1.

Alternative investments
Stocks, bonds and cash are the most commonly known traditional investments. Alternative
investments may encompass any non-traditional investments of financial assets such as hedge
funds, private equity, venture capital, real estate, commodities, and other assets.
Some of the distinctive characteristics of alternative investments compared with traditional
investments:
Lower liquidity due to their lack of standard markets and limited activities on both sides of the
deal.
Less regulation but rather unique legal and tax considerations.
Lower transparency - certain alternative investments lack an efficient market mechanism and may
subject their valuation to speculations, creating uncertainties. Risks of alternative investments
increase due to absent of ready valuation information.
Higher fees - costs of purchase and sale may be relatively high.
Limited and potentially problematic historical risk and return data.Investors must be careful in
evaluating the historical record of alternative investments as the higher than normal returns may
be subject to a variety of biases, and the volatility of returns tend to be underestimated.
There are two basic investment strategies.
Passive managers "buy-and-hold". There are very limited ongoing buying and selling actions.
Their portfolios are expected to generate Beta return.
Most alternative investment managers use active, alpha-seeking strategies. The assumption is
inefficiencies exist that can be exploited to earn positive return after adjusting for beta risk. These
active strategies include absolute return, market segmentation and concentrated portfolios.
Sharpe ratios and many downside risk measures are commonly used to measure risk and return of
alternative investments.
Despite unique risks and considerations, alternative investments can be useful tools to improve the
risk-return characteristics of an investment portfolio. They can increase diversification and reduce
volatility given low correlations to more traditional investments.
Many alternative investments use a partnership structure.
The general partner (the fund) manages the business, assumes unlimited liability, and receives a
management fee and an incentive fee.
Limited partners own fractional interest in the partnership.
2. Hedge funds
To "hedge", according to Webster's dictionary, is "a means of protection or defense (as against
financial loss), or to minimize the risk of a bet". The term "hedge fund" includes a multitude of
skill-based investment strategies with a broad range of risk and return objectives. A common

element is the use of investment and risk management skills to seek positive returns regardless of
market direction.
A hedge fund is a private "pool" of capital for accredited investors only and organized using the
limited partnership legal structure. The general partner is usually the money manager and is likely
to have a very high percentage of his/her own net worth invested in the fund.
The fund has an offering memorandum, which is intended to provide much of the necessary
information to support an investor's due diligence. Among several topics, the offering
memorandum will specify the trading style, hedging strategies, and instruments to be employed by
the fund at the discretion of the general partner (e.g. being long and /or short stock; use of puts,
calls, and futures; use of OTC derivatives).
Hedge funds utilize alternative investment strategies for the purpose of achieving superior returns
relative to risk (i.e. return vs. standard deviation). Performance objectives range from conservative
to aggressive. The degree of hedging varies. In fact, some do not hedge at all while others simply
use S&P put options and futures in lieu of shorting equities. Consequently, there is a broad
spectrum of expected risk and return within the hedge fund universe.
Hedge Fund Strategies
Hedge funds can be classified in a variety of ways. Here is one way of classification (by
investment strategy):
Event-driven investing is an investing strategy that seeks to exploit pricing inefficiencies that may
occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spinoff.
Merger arbitrage. Before the effective date of a merger, the stock of the acquired firm typically
sells at a discount to its announced acquisition value. A risk arbitrage involves buying stocks of
the acquired firm and simultaneously selling the stocks of the acquirer. However, there is the risk
that the merger may fall though.
Distressed debt investing. The securities of companies having financial problems usually sell at
deeply discounted prices. Distressed securities funds take bets on the debt and/or equity securities
of such companies. For example, if a fund manager believes such a company will successfully
return to profitability, he or she will buy its securities. If the manager believes the company's
situation will deteriorate, he or she will take a short position in its securities.
Activist. A fund takes large positions in companies and uses the ownership to participate in the
management.
Special situations, such as corporate spin-offs.
A relative-value arbitrage strategy seeks to take advantage of price differentials between related
financial instruments, such as stocks and bonds, by simultaneously buying and selling the different
securities - thereby allowing investors to potentially profit from the "relative value" of the two
securities. Examples include fixed income convertible arbitrage, fixed income asset backed, fixed
income general, volatility, and multi-strategy.
Macro funds take bets on the direction of a market, a currency, an interest rate, a commodity, or
any macroeconomic variable. For example, George Soros of the Quantum fund took a billion

