Alternative Investment Performance and Returns

Why alternative investments are harder to appraise than listed stocks and bonds (life cycle, leverage, valuation and fees), how IRR and MOIC measure their returns, and how management fees, performance fees, hurdles, catch-ups, high-water marks, clawbacks and fund-of-funds layers turn a gross return into the net return a particular investor actually earns.

1. 1. Why appraisal is harder: the life cycle and the J-curveAlternative investments are customised, long-lived and lumpy in their cash flows, so a simple period return tells you far less than it does for a listed share or bond.Video · 6 minFree12 min
2. 2. Measuring returns: IRR versus MOICIRR captures both the size and the timing of a fund's cash flows, so it is the preferred measure; MOIC is a quick multiple that ignores how long the money was tied up.Video · 6 min13 min
3. 3. Leverage: magnifying gains and lossesBorrowing lets a fund hold a position larger than its own capital, so the leveraged return equals the asset return plus a magnified spread between that return and the borrowing rate.11 min
4. 4. Valuation: fair value levels and smoothed returnsIlliquid alternatives are often valued by models rather than prices, which tends to smooth reported returns and understate their true volatility.11 min
5. 5. Fees, custom terms and redemption provisionsAlternative funds charge a management fee plus a performance fee, with terms that vary by investor; the order in which fees are calculated changes the net return.14 min
6. 6. Hurdle rates, catch-up, waterfalls and clawbackHurdles make the manager earn a minimum return for investors before taking a performance fee, and clawbacks make sure the fee reflects the fund's overall result, not its best early deals.Video · 6 min15 min
7. 7. High-water marks, investor timing and either/or feesA high-water mark stops the manager charging performance fees twice on the same gains, which means investors who entered at different times pay different fees for the same fund performance.Video · 5 min13 min
8. 8. Integrated case: hurdle rate and high-water mark in one feeWhen a fund has both a hurdle and a high-water mark, the incentive fee is due only on the value, after the management fee, that clears the high-water mark grown at the hurdle rate; this case runs four years of it.16 min
9. 9. Integrated case: three investors, one fund, four yearsA high-water mark is tracked per investor, so one fund with one series of gross returns pays different incentive fees to investors who entered at different times, and the highest net return can belong to the earliest or the latest entrant.15 min
10. 10. Funds of funds, benchmarks and index biasesA fund of funds adds a second layer of fees on top of the underlying funds' fees, and hedge fund indexes overstate typical returns because failed funds drop out and only winners get backfilled.12 min