Global Alternative Investment Portfolio Management

By M. Isi Eromosele

There are six basic categories of alternative investments. Most share similar properties, such as low liquidity and difficulty in measuring returns. There are many issues concerning composing suitable indices as benchmarks.

There are special due diligence issues ranging from assessing the type of market opportunity the investment offers to managers of the investment. Hedge funds are a broad class of alternative investments and have many varied sub-categories.

Based upon historical data, most alternative asset classes would have improved risk-adjusted returns, if added to a stock and bond portfolio. Many alternative investments have high Sharpe ratios as standalone investments; however, the Sharpe ratio may not be an appropriate risk measure due to skewed return distributions on many alternative investments.

Many institutional investors and high-net-worth individuals invest in alternative investments because they combine the potential for diversification with the opportunity for active management. There are six basic categories of alternative investments: real estate, private equity, commodities, hedge funds, managed future, and distressed securities.

Common Features of Alternative Investments

The following list summarizes the common features of alternative investments:

• Low liquidity. Because of their general lack of liquidity, alternative investment returns include a liquidity premium.
• Diversification. As most alternative investments are minimally correlated with stock and bond returns, they are a good diversification tool for a stock and bond portfolio.
• Due diligence costs.  Costs associated with researching and monitoring alternative investments can be high because of their individual characteristics, the complex strategies in which they are employed, and/or low-transparency in reporting.
• Difficult to value. It is sometimes very difficult to value (appraise) alternative investments because of lack of transparency and/or difficulty identifying appropriate valuation benchmarks.
• Access to information.  Markets for alternative investments are informationally less efficient than most stock markets.

 In addition to their general characteristics, alternative investments can be categorized into three categories by how they are utilized in a portfolio. Alternative investments can provide:

• Exposure to asset classes that stocks and bonds cannot provide
• Exposure to special investment strategies (hedge and venture capital funds)
• Special strategies and unique asset classes (funds that invest in private equity  and distressed securities)

Checkpoints for selecting an alternative investment manager include assessing the market opportunity, the investment process, the organization, the people, the terms and structure, the ancillary service providers and the documents.

• Assess the market opportunity offered. Are there exploitable inefficiencies in the market for the type of investments in which the manager specializes?
• Assess the investment process. Does the manager seem to have a competitive edge over others in that market?
• Assess the organization. Is it stable and well-run? What has been the staff turnover?
• Assess the people by meeting with them and assessing their characters
• Assess the terms and structure (amount and time period) of the investment
• Assess the service providers (lawyers, brokers, ancillary staff ) by investigating the outside firms that support the manager’s business
• Review documents such as the prospectus or private-placement memorandum and the audits

Issues For Private Clients

In contrast to institutional investors, the special issues advisers of private-wealth clients should address are tax issues, determining suitability, communicating with the client, decision risk and determining whether the client has a large position in closely held equity.

• Taxes. Tax issues can be unique to the individual because the characteristics of private-wealth clients and their investments can vary greatly. For individuals, there can be partnerships, trusts and other situations that make tax issues complex.
• Suitability. Determining suitability is important for the same reason. Unlike institutional investors, who usually have long time horizons, the horizons of individuals can vary a great deal. With individuals there is also the emotional aspect, like preferences for, or aversion to certain types of assets.
• Communication. Communicating with the client helps determine suitability of recommendations and the overall management process. This is more important because the client may not be knowledgeable enough to effectively communicate his/her needs.
• Decision risk. Decision risk is the risk of irrationally changing a strategy. For example, since individuals tend to make emotional decisions, the adviser must be prepared to deal with a client who wants to get out of a position that has just declined in value. This is particularly relevant for alternative investments, which can have large swings in value.
• Concentrated positions. Wealthy individuals’ portfolios frequently contain large positions in closely held companies. Such ownership should be considered with the overall allocation to alternative investments like private equity, just like the client’s home should be factored in with the real estate allocation.

There are subgroups within each of the classes of alternative investments, and in some cases there is more than one way to categorize the investment subgroups. One of the more common methods is whether the investments are direct or indirect.

Generally, in a direct investment, you actually own the asset, and in an indirect investment, you own shares of a fund (e.g., a limited partnership) that owns the assets.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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