash made with the prospect of receiving future benefits might be considered an investment. So investments can range from planting a tree to buying stocks to acquiring a college education. As such, a more accurate definition of alternative investments requires more specificity than simply that of being nontraditional.
This book and the overall CAIA curriculum are focused on institutional-quality alternative investments. An institutional-quality investment is the type of investment that financial institutions such as pension funds or endowments might include in their holdings because they are expected to deliver reasonable returns at an acceptable level of risk. For example, a pension fund would consider holding the publicly traded equities of a major corporation but may be reluctant to hold collectibles such as baseball cards or stamps. Also, investments in very small and very speculative projects are typically viewed as being inappropriate for such an institution due to its responsibility to select investments that offer suitable risk levels and financial return prospects for its clients.
Not every financial institution, or even every type of financial institution, invests in alternative investments. Some financial institutions, such as some brokerage firms, are not focused on making long-term investments; rather, they hold securities to provide services to their clients. Other financial institutions, such as deposit-taking institutions like banks (especially smaller banks) might invest in only traditional investments because of government regulations or because of lack of expertise.
Of course, institutional-quality alternative investments are also held by entities other than financial institutions. Chapter 2 of this book discusses the alternative investment environment, including the various entities that commonly hold them (e.g., endowment funds and wealthy individuals).
1.2 Alternative Investments by Inclusion
Another method of identifying alternative investments is to define explicitly which investments are considered to be alternative. In this book, we classify four types of alternative investments:
1. REAL ASSETS (including natural resources, commodities, real estate, infrastructure, and intellectual property)
2. HEDGE FUNDS (including managed futures)
3. PRIVATE EQUITY (including mezzanine and distressed debt)
4. STRUCTURED PRODUCTS (including credit derivatives)
These four categories correspond to Parts 2 to 5 of this book. Our list is not an exhaustive list of all alternative investments, especially because the CAIA curriculum is focused on institutional-quality investments. Furthermore, some of the investments on the list can be classified as traditional investments rather than alternative investments. For example, real estate and especially real estate investment trusts are frequently viewed as being traditional institutional-quality investments. Nevertheless, this list includes most institutional-quality investments that are currently commonly viewed as alternative. Exhibit 1.1 illustrates the relative proportion of these four categories of alternative investments.
Exhibit 1.1 Major Alternative Asset Categories (percentages approximate), 2014
Source: Global Alternatives Survey 2014, Towers Watson; CAIA Association estimates.
The following sections provide brief introductions to the four categories.
1.2.1 Real Assets
Real assets are investments in which the underlying assets involve direct ownership of nonfinancial assets rather than ownership through financial assets, such as the securities of manufacturing or service enterprises. Real assets tend to represent more direct claims on consumption than do common stocks, and they tend to do so with less reliance on factors that create value in a company, such as intangible assets and managerial skill. So while a corporation such as Google holds real estate and other real assets, the value to its common stock is highly reliant on perceptions of the ability of the firm's management to oversee creation and sales of its goods and services.
An aspect that distinguishes types of real assets is the extent to which the ownership of the real assets involves operational aspects, such as day-to-day management decisions that have substantial impacts on the performance of the assets. For example, in many instances, direct ownership of oil reserves or stockpiles of copper involve substantially less day-to-day managerial attention than does direct ownership of real estate, infrastructure, or intellectual