Alternative Investments – What are some examples?

If you read our article Alternative Investments I – what are they, you will remember that an alternative investment is generally anything that is NOT a stock, bond or cash. This article explores a few types of alternative investments and attempts to describe who can invest, what they are, and why someone would benefit from using them.

Derivatives Contracts

Who can invest? Some of these can be limited to accredited investors.

What are they?  A derivative contract is a security whose price depends on the price of an underlying asset. An example of a derivative is a futures contract. The contract’s value depends on the value of the underlying asset (like the sugar in our example below).

Examples of investments that use derivatives contracts include structured products, hedge funds, and futures markets (read on for explanations of what these are).

There are three major classes of derivatives including a) futures and forwards contracts (see below) b) options (the right to buy or sell an asset at a certain price in the future) and c) swaps (an agreement for the exchange of one stream of future interest payments for another based on a principal amount).

The main types of underlying assets in derivative contracts are:

• Interest-rates (the right to pay or receive a given amount of money at a certain rate)
• Foreign exchange-rates and currencies (taking advantage of differences in valuations between pairs of different country’s currencies)
• Debt (basically a bet on whether or not the bond or loan will go bust)
• Commodities (wheat, corn, precious metals, etc)
• Equity derivatives including the below types:
• Options (the right to buy or sell a stock at a certain price in a certain time frame)
• Warrants (the right to purchase an underlying security -usually an equity- from the issuing company at a certain price for a certain period into the future. These warrant documents can be traded – the prices fluctuate based on the company stock value. Warrants are usually attached to a bond sale. The main difference between a warrant and an option is that a warrant period is typically in years, an option typically is in months. Warrants can also be sold to third parties.)
• Swaps (the right to exchange one stream of income for another based on a certain principal amount)
• Interest rate options (caps – the seller pays the buyer if the interest rate exceeds the specified rate, floors – the seller pays the buyer if the interest rate falls below the specified amount, collars – the purchase of both an interest rate cap and floor to limit the range in which the interest rate will fluctuate.)

Benefits of using derivative contract’s.

The various types of derivatives offer differing benefits. Warrants, for example, can make it easier to sell a bond at a lower interest rate and allow the bond buyer to profit from rising share prices because the warrant can let them get the shares at less than market price.

Interest-rate options can lower the risk when you borrow money at an adjustable interest rate. You buy an interest rate cap from a bank other than the one you borrow from, to get funds to pay the higher rate if the bank loan interest rate goes up.

Hedge fund managers use derivatives in conjunction with other types of investments to present a pre-packaged diversified product to investors.

Structured Products.

Who can invest?  Typical investors will be accredited.

What are they?  According to Bruce Glassman, JD, CPA/PFS in “Structured Products”:

“The term “structured products” is used to describe a broad assortment of financial instruments that generally combine derivatives with either securities or other derivatives to create what is essentially a prepackaged investment strategy in a single product. Generally, a structured product offers a way to gain exposure to a given type of asset without actually owning that asset.

Most structured products are debt instruments issued by investment banks or other large financial institutions. Like ordinary bonds, they have a fixed maturity date” Example: A principal-protected note is designed to return the principal invested when the note matures, plus (or minus) a return based on the value of whatever underlying assets the note is linked to. “

For more information on structured products check out the Wells Fargo Advisor site: https://saf.wellsfargoadvisors.com/emx/dctm/Marketing/Marketing_Materials/Structured_Products/0000587580.pdf

Benefits of using structured products.

Structured products provide a convenient way to implement a complex investment strategy with just one product. They also can provide a customized solution to a particular investor or class of investor’s needs.

Hedge Funds

Who can invest?  Accredited investors.

What are they?  A hedge fund is a private investment company or partnership structure that is managed by a professional manager. The manager can use strategies and techniques not allowed with SEC regulated companies (such as options, futures, swaps and short selling). Hedge funds invest in publicly traded securities and/or financial derivatives.

Hedge funds are characterized by high fees, low liquidity, high leverage and have had better than average returns in the past.

Neil Chriss, in Introduction to Hedge Funds, lists three types of hedge funds: a) Market neutral (which strive for a low correlation of the hedge fund’s returns to the regular market’s returns) b) Event driven (which strive to take advantage of specific events – such as a corporate spinoff and restructure) and c) Long-short funds (buying ‘long’ means that you expect the price to go up so you will hold the position for a longer time – selling short means that you sell a position you don’t own now because you think the price will go down later).

