The evolution of financial markets together with globalization, have interconnected the economies between countries. Consequently, the correlation between traditional assets has increased dramatically in recent decades. In times of market stress, the correlation between these can be 1.
As a result, portfolio managers are expanding their investment universe by investing in non-traditional or alternative assets. These assets have a lower correlation with stocks, bonds, and cash. As a result of the above, alternative management is born.
Alternative management characteristics
Alternative management seeks uncorrelated returns to the market. That is, they try to offer a risk-adjusted return regardless of the behavior of the market in general.
The main characteristics of alternative management are the following:
- Lower correlation with traditional investments (stocks, bonds and liquidity).
- Greater investment universe.
- Greater possibilities in the use of derivatives.
- Greater leverage capacity.
- Frequent use of short sales.
- Higher potential return.
- Higher minimums to invest.
- Lower liquidity of alternative investment vehicles.
- Lower requirement in transparency and public information requirements.
It is worth mentioning after the above, that alternative management strategies do not follow a normal distribution of returns. Return distribution functions can be very complex. For this reason, it is not enough to characterize the distribution through the mean and the variance.It is also necessary to take into account the kurtosis and asymmetry to be able to have a more faithful idea of the result that the investments could have.
Popular Alternative Management Strategies
There are an infinity of alternative strategies. Here are some of the most popular:
- Hedge funds: Hedge funds are investment vehicles that can invest in a wide range of assets (traditional or not) using alternative management techniques. Among the most popular strategies we find long-short strategies, pair trading and arbitrage.
- Private Equity: Private equity funds (or venture capital in Spanish) take positions in unlisted private equity companies. The objective is to increase the value of the company through a restructuring, eliminating organizational and productive inefficiencies.
- Venture capital: Venture capital could be defined as the younger brother of private equity. Venture capital as well as private equity participate in the shareholding of companies with private capital. The difference between the two is that venture capital participates in companies that are in the initial stages of development.
- Alternative credit: Alternative credit is aimed at companies that need financing as they cannot find it through the usual channels of credit or capital markets. Some examples are direct lending and distress debt.
- Real estate: investment in real estate (or real estate investment in Spanish) invests in properties of different types. The investment can be made through investment vehicles such as American REITs or SOCIMIs in Spain or through direct participations in the shareholders or the debt of the companies that own and manage the properties.
- Commodities: Investing in commodities or raw materials is a classic of alternative management. When you think about investing in commodities, oil or gold usually comes to mind. The reality is that commodities go much further. In addition to oil and gold, there are, among others, investment in forestry, livestock, minerals, other precious metals such as silver, industrial metals, gas, etc.
Main investors in alternative management
After the above, the reader may have imagined that alternative management is not available to everyone. Although this has been changing in recent decades through more liquid and transparent vehicles, alternative management is aimed at a more sophisticated public with greater heritage. Among them we have the following:
- Sovereign funds.
- Great pension plans.
- Large investment funds.
Benefits of investing in alternative management
Alternative investment has a number of benefits that make it interesting for investors who can access it. Some of those benefits are:
- Greater diversification due to access to a greater universe of assets.
- Lower volatility and uncorrelation with the market.
- Higher potential return.
- Profitability potential in low interest rate environments.
As for the advantages mentioned, you have to be careful with the least volatility. The valuation of many of the alternative assets does not exist in real time and sometimes incorporates some subjectivity. Therefore, their volatility is sometimes underestimated.
Let's think about a property. This is not listed and its value is generally updated every 3 months in the best of cases. This causes a smoothing effect on price deviations from its average price. Therefore, the standard deviation could be less than it actually would be if it were assessed more frequently.