What Are Alternative Investments?
An alternative investment is an investment that does not fit into one of the two traditional categories of publicly traded assets—stocks and bonds. There are several types of alternative investments, including:
- hedge funds;
- commodities, such as energy, precious metals and agricultural products;
- distressed debt;
- affordable housing loans;
- private real estate; and
- private equity.
The General Board’s Alternative Investments
The General Board regularly evaluates and, in some cases, invests in alternative assets for its various daily priced funds. For example, the two equity funds offered by the General Board—the U.S. Equity Fund and the International Equity Fund—currently hold investments in private equity and private real estate.
Private equity investments are shares of privately held companies (i.e., those whose stock is not traded on a stock exchange). Venture capital investing is probably the most well-known type of private equity investing. Venture-backed companies sometimes start in an entrepreneur’s garage or basement and evolve, with venture capital support, to become major American success stories, such as Microsoft, Apple Computer and Hewlett Packard.
Private real estate investing involves purchasing ownership in the debt or equity securities of commercial real estate properties, such as office buildings, shopping centers and apartment complexes. In a private real estate portfolio, investments are generally diversified with respect to property type and/or geographic location.
Alternative vs. Publicly Traded Investments
An alternative investment differs from a publicly traded investment in three key ways. First, the alternative asset can only be purchased in a privately negotiated transaction. Alternative investments are not listed or traded on a U.S. or international exchange. The value of an alternative investment is generally established once per calendar quarter by the alternative asset manager (also known as the general partner) upon issuance of financial statements (three times a year using unaudited statements and once a year using audited statements).
Second, because alternative investments are not traded on a public exchange, they typically are illiquid—that is, they cannot be exchanged readily for cash. This illiquidity provides flexibility to the general partner. Most alternative investments are set up to allow the general partner to invest over an extended time period in an effort to deliver enhanced investment returns. For example, a private real estate manager may invest in an office building, which is not fully leased and requires renovation work to make it attractive to prospective new tenants. With capital from investors, such as the General Board, the general partner can improve the building, rent the unoccupied space to new tenants and maybe even raise the rent due to the upgraded facilities. This investment strategy typically requires a few years to come to fruition.
Alternative investing is best accomplished in an investment structure in which the general partner does not have to worry about capital being deposited or withdrawn by investors. The general partner controls the flow of capital to and from investors based upon need and the performance of the underlying investments, and then returns capital and any earnings to investors at the end of the fund’s contractual life. While decreased liquidity does increase risk, the expectation is that investors will be rewarded with higher returns than those on more liquid investments, such as publicly traded equities. Of course, there is never a guarantee of this. Because of the risk associated with illiquidity, the General Board limits the allocation of alternative investments in its daily priced funds.
The third primary difference with publicly traded stocks is that institutional investors typically invest as joint limited partners or on a “commingled” basis in alternative funds. This means that they pool their capital in a single fund and then share proportionately in future fund payouts and profits. The ability to gather capital from a variety of investors provides the general partner with enhanced buying power and diversification. The fund can create a larger and more diversified portfolio that is spread across a broader base of assets. For example, a large private equity fund allows the general partner to invest in companies diversified by geography, industry and stage of development.
The General Board began actively committing funds to equity alternative investments in the early 2000s. Since alternative funds typically have lives that extend from seven to 10 years, the General Board’s history with these investments is not extensive enough to demonstrate their full benefits. However, academic studies indicate that over longer time frames, such as 10 years or more, alternative assets provide a diversifying benefit by helping to reduce overall risk when combined with a traditional public equity portfolio.
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