dollar profit from his historical bet against Sterling and the Bank of England in September 1992.
Equity hedge strategies take long and short positions in equity and equity derivative securities. For
example, the key feature of market neutral funds is the low correlation between their returns and
the general market's movements. Other examples include fundamental growth, fundamental value,
quantitative directional, short bias and sector specific strategies.
In terms of performance, hedge funds are generally viewed as having:
Net returns higher than those available for equity or bond investments.
A low correlation with conventional investments.
However, the performance data from hedge fund databases and indices suffer from serious biases
such as self-selection bias, instant history bias and survivorship bias.
Hedge Fund Fees and Other Considerations
Hedge funds almost always have a fee structure that includes both a fixed fee and a management
fee. The most common fee structure is "2 and 20", meaning 2% management fee and 20%
incentive fee.
Hurdle rate. Incentive fees are not paid until the returns exceed the rate. It may be based on an
agreed upon rate, LIBOR or the yield on US treasury bills.
High water mark. Investors in hedge funds enter the fund at a certain net asset value, which we'll
call the entering NAV. If the fund loses money in a given year and then makes back that money in
a subsequent year, the investor is usually not required to pay a management fee on any portion of
the upside in the subsequent year that was below the entering NAV. The high water mark limits the
risk taking of the fund. Without it, the manager gets all the upside from big bets but suffers little
from the downside.
A fund of funds invests in a portfolio of hedge funds to provide access, diversification, risk
management and due diligence benefits to investors. Such funds of funds generally charge a fee
for their services. Recently funds of funds have been criticized for the significant incremental
costs they impose.
Although some hedge funds don't use leverage at all, most of them do. Leverage in hedge funds
often runs from 2:1 to 10:1, depending on the type of assets held and strategies used. High
leverage is often part of the trading strategy and is an essential part of some strategies in which the
arbitrage return is so small that leverage is needed to amplify the profit. As in any other
investments, however, leverage also amplifies losses when the market direction turns out to be
unfavorable.
Investor redemptions can also magnify losses for hedge funds.
Hedge Fund Valuation Issues
Questions to ask:
Which price to use? Bid price, ask price, average price or estimated value?
Any liquidity discounts? The lack of liquidity under extreme market conditions can cause
irreversible damage to hedge funds whose strategies rely on the presence of liquidity in specific

markets.
Due Diligence
Generally, due diligence refers to the care a reasonable person should take before entering in an
agreement or transaction with another party. The due diligence that has to be performed by an
institutional investor when selecting a hedge fund is highly specialized and time consuming, given
the secretive nature of hedge funds and their complex investment strategies.
The key factors to consider include investment strategy, investment process, competitive
advantage, track record, size and longevity, management style, key-person risk, reputation,
investor relations, plans for growth, and systems risk management.
3. Private equity
Private equity firms generally buy companies, repair them, enhance them, and sell them on. By
definition, these private equity acquisitions and investments are illiquid and are longer term in
nature. Consequently, the capital is raised through private partnerships which are managed by
entities known as private equity firms.
Private Equity Structure and Fees
A private equity firm is typically made up of limited partners (LPs) and one general partner (GP).
The LPs are the outside investors who provide the capital. They are called limited partners in the
sense that their liability extends only to the capital they contribute.
GPs are the professional investors who manage the private equity firm and deploy the pool of
capital. They are responsible for all parts of the investment cycle including deal sourcing and
origination, investment decision-making and transaction structuring, portfolio management (the
act of overseeing the investments that they have made) and exit strategies.
The GP charges a management fee based on the LPs? committed capital. Generally, after the LPs
have recovered 100% of their invested capital, the remaining proceeds are split between the LPs
and the GP with 80% going to LPs and 20% to the GP.
The clawback provision gives the LPs the right to reclaim a portion of the GP's carried interest in
the event that losses from later investments cause the GP to withhold too much carried interest.
Private Equity Strategies
Private equity investors have four main investment strategies.
1. The leveraged buyout (LBO) is a strategy of equity investment whereby a company is acquired
from the current shareholders, typically with the use of financial leverage.
A buyout fund seeks companies that are undervalued with high predictable cash flow, low
leverage and operating inefficiencies. If it can improve the business, it can sell the company or its
parts, or it can pay itself a nice dividend or pay down some company debt to deleverage.