Benefits of investing in hedge funds.

Hedge fund managers generally have a personal stake in the fund, and they typically get upwards of a 20% performance compensation (meaning they get 20% of the performance gains) – so the funds attract some of the best managers. A hedge fund that strives for market neutrality can provide portfolio diversification.

Futures Markets.

Who can invest?  Some arenas are limited to accredited investors, some are open to all with a large risk appetite.

What are they?  The futures market deals in the buying and selling of standardized futures contracts – where the seller agrees to deliver an asset (commodity or financial instrument) to the buyer in a specified quantity and quality for a specified price on a specific future date. Futures markets are characterized by the use of high leverage. You can gain a lot but you can also lose a lot.

There are several types of underlying assets that can be traded in a futures contract:

• Commodities futures – the underlying assets are commodities such as wheat, corn, oil, etc.
• Financial futures – the underlying assets are financial in nature, such as currencies (foreign exchange-rate trading), CDs, treasury bonds, etc.

There are various ways to trade in the futures market:

• Directly engage in a futures contract: You want to buy a lot of sugar next September for your large scale baking operation. You don’t know what the price will be but you think it will go up. A sugar plantation owner wants to make sure they have a market for sugar in the fall, and they want to solidify the price of it. You write up a standard contract to buy xx pounds of sugar, of xx grade on xxx date in September. The seller is on the hook to deliver the sugar at the contract price on the contract date. You are on the hook to take delivery of the sugar at the contract price on that date. The contract you write up between the two of you can then be sold on a commodities exchange (specifically the Coffee, Sugar and Cocoa Exchange).
• Buy an individual futures contract over the counter: An example is the purchase or sale of Foreign Exchange Currency pairs (see http://www.forex.com/Learn for more information on this), or perhaps you want to buy the above contract for sugar.
• Open a Futures Commission Merchant account: This lets you individually trade on the actual futures exchanges such as the Chicago Mercantile Exchange.
• Open a managed futures account – an individual investor’s account, managed by a professional money manager (known as a Commodity Trading Advisor). Note that there are significant management fees associated with this type of account and you need to be an accredited investor.
• Open an account with a commodity pool – an investment company pools money from multiple individuals to invest in commodities, futures and options. The Commodity Pool Operator takes the pooled money and invests it.

For more information in how to invest in futures: http://www.dummies.com/how-to/content/covering-top-ways-to-invest-in-commodities.html.

You can make money in the futures market several ways.

• The contract you own can be sold to someone else for more than you paid.
• The underlying asset the contract defines (wheat, oil, etc) can sell in the ‘spot’ market on the day your contract is due for more than the price in your contract.
• You can ‘roll’ the contract into a new one (sell the one you have and buy a new one) and sell for more than you have to pay to buy the new one.

For more information, visit the site of the government agency that controls futures trading the Commodity Futures Trading Commission (CFTC) at: http://www.cftc.gov/ConsumerProtection/EducationCenter/index.htm or view this tutorial on futures at Investopedia: http://www.investopedia.com/university/futures/.

Benefits of trading in futures markets.

There is a low correlation between futures trading results and the results of other investment types – allowing more diversification in your portfolio. The trading is very liquid, you don’t necessarily need to hold the investment for a long time. You can use a high degree of leverage in futures trading because the margin required is much less than the value of the futures contract (note that this can also be a disadvantage as you can also lose more than you have in your futures margin account).

Private Equity.

Who can invest?  Accredited Investors.

What is it?  Investing in private equity means investing in operating companies that are not publicly traded.

Strategies used to invest in private equity include:

• Leveraged buyouts (buying controlling interest in a company using borrowed funds).
• Venture capital (providing funds to start up companies in exchange for stock in the company).
• Growth capital (providing funds – usually in exchange for company stock – to companies past their start up phase so the company can grow or change direction).
• Distressed investments (taking on the debt of a company in trouble in hopes of turning it around by use of new expertise, direction or owners).
• Mezzanine capital (debt or equity in a company that is only paid out before the common stock – typically paying higher interest rates due to the reduced ability to recover the debt).
• Institutional investors can get into private equity through the use of private equity funds. They don’t have to invest in individual companies. Accredited investors deal with companies they know through personal networks or through private banks or family offices..

