Alts: Hedge Funds, Private Equity, and More

There is no set definition for alternative investments, so for the purposes of this article, we'll limit the discussion to two broad categories: hedge funds and private capital. 

These are investment vehicles that pool investors' capital and invest primarily in publicly traded securities. However, unlike traditional mutual funds—which are subject to certain regulatory constraints and tend to have a longer-term focus—hedge funds have more flexible mandates. They can deploy borrowed money to drive returns, engage in short-selling, use derivatives, and may trade more frequently. 

Hedge fund strategies can be grouped into several categories, including:

- Equity long-short strategies: These funds target potentially undervalued stocks, while shorting stocks that are seen as overvalued. Fund managers often do this by pairing stocks within the same industry. For example, they might take a long position on one oil company while shorting another).

- Relative value strategies: Similarly, these funds buy undervalued securities—with a focus on fixed income, though they can also include commodities, and currencies—and sell overvalued securities in positions that are generally related to each other. Relative value strategies are designed to reduce market risk relative to long-only portfolios.

- Event-driven strategies: Managers in this category count on their ability to predict, take advantage of, or even create events that increase the value of the fund's underlying securities, which is difficult to do for most regular investors. For example, an activist hedge fund manager may attempt to influence a company's management to re-structure its business in the hope of boosting its share price.

- Macro strategies: These funds seek to profit from global political or economic trends and events. Macro strategies can take long or short positions across all major asset classes, including equities, fixed income, currencies, and commodities. 

- Multi-strategy hedge funds: As the name implies, these funds can combine two or more of any of the above strategies in pursuit of broader diversification and more stable returns. 

Private capital funds can be grouped into several large buckets, comprising private equity, private credit, and private real estate. 

As the name implies, private equity funds take ownership stakes in their investment targets. Fund managers typically have a playbook for improving their target companies, with an eye toward increasing revenue and/or reducing expenses—and thereby making the companies more profitable and valuable. For example, they may work to strengthen a company's management team, bolster its capital structure, or make acquisitions. 

Such funds tend to fall in three categories:

- Venture capital strategies: These often focus on funding and building young, innovative companies that are seeking to scale up their operations.

- Growth equity strategies: These funds target firms that are generating revenues or are already profitable, and then the funds help them expand by providing capital for expanding their operations or acquiring other firms. The fund manager typically buys a minority stake and may provide active guidance on how to expand.

- Buyout strategies: These funds secure controlling stakes in mature companies, and then work to improve operations or management.

Private credit funds, meanwhile, typically lend to companies or to other types of borrowers rather than making equity investments. 

Some strategies available here include:

- Income-producing strategies: These funds typically lend to smaller companies that may not be large enough to borrow in the public markets. They may also lend against assets, such as airplanes or farm equipment or payment streams such as healthcare or music royalties. Such funds may offer higher yields compared to traditional fixed income investments. 

- Capital appreciation strategies: These funds may lend to or invest in the debt of financially distressed companies. Returns from these strategies can be more equity-like, with most of the returns coming from price gains rather than income.

Private real estate funds may buy equity stakes in—or lend to—commercial and residential properties, which can include apartments, hotels, retail, offices, and industrial facilities. 

Private real estate investments can be grouped into three categories:

- Core/core plus: These strategies aim to generate stable rental income from high-quality properties.

- Value add: These focus on properties that require some refurbishment to enhance the value and perhaps move them into the core tier.

- Opportunistic: These target properties that need to be built but can also include stressed/distressed properties that may have redevelopment potential.

Traditional asset classes like stocks and bonds have a well-documented history of long-term growth potential. So, why allocate to alts?

Given how diverse the category is, there's really no one reason. It depends on the particular investment and broader market conditions. For example, hedge funds have the flexibility to shift their asset allocations to adapt to changing market conditions, conduct short sales to reduce their market exposure, and can use derivatives or leverage to potentially ramp up performance. Depending on the approach, that can mean potentially larger returns than what one might see from traditional investments or perhaps less volatility. 

Private capital, meanwhile, can provide access to investment opportunities that aren't available in public markets, such as direct ownership in promising fledgling companies. Some of them might offer higher returns than traditional investments. For example, a venture capital investment could pay off by going public. 