In a management buyout (MBO), the current management team is involved in the acquisition. Not
only is a far larger share of executive pay tied to the performance of the business, but top
managers may also be required to put a major chunk of their own money into the deal and have an
ownership mentality rather than a corporate mentality. Management can focus on getting the
company right without having to worry about shareholders.
2. Venture capital is financing for privately held companies, typically in the form of equity and/or
long-term debt. It becomes available when financing from banks and public debt or equity markets
is either unavailable or inappropriate.
Venture capital investing is done in many stages from seed through mezzanine. These stages can
be characterized by where they occur in the development of the venture itself.
Formative-stage financing includes angel investing, seed-stage investing and early stage financing.
The capital is used from the idea stage, to product development, and pre-commercial production
stage.
Later-stage financing is capital provided after commercial manufacturing and sales have begun but
before any initial public offering.
Mezzanine (bridge) financing is capital provided to prepare for the step of going public and
represents the bridge between the expanding company and the IPO.
3. Development capital (minority equity investments) earns profits from funding business growth
or restructuring.
4. Distressed investing. A distressed opportunity typically arises when a company, unable to meet
all its debts, files for Chapter 11 (reorganization) or Chapter 7 (liquidation) bankruptcy. Investors
who understand the true risks and values involved can scoop up these securities or claims at
discounted prices, seeing the glow beneath the tarnish.
Exit Strategies
Every private equity investment starts with the end in mind: no fund will support a private equity
company without a clear exit plan. Common exit strategies include trade sale, IPO,
recapitalization, secondary sales, and write off or liquidation.
Other Considerations
Risk and return:
Higher long-term return opportunities than traditional investments.
Performance maybe overstated due to various biases.
Riskier than common stocks.
Can add diversity to a portfolio of traditional investments.
Valuation approaches: market or comparable, discounted cash flow (DCF), and asset based.
. Real estate

In general, real estate refers to buildable lands and buildings, including residential homes, raw
land and income-producing properties (such as warehouses, office and apartment buildings). Real
estate is a type of tangible assets, which are investment assets that can be seen and touched. In
contrast, financial assets are only recorded as pieces of paper.
Characteristics of real estate as an investable asset class:
Properties are immovable and basically indivisible so they are illiquid.
Every property is unique, primarily because no two properties can share the same location. In
addition, terms and conditions of transactions may differ significantly. Therefore, properties are
only approximately comparable to other properties.
There is no national, or international, auction market for properties. Therefore it is difficult to
assess the market value of a given property.
Transaction costs and management fees for real estate investments are high.
Real estate markets suffer inefficiencies because of the nature of real estate itself and because
information is not freely available.
Forms of Real Estate Investment
They may be classified along two dimensions, debt or equity based, and in private or public
markets. There are many variations within the basic forms.
Direct ownership. Also called fee simple, it refers to full ownership rights for an indefinite period
of time, giving the owner the right, for example, to lease the property to tenants and resell the
property at will.
Leveraged ownership. It refers to the same ownership rights but subject to debt (such as a
promissory note) and/or a pledge (mortgage) to hand over real estate ownership rights if the loan
terms are not met.
Mortgages. They represent a type of debt investment as a mortgage provides the investor a stream
of bondlike payments. This is a form of real estate investment as the creditor may end up with
owning the property being mortgaged. To diversify risks a typical investor often invests in
securities issued against a pool of mortgages.
Aggregation vehicles. They aggregate investors and serve the purpose of giving investors
collective access to real estate investments.
Real Estate Partnerships (RELPs). A RELP is a professionally managed real estate syndicate that
invests in various types of real estate. The purpose of the RELP varies from raw land speculation
to investments in income producing properties. Managers assume the role of general partner with
unlimited liability, while other investors are treated like limited partners with limited liability.
Real Estate Investment Trusts (REITs). A REIT is a type of closed-end investment company that
sells shares to investors and invests the proceeds in various types of real estate and real estate
mortgages.
It allows small investors to receive both the capital appreciation and the income returns without
the headache of property management.
Its shares are traded on a stock market.
It provides a tax shelter.
It also has strong restriction on the use, and distribution of funds.