Benefits of using private equity.

Private equity provides portfolio diversification because it is not closely correlate with normal investments. Investors may have enhanced performance results because they know something about a private company that others don’t and stand ready to take advantage of that knowledge.

Real Estate.

Who can invest?  Anyone with sufficient funds who doesn’t necessarily need liquidity.

What is it?  You can make various types of investments in real estate. Some of them are listed below:

• Residential and commercial real estate – homes and business buildings.
• Real estate investment trusts (REITS)– a pool of money to invest in real estate (actual buildings) or real estate mortgages. REITs receive favorable tax treatment and must pass at least 90% of their profits to investors. A REIT may be public, in which case it is listed on stock exchanges, or privately held.
• Real estate held in foreign countries – privately purchased buildings in a country different than your own or participation in a mutual fund or exchange traded fund. Investing in foreign real estate provides geographic diversification in a real estate portfolio.
• Real estate tax lien certificates – a document providing conditional ownership to a real property if the current owner remains delinquent in county tax payment for a proscribed period of time. Investing in tax lien certificates can provide interest payments to the lien certificate holder and may provide the opportunity to obtain the property it describes for a discounted price (in some states, just the price paid at auction for the tax lien certificate).

Benefits of investing in real estate.

A real asset keeps it’s value in rising inflation scenarios. You probably will get income (from rent, dividends or interest depending on the type of asset you hold). You may find that the value of the property appreciates over time. A component of real estate in your portfolio provides diversification.

Collectible Items.

Who can invest?  Anyone.

What are they?  Investing in collectible items means buying art, stamps, automobiles, boats, planes, stamps, jewelry or other real items in hopes that their value will increase. You can purchase some of these at auctions such as those held by Christie’s, Sotheby’s, the American Numismatic Association (for coin collectors), the American Stamp Dealer’s Association’s (for stamp collectors) or the Barrett-Jackson Collector Car Auction.

Most sources agree that knowledge of the particular type of collectible is a must have, as well as the ability to enjoy the object(s) you are collecting. Appreciation in value of the object (if indeed it occurs) is merely a side benefit.

See: http://www.cnbc.com/id/32387570/ for a CNBC special on alternative investments of the collectible nature.

Benefits of using collectibles.

• The value of collectible real objects tends to keep pace with inflation. You can enjoy what you collect. Collectibles provide some diversification to your asset base.

Drawbacks of using any alternative investments include the elevated risks, the heightened complexity and the enhanced opportunity for fraud.

Sources:

“Should Managed Futures Be in the Cards for You?”: http://online.wsj.com/article/SB124242429895325075.html

“Introduction to Hedge Funds” Neil A. Chriss, December 1998 Banking and Finance G63.2751

http://www.wilmingtontrust.com/wtcom/index.jsp?fileid=3000237

http://en.wikipedia.org/wiki/Private_equity

Hedge Funds Consistency Index web site: http://www.hedgefund-index.com/d_structured.asp

http://www.anywherelegal.com/uploads/Structured_Products.pdf

https://saf.wellsfargoadvisors.com/emx/dctm/Marketing/Marketing_Materials/Structured_Products/0000587580.pdf

Investopedia Web site: http://www.investopedia.com/terms/a/alternative_investment.asp

http://www.investopedia.com/university/futures/futures2.asp

http://www.investopedia.com/terms/p/privateequity.asp

Securities and Exchange Administration Web site: http://www.sec.gov/answers/accred.htm

Hedge Funds Consistency Index web site: http://www.hedgefund-index.com/d_structured.asp

“Investing in art takes taste and business savvy” By Robbie Woliver • Bankrate.com http://www.bankrate.com/brm/news/investing/20010912a.asp

“Don’t ‘Invest’ in Art” by Paul Johnson, 01.14.09, 06:00 PM EST Forbes Magazine dated February 02, 2009 http://www.forbes.com/forbes/2009/0202/017.html

“Alternative Investments: Where, What, When” by By: Cadie Thompson Published: Monday, 31 Aug 2009 Producer, CNBC.com http://www.cnbc.com/id/32329423/Alternative_Investments_Where_What_When