Understanding Alternative Investments
The Investment Team at Yellowstone Partners strives to generate returns for clients by investing in ‘traditional investments’, which in our industry refers to stocks, bonds and cash. Other asset classes are often referred to as ‘alternative investments’, which includes real estate, commodities, options, derivatives, hedge funds, private equity, etc. Although Yellowstone Partners does not manage alternative investments directly, the investment team may occasionally use other investment managers that specialize in these asset classes. We therefore wanted to provide our clients a high level summary of the alternatives space.
Types of alternatives
- Real Estate – Investments in commercial property, your home, real estate investment trusts (REITS), land, etc are all examples of investing in real estate. In our subsequent newsletter we will provide further commentary on Real Estate as an investment.
- Commodities – Commodities include investments in crude oil, potatoes, cattle, grain, wind, natural gas, jet fuel, and an innumerous number of other similar investments. Investing in commodities often occur through future, forward and other option and derivative contracts issued through exchanges and with investment banks.
- Private Equity Funds – Private equity funds pool together investor money and purchase private companies (not listed equities) or buyout publicly traded equities and delist them from the exchange. These firms often use large amounts of debt financing to purchase to the private companies.
- Hedge Funds – Hedge Funds also pool investor money together to employ various strategies to take advantages of perceived market opportunities. Hedge fund managers are very flexible to deploy investment capital in a way to pursue excess returns often through investments which use derivatives and leverage to increase returns.
Why alternatives and what should be considered
- Correlation and Diversification – One of the main arguments for adding alternatives to your portfolio is that alternatives may be “non-correlated” to traditional assets. In other words, the performance of these asset classes may not move in lock-step with stocks and bonds. For example, if the stock market goes up by 1%, real estate does not necessarily also move up by 1%. Owning alternative asset classes may therefore be an excellent way to diversify your overall portfolio.
- Reduction of Downside Risk – Many hedge funds are designed to provide favorable performance over longer periods of time, not from high performance over short periods, but through avoiding significant negative performance.
- Leverage and Derivatives – Alternatives may employ leverage to increase the returns generated by the investment. If you invest in a private equity or hedge fund, it is likely that they will either borrow funds from banks to purchase more assets or invest in derivatives that increase the relative position of the investment. Leverage and investing in derivatives can increase returns, but it also increases the volatility of those returns. As such, alternative investments are often limited to accredited investors who have sufficient wealth to be able to manage the volatility in risk.
- Liquidity – Often investments in alternatives do not allow you to withdrawal your money for a fixed period of time. For example a private equity fund might require a 5 to 7 year commitment before your investment principal and capital gain are returned. It is important to understand the liquidity of your alternative investment and make sure that you won’t have other needs during the lock-up period of your investment.
- Investment Structure – Many alternative investments use limited partnerships as the structure for investment. You join other investors in a limited partnership and receive distributions. This is done for tax benefit and often is these types of investments have tax advantages.
- Fees – On average, fees in alternatives are higher that with traditional investments. Private equity and Hedge funds often apply management fees of approximately 2% per year. Additionally, they may charge a performance fee, or “carry” equivalent to 20% of the capital appreciation. As with all investments, it is important to understand the fees associated with investing in these asset classes.
The Investment Team at Yellowstone Partners recognizes the value of adding alternative investments to client portfolios. There are multiple mutual funds and ETFs available to the investment team that give exposure to Real Estate, Hedge Fund type investments, Private Equity, etc. These funds and ETFs are specifically designed to allow traditional fund managers like Yellowstone Partners to assist their clients gain exposure to alternative asset classes. These types of investments may be appropriate for some clients, but due to some of the characteristics described above we will always recommend that they represent a small allocation of the overall holdings of our clients. As always, if you have any specific questions regarding alternative investments, please feel free to speak with your Yellowstone Wealth advisor or reach out to a member of the investment team directly.