Investment Categories
Residential properties: an individual or a family purchases a home. In most cases an financial
institution makes a direct debt investment in the home by offering a mortgage.
Commercial real estate: a direct equity and/or debt investment is made into a property which is
then managed to generate economic benefit to the parties.
REIT investing: mortgage REITs invest in mortgages and equity REITs invest in commercial and
residential properties.
Mortgage-backed securities (MBS): securitization of mortgages.
Timberland and farmland.
Performance and Diversification Benefits
There are different types of indices: appraisal indices, repeat sales indices and REIT indices. They
are constructed differently and have their own limitations such as sample selection biases and
understated volatility. The correlations of global real estate and equity returns are higher than the
correlation of global real estate and bond returns.
Valuation
There are three commonly used approaches to real estate market value:
The comparison sales approach uses as the basic input the sales prices of properties (benchmark
value) that are similar to the subject property. The price must be adjusted to reflect its superiority
or inferiority to comparable properties. This approach can give a good feel for the market.
The income approach calculates a property's value as the present value of all its future income. It
assumes that the annual net operating income (NOI) of a property can be maintained at a constant
level forever (that is, NOI is a perpetuity). The most popular income approach is called direct
capitalization:

Net operating income (NOI) equals the amount left after subtracting vacancy and collection losses
and property operating expenses from an income property's gross potential rental income.
The market capitalization rate is obtained by looking at recent market sales figures to determine
the rate of return required by investors.
The discounted cash flow approach is a variation of the income approach.
The cost approach is based on the idea that an investor should not pay more for a property than it

would cost to rebuild it at today's prices. It generally works well for new or relatively new
buildings. Most experts use it as a check against a price estimate. Limitations:
An appraisal of the land value is not always an easy task.
The market value of an existing property could differ significantly from its construction cost.
An income-based or asset-based approach can be used to value a REIT.
5. Commodities and other altenative investments
Commodities include agricultural products, energy products and metals. Returns are based on
changes in price and do not include an income stream such as dividends, interests, or rent.
Most investors do not want to get involved in storing commodities such as cattle or crude oil. A
common investment objective is to purchase indirectly those real assets that should provide a good
hedge against inflation risk. Another investment objective is for portfolio diversification.
Commodity derivatives are financial instruments that derive their value from the value of the
underlying commodities. They include commodity futures, forwards, options and swaps. There are
also other means of achieving commodity exposure.
Commodity spot prices are determined by market supply and demand.
The price of a commodity futures contract is determined by the spot price, risk-free rate, storage
costs and convenience yield.
Contango: when futures prices are higher than the spot price.
Backwardation: when futures prices are lower than the spot price.
Three sources of return for each commodity futures contract:
Roll yield.
Collateral yield.
Spot prices.
Other alternative investments include collectibles such as antiques and fine arts, fine wine, stamps
and coins, jewelry and watches, etc. Collectibles usually:
Don't provide current income.
Are illiquid, and not easy to value fairly.
Incur storage costs.
There are a few price indices for different collectibles.
Risk management overview
Managing risks associated with alternative investments can be challenging because these
investments are often characterized by asymmetric risk and return profiles, limited transparency,
and illiquidity.
Traditional risk and return measures such as mean return, standard deviation of returns, and beta
may not provide an adequate picture of characteristics of alternative investments. Moreover, these
measures may not be reliable or representative of specific investments.

Operational, financial, counterparty, and liquidity risks may be key considerations for those
investing in alternative investments.
It is critical to do due diligence to assess whether (a) a potential investment is in compliance with
its prospectus; (b) the appropriate organizational structure and policies for managing investments,
operations, risk, and compliance are in place; and (c) the fund terms appear reasonable.
The inclusion of alternative investments in a portfolio, including the amounts to allocate, should
be considered in the context of an investor's risk-return objectives, constraints, and preferences.