investment management fees.
3. PRIVATE EQUITY is clearly distinguished by the institutional structure that it is not publicly traded. Compensation, securities, and trading structures also play nontrivial roles in shaping the nature of private equity.
4. STRUCTURED PRODUCTS are clearly distinguished by the securities structure. However, structured products are also typically moderately influenced by institutional, regulatory, and compensation structures.
1.3.3 Limits on Categorization
Structures are an essential concept in understanding the nature of an investment; however, they are not necessarily a defining feature of alternative investments. For example, can we view an investment as an alternative investment if it is substantially affected by a particular number of these aspects? The answer is no. Some alternative investments, such as timberland, have minimal influences from structures. Typically, the cash flows of the underlying timberland are not substantially altered by structures as they pass from the underlying real assets to the ultimate investor. On the other hand, investments such as equity derivatives and interest rate derivatives can be heavily structured and regulated and yet be considered in many cases to be traditional investments.
The concept of the five structures is designed to help us understand and analyze investment products but not necessarily to define classes of securities. The context of these five structures can help identify an investment's distinguishing characteristics. Structures help explain why some investments offer different return characteristics than others and why some investments require different methods of analysis than others; these topics are covered in the next two sections.
1.4 Investments Are Distinguished by Return Characteristics
A popular way of distinguishing between traditional and alternative investments is by their return characteristics. Investment opportunities exhibiting returns that are substantially distinct from the returns of traditional stocks and bonds might be viewed as being alternative investments. Stock returns in this context refer to the returns of publicly traded equities; similarly, bond returns refer to the returns of publicly traded fixed-income securities.
1.4.1 Diversification
An investment opportunity with returns that are uncorrelated with or only slightly correlated with traditional investments is often viewed as an alternative investment. An attractive aspect of this lack of correlation is that it indicates the potential to diversify risk. In this context, many alternative investments are referred to as diversifiers. A diversifier is an investment with a primary purpose of contributing diversification benefits to its owner. Absolute return products are investment products viewed as having little or no return correlation with traditional assets, and have investment performance that is often analyzed on an absolute basis rather than relative to the performance of traditional investments. Diversification can lower risk without necessarily causing an offsetting reduction in expected return and is therefore generally viewed as a highly desirable method of generating improved risk-adjusted returns.
Sometimes alternative assets are viewed as synonymous with diversifiers or absolute return products. But clearly most types of investments, such as private equity, REITs, and particular styles of hedge funds, have returns that are at least modestly correlated with public equities over medium- to long-term time horizons and are still viewed as alternative investments. Accordingly, this non-correlation-based view of alternative investments does not provide a precise demarcation between alternative and traditional investments. Nevertheless, having distinct returns is often an important characteristic in differentiating alternative investments from traditional investments.
Alternative investments may be viewed as being likely to have return characteristics that are different from stocks and bonds, as demonstrated by their lack of correlation with stocks and bonds. The distinctions between traditional and alternative investments are also indicated by several common return characteristics found among alternative investments that either are not found in traditional investments or are found to a different degree. The following three sections discuss the most important potential return characteristic distinctions.
1.4.2 Illiquidity
Traditional investments have the institutional structure of tending to be frequently traded in financial markets with substantial volume and a high number of participants. Therefore, their returns tend to be based on liquid prices observed from reasonably frequent trades at reasonable levels of volume. Many alternative investments are illiquid. In this context, illiquidity means that the investment trades infrequently or with low volume (i.e., thinly). Illiquidity implies that returns are difficult to observe due to lack of trading, and that realized returns may be affected by the trading decisions of just a few participants. Other assets, often termed lumpy assets, are assets that can be bought and sold only in specific quantities, such as a large real estate project. Thin trading causes a more uncertain relationship between the most recently observed price and the likely price of the next transaction. Generally, illiquid assets tend to fall under the alternative investment classification, whereas traditional assets tend to be liquid assets.
The risk of illiquid assets may be compensated for by higher returns. An illiquid asset can be difficult or expensive to sell, as thin volume or lockup provisions prevent the immediate sale of the asset at a price close to its potential sales value. The urgent sale of an illiquid asset can therefore be at a price that is considerably lower than the value that could be obtained from a long-term comprehensive search for a buyer. Given the difficulties of selling and valuing illiquid investments, many investors demand a risk premium, or a price discount, for investing in illiquid assets. While some investors may avoid illiquid investments at all costs, others specifically increase their allocation to illiquid investments in order to earn this risk premium.
1.4.3 Inefficiency
The prices of most traditional investments are determined in markets with relatively high degrees of competition and therefore with relatively high efficiency. In this context, competition is described as numerous well-informed traders able to take long and short positions with relatively low transaction costs and with high speed. Efficiency refers to the tendency of market prices to reflect all available information. Efficient market theory asserts that arbitrage opportunities and superior risk-adjusted returns are more likely to be identified in markets that are less competitively traded and less efficient. (Market efficiency is detailed in Chapter 6.) Many alternative investments have the institutional structure of trading at inefficient prices. Inefficiency refers to the deviation of actual prices from valuations that would be anticipated in an efficient market. Informationally inefficient markets are less competitive, with fewer investors, higher transaction costs, and/or an inability to take both long and short positions. Accordingly, alternative investments may be more likely than traditional investments to offer returns based on pricing inefficiencies.
1.4.4 Non-Normality
To some extent, the returns of almost all investments, especially the short-term returns on traditional investments, can be approximated as being normally distributed. The normal distribution is the commonly discussed bell-shaped distribution, with its peaked center and its symmetric and diminishing tails. The return distributions of most investment opportunities become nearer to the shape of the normal distribution as the time interval of the return computation nears zero and as the probability and magnitude of jumps or large moves over a short period of time decrease. However, over longer time intervals, the returns of many alternative investments exhibit non-normality, in that they cannot be accurately approximated using the standard bell curve. The non-normality of medium- and long-term returns is a potentially important characteristic of many alternative investments.
What structures cause non-normality of returns? First and