Regardless of the type, alts may behave very differently than typical stock or bond investments, which means they can add diversification and help mitigate volatility.

Like all investments, returns from alts aren't guaranteed, and you could lose all of the invested sum from a bad investment. They are also far less transparent than traditional investments, as alternatives aren't listed in open markets, may not be regulated, and can include investment holdings and trading methods that aren't required to be publicly disclosed. In addition, many alternative investments include assets that can be difficult to value.

Beyond that, investors should also consider: 

Because hedge funds deal for the most part in publicly listed securities, they tend to be more liquid than other alternative investments—like private capital—and may provide access to funds on a quarterly basis. 

That said, hedge funds can impose lockups and gates that prohibit withdrawals under certain conditions. This may not be a bad thing, as the managers may need to maintain certain amounts of capital to execute the fund's investment strategies. Some restrictions are designed to avoid mismatches between liquidity offered to investors and that of the underlying assets in the fund. Others exist to help managers to withstand periods of significant market stress.

As noted, private capital investments can be even less liquid, as it can take a long time to improve a business or property to the point of profitability. A typical private capital investment might take 10-15 years, during which investors' capital is drawn down and injected into the target asset. Investing in private capital requires a long-term focus and the ability to stomach periods of negative cash flows. Investors may also face calls for additional capital from fund managers—which they are contractually obligated to meet. Failing to meet capital calls could result in an investor's investment in a fund being slashed, forfeit, and/or assessed additional fees and penalties.

Alternative investments generally come with higher fees, which are typically charged on a monthly or quarterly basis to cover operating costs. Minimum investment requirements—meaning the minimum sums an investor must commit to access a given fund—may also be higher than with traditional investments. Depending on a particular investment's structure and its underlying holdings, various additional layers of fees may be present, making the full cost opaque or difficult to assess. Clients should read the prospectus or private placement memorandum to understand any given funds fees. 

For hedge funds, management fees are generally calculated as a percentage of the fund's total net asset value, while private capital funds base fees on the amount of committed capital and/or invested capital. 

Hedge funds may also charge performance fees when they achieve certain results, known as a high-water mark. If the fund drops in value, investors don't pay the performance fee again until the fund reaches its previous peak value. 

Private capital funds have something similar, known as carried interest, which can apply when the fund earns a certain minimum return, known as a hurdle rate. If the fund falls short of the hurdle rate, it isn't allowed to charge carried interest.

Because some alts are so unlike  investments in traditional public markets, their performance may not line up neatly with traditional benchmarks like the S&P 500^® Index.

In fact, hedge fund strategies may be designed specifically not to track conventional market benchmarks. So, to measure a fund's performance and risk, analysts typically compare a given fund against others that pursue the same, or a similar, strategy. 

Private capital has other ways of measuring performance, which may not be a surprise given that returns may not materialize for years after the initial investment. Private capital funds typically use cash flows to compute returns, and then report an internal rate of return (IRR)—ideally this rate would be higher than the hurdle rate mentioned above.

Funds may also track RVPI (residual value/divided by paid-in capital), which measures the amount of unrealized value relative to the amount of contributed capital. Or DPI (distributions/paid-in capital), which measures how much of the contributed capital has been returned to investors. Or TVPI (total value/paid-in capital), which measures total returns, realized and unrealized, relative to the amount of contributed capital. 

Analysts can use such measures to see how funds compare across "vintage years," or the year when a fund was established. 

This isn't to say investors must rely on non-traditional performance measures entirely, without reference to more traditional benchmarks. Analysts have also developed a measure known as Public Market Equivalents (PMEs) to give investors a way of evaluating how a private market investment fared relative to an investment in publicly traded assets. It works like this: A PME analysis uses a private fund's cashflows as the basis for a hypothetical investment in the assets of a benchmark, such as the S&P 500, and then measures what sort of returns an investor might have seen. 

The features that make alts unique—potentially higher returns than those available in public markets, lack of correlation with traditional investments, etc.—are reasons to consider including them in a portfolio composed primarily of traditional asset classes. However, investors also need to understand and accept the myriad additional risks that come with such investments before committing. Alts may complement a portfolio of carefully diversified traditional investments, but  are no substitute for a traditional portfolio in and of themselves. 

As always, be sure to discuss any significant investment with a professional before committing.