What makes an investment alternative

Defined by what they are not

The traditional asset classes are listed shares, bonds and cash. An alternative investment is any investment other than ownership of those. That is a definition by exclusion, so alternatives are a family of misfits rather than a group with one common feature.

What unites them is that their characteristics and the way they are structured differ from traditional securities. A share of a listed bank can be bought in seconds for a few hundred euros; a stake in a private buyout fund needs a multi-million commitment locked up for a decade. That gap in liquidity, size and complexity is what earns the 'alternative' label.

A useful test: ask whether the thing itself, or the way it is accessed, falls outside public equity, public debt and cash. A hedge fund that only trades listed shares is still an alternative, because the investor holds an interest in a private vehicle that uses leverage, short selling and derivatives. A currency future bought on an exchange is not: it is a traditional exchange-traded instrument.

The trade-off: diversification and return for illiquidity

Investors are drawn to alternatives for two reasons. First, diversification: many alternatives have low correlation of returns with listed shares and bonds, so they can smooth a portfolio. Second, higher expected returns, partly as reward for tying money up and for operating in less efficient markets where skilled managers can find mispriced assets.

The price is paid in other currencies. Alternatives are typically illiquid, have long investment horizons (an asset's life cycle can span many years) and need large capital outlays, sometimes too large for smaller investors to hold even one. Valuing their cash flows and risks requires specialised knowledge that a generalist does not have.

Because of this, most investors only use alternatives for the slice of the portfolio that funds obligations several years away. Investors with the longest horizons and deepest resources, such as large pension funds, sovereign wealth funds and university endowments, tend to allocate the largest share.

From features to characteristics

The distinguishing features explain why alternatives look and feel different. Direct investment is hard for most investors, so different investment structures (funds, partnerships, co-investment rights) exist to let them in indirectly.

The manager knows far more about the assets than the investor and controls them for years. To reduce this information asymmetry, pay is tied to results through incentive-based fees rather than a flat percentage.

Finally, there are performance appraisal challenges. With no daily market price, values rest on appraisals and models, returns arrive irregularly and benchmarks are imperfect, so judging a manager is harder than comparing a mutual fund with an index.

• Private capital: equity or debt financing for companies from outside the public markets (private equity, venture capital, private debt).
• Real assets: real estate, infrastructure, natural resources (land, timber, farmland, commodities), plus collectibles and intangibles such as patents and digital assets.
• Hedge funds: private vehicles defined by their investment approach (leverage, derivatives, short selling), not by what they hold.

Think of it as a bargain: the investor gives up liquidity, transparency and simplicity, and in return hopes to earn diversification and a higher return. Every structure in this module exists to keep that bargain fair over a long time.