Understanding Alternative Investments

22 July, 2024 / Articles

Alternative investments are those that fall outside the conventional investments types such as publicly traded stocks, bonds, and cash. The terms “traditional” and “alternative” should not be taken to imply that alternative investments are necessarily uncommon or are relatively recent additions to the investments universe. Some alternative investments actually date back further than other kinds. For example, assets such as real estate and commodities which are arguably two of the oldest investment classes fall under the umbrella of alternative investments.

They also include non-traditional approaches to investing using special investment vehicles (SIVs) such as private equity funds, hedge funds and exchange-traded funds (ETFs). SIVs enable investors to invest indirectly in assets. These vehicles collect money from many investors and pool it into a fund, which is then used to make investments and is overseen by an investment manager who makes decisions on behalf of the fund.

Compared to traditional investments, alternative ones are illiquid. This means that they cannot be converted to cash easily. They also have a low correlation of returns compared to those of traditional investments. This means that the market performance of traditional investments and alternative investments are independent of each other. Therefore, the inclusion of alternative investments in a portfolio can reduce its risk. Alternative investments face fewer regulations and have less transparency than traditional ones. They have limited data, which is not publicly available and also have unique legal and tax considerations.

The most pervasive alternative investments today are private equity and real estate. However, there are other, more specialized types, which also offer considerable returns. They include hedge funds, commodities, and infrastructure.

Private Equity

Private equity generally involves buying shares in companies that are not listed on a public exchange or buying shares of public companies with the intent to make them private. Private equity can involve many strategies that may help provide money to companies at different stages of their development. The most widely used strategies are venture capital, buyouts and distressed investing.

Venture capital is putting money into a small business or startup, which is felt to have great potential for growth in the long run. This investment strategy can occur at different stages of a business cycle. The first is investing in the early stages of companies that have an innovative business idea with high potential for growth, commonly referred to as angel investment. The second is financing or investing in companies with proven business models which have good customer bases and positive cash flows or profits, commonly referred to as growth equity. These companies have the opportunity to grow by adding new production facilities or through expansion, but they don’t generate sufficient cash flows from their operations to support their growth plans. The other strategy is buyouts, a method that consists of financing established companies that require money to restructure and facilitate a change of ownership. Buyouts include making a public company private. The last strategy is distressed investing which involves investing in companies that are in financial distress. The capital is usually used to pay debt and restructure the company.

The private equity market in Africa remained steady in 2017 according to the Africa Venture Capital Association as evidenced by an all-round performance in terms of funds raised, successful exits completed, and the number and variety of projects that were set in motion. Consumer discretionary and Information Technology were the most active sectors for private equity deals in Africa last year. There has also been a recent trend of rising private equity investments in Africa’s education sector.

One advantage of private equity is that it has a great potential upside, especially from venture capital investments. The universe of potential company investments for private equity is huge. Private equity is a vast and unchartered land of opportunity. One of its disadvantages includes illiquidity because the funds are tied up in the company for a lock-out period. Another demerit is that the management of the company can choose to hide information about it, and making informed decisions can prove to be challenging or sometimes even impossible.

Real Estate

Real estate investments take different forms. For many people, it is the purchase of their home, apartment or other residential properties that the owner occupies. This is the foundation of many individuals’ financial plans. Real estate is property comprised of land and the buildings on it, as well as the natural resources of the land, including forests and wildlife, farmed crops and livestock, water and mineral deposits. Real estate investments can be made either directly or indirectly. The growing popularity of securitizations broadens the definition of real estate investing. They now include public real estate equity for example REITs and public real estate debt, for example, mortgage-backed securities. Real estate can be grouped into three broad categories based on its use: residential, commercial and industrial. Residential real estate includes houses, apartments, and townhouses. Commercial real estate is office buildings, warehouses, and retail store buildings while industrial real estate includes factories, mines, and farms.

The current market for real estate in Africa is being driven by rapid population growth and urbanization. The population in Africa is growing at a faster rate than that of any other continent in the world. Its demographic profile is both young and increasingly urbanized. A growing volume of capital is targeted at Sub-Saharan Africa real estate investment and development, with a series of new investment targeted at the region. The retail property sector continues to be a major focus for development activity, causing the shopping mall concept and mixed development concept to take root in an increasingly wide range of Sub-Saharan cities. Nairobi has been a retail development hotspot over the last two years, highlighted by the opening of the Two Rivers Mall, Garden City Mall, and The Hub, Karen. The logistics property sector has also emerged as a focus for new development in Sub-Saharan Africa in recent years, and there is a growing recognition that the region’s key cities are undersupplied with modern warehousing space.

Some advantages of real estate investments include its ability to act as an inflation hedge as home values and rent increase in value over time; its virtue of being visible and tangible, unlike other investments, which are virtual; and the high returns it offers. One disadvantage is its costliness in buying, selling and operating. Some real estate investments also need management, which increases costs.

Other Alternative Investments

Commodities investments may be in physical commodity products such as grains, metals and crude oil, either through owning cash instruments, using derivative products, or investing in businesses engaged in the production of physical commodities. The main vehicles investors use to gain exposure to the commodities are commodity futures contracts and funds which are benchmarked to commodity indexes. Commodity indexes are typically based on various underlying commodities.

Hedge funds are private investment vehicles that manage portfolios of securities and derivative positions using a variety of strategies. They may use long or short positions, may be highly leveraged and aim to deliver investment performance that is independent of broad market performance.

Infrastructure assets are capital intensive, long-lived, real assets, such as roads, dams, and schools, which are intended for public use and provide essential services. Infrastructure assets may be financed, owned, and operated by governments, but increasingly the private sector is investing in infrastructure assets. Investors may gain access to these assets directly or indirectly. Indirect investments vehicles include shares of companies, ETFs, private equity funds, listed funds and unlisted funds that invest in infrastructure.

Other alternative investments may include tangible real assets such as fine wine, art, antique furniture and automobiles, stamps, coins and other collectibles. There also some intangible assets that individuals can invest in, such as patents.

Why invest in alternative investments?

So in conclusion why invest in alternative investments? For one, they can help to diversify an investor’s portfolio, and since they have a low correlation with traditional investments, they help an investor to reduce risk. Alternative investments have also historically outperformed traditional investments, so, they can offer superior returns compared to traditional options. Alternative investments also have the advantage of providing social development to an economy. In real estate, they help provide development in infrastructure and uplift the image of the community in which they are developed. In private equity, they help create jobs and improve people’s standards of living.

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