specialized pricing and valuation methods are driven by the structures that determine the characteristics of alternative investments.
1.5.4 Portfolio Management Methods
Finally, issues such as illiquidity, non-normal returns, and increased potential for inefficient pricing introduce complexities for portfolio management techniques. Most of the methods used in traditional portfolio management rely on assumptions such as the ability to transact quickly, relatively low transaction costs, and often the ability to confine an analysis to the mean and variance of the portfolio's return.
In contrast, portfolio management of alternative investments often requires the application of techniques designed to address such issues as the non-normality of returns and barriers to continuous portfolio adjustments. Non-normality techniques may involve skewness and kurtosis, as opposed to just the mean and variance. In traditional investments, the ability to transact quickly and at low cost often allows for the use of short-term time horizons, since the portfolio manager can quickly adjust positions as conditions change. The inability to trade some alternative investments like private equity quickly and at low cost adds complexity to the portfolio management process, such as liquidity management, and mandates understanding of specialized methods. Finally, alternative investment portfolio management tends to focus more on the potential for assets to generate superior returns.
1.6 Investments Are Distinguished by Other Factors
Three other issues help form the complex differentiation between alternative and traditional investments: information asymmetries, incomplete markets, and innovation.
Information asymmetries refer to the extent to which market participants possess different data and knowledge. In traditional investments, most securities are regulated and are required to disclose substantial information to the public. Many alternative investments are private placements, and therefore the potential for large information asymmetries is greater. These information asymmetries raise substantial issues for financial analysis and portfolio management.
Incomplete markets refer to markets with insufficient distinct investment opportunities. The lack of distinct investment opportunities prevents market participants from implementing an investment strategy that satisfies their exact preferences, such as their preferences regarding risk exposures. In an ideal world, securities could be costlessly created to meet every investor need. For example, an investor may desire an insurance contract that contains a specific clause regarding payouts, but regulations may make such clauses illegal. Or perhaps a contract with regard to a potential risk may be subject to unacceptable moral hazard. Moral hazard is that risk that the behavior of one or more parties will change after entering into a contract. As a result of this inability to contract efficiently, the investor might be unable to diversify perfectly. Trading structures in some alternative investments, such as large minimum investment sizes, can be viewed as exacerbating the problem of incomplete markets and the investment challenges that accompany them.
Finally, substantial degrees of innovation permeate the world of alternative investments, from the nascent enterprises of venture capital to the pioneering structures implemented in financial derivatives. The new and rapidly changing nature of alternative investments raises issues regarding methods of financial analysis and portfolio management that distinguish the study of alternative investments from the study of traditional investments.
1.7 Goals of Alternative Investing
Having defined what alternative investments are from a variety of perspectives, we introduce the questions of how and why people pursue alternative investing. Understanding the goals of alternative investing is essential; the following sections provide an introduction to the most important of these goals.
1.7.1 Active Management
Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return. Alternative investment analysis typically focuses on evaluating active managers and their systems of active management, since most alternative investments are actively managed. Active management is the converse of passive investing. Passive investing tends to focus on buying and holding securities in an effort to match the risk and return of a target, such as a highly diversified index. An investor's risk and return target is often expressed in the form of a benchmark, which is a performance standard for a portfolio that reflects the preferences of an investor with regard to risk and return. For example, a global equity investment program may have the MSCI World Index as its benchmark. The returns of the fund would typically be compared to the benchmark return, which is the return of the benchmark index or benchmark portfolio.
Active management typically generates active risk and active return. Active risk is that risk that causes a portfolio's return to deviate from the return of a benchmark due to active management. Active return is the difference between the return of a portfolio and its benchmark that is due to active management. An important goal in alternative investing is to use active management to generate an improved combination of risk and return.
Active management is an important characteristic of almost all alternative investments. Unlike traditional investing, in which the focus is often on security analy- sis and passive portfolio management, the focus of alternative investing is often on analyzing the ability of the fund to generate attractive returns through active management.
1.7.2 Absolute and Relative Returns
The concepts of benchmark returns, absolute return products, and investment diversifiers have been briefly introduced in this chapter. Let's examine these and other concepts in more detail. In alternative investing, there are two major standards against which to evaluate returns: absolute and relative.
An absolute return standard means that returns are to be evaluated relative to zero, a fixed rate, or relative to the riskless rate, and therefore independently of performance in equity markets, debt markets, or any other markets. Thus, an investment program with an absolute return strategy seeks positive returns unaffected by market directions. An example of an absolute return investment fund is an equity market-neutral hedge fund with equal-size long and short positions in stocks that the manager perceives as being undervalued and overvalued, respectively. The fund's goal is to hedge away the return risk related to the level of the equity market and to exploit security mispricings to generate positive returns.
A relative return standard means that returns are to be evaluated relative to a benchmark. An investment program with a relative return standard is expected to move in tandem with a particular market but has a goal of consistently outperforming that market. An example of a fund with a relative return strategy is a long-only global equity fund that diversifies across various equity sectors and uses security selection in an attempt to identify underpriced stocks. The fund's goal is to earn the benchmark return from the fund's exposure to the global equity market and to earn a consistent premium on top of that return through superior security selection.
1.7.3 Arbitrage, Return Enhancers, and Risk Diversifiers
The concept of arbitrage is an active absolute return strategy. Pure arbitrage is the attempt to earn risk-free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets. Modern finance often derives pricing relationships based on the idea that the actions of arbitrageurs will force the prices of identical assets toward being equal, such that pure arbitrage opportunities do not exist or at least do not persist. Chapter 6 provides details on arbitrage-free modeling.
The term arbitrage is often used to represent efforts to earn superior returns even
