| Alternatives like private equity, commodities and real | | | | be independent of the fund manager. |
| estate may be somewhat familiar to investors. | | | | Hedge funds can use more complex investment |
| Others, like hedge funds, managed futures, and | | | | strategies and are often classified according to |
| "distressed" securities are more recent and may not | | | | investment style. The five most widely used hedge |
| be as well-known. Alternatives are not for investors | | | | fund strategies are: equity market-neutral, equity |
| who have had no previous experience with them, or | | | | hedge, merger arbitrage, convertible arbitrage, and |
| who are accustomed to making less complex | | | | global macro. (See sidebar, The 5 Most Common |
| investment decisions. | | | | Hedge Fund Investment Strategies.) |
| It's critical that investors analyze the complexities of | | | | Managed Futures |
| the investment's structure and strategy; evaluate the | | | | These private pooled investment vehicles can invest |
| business or other expertise of the investment's | | | | in the cash, spot and derivatives markets and have |
| owner or manager, and obtain and interpret any | | | | the ability to use leverage (borrowed money) in a |
| available performance or other information about the | | | | wide variety of trading strategies. Similar to hedge |
| investment There may also be higher costs | | | | funds, managed futures programs are actively |
| associated with determining the suitability of an | | | | managed and are structured as limited partnerships |
| alternative investment. | | | | open only to accredited investors. The managers |
| TYPES OF ALTERNATIVES | | | | take positions based on expected profit potential. |
| Alternative investments can be placed into three | | | | Distressed Securities |
| groups by the primary role that they usually play in | | | | These are securities of companies that are in financial |
| portfolios: | | | | distress or near bankruptcy. Investment strategies |
| Investments that provide exposure to markets other | | | | using distressed securities exploit the fact that many |
| than the traditional stock, bond and cash equivalents; | | | | investors are unable to hold below investment grade |
| Investments that provide exposure to specialized | | | | securities because of investment policy or regulatory |
| investment strategies run by an outside management | | | | restrictions. Also, comparatively few analysts cover |
| company. Hedge funds and managed futures might | | | | distressed securities markets and bankruptcies, |
| fall into this category; | | | | resulting in unresearched investment opportunities for |
| Investments that combine features of the prior two | | | | knowledgeable investors willing to do their homework. |
| groups, like private equity funds and managed | | | | |
| futures. | | | | (SIDEBAR) |
| Let's take a brief look at the major types of | | | | The 5 Most Common Hedge Fund Investment |
| alternative asset classes: | | | | Strategies |
| Commodities | | | | These investment strategies are the ones most |
| Investors can gain direct exposure to commodities in | | | | often used in managing a hedge fund. |
| spot (cash markets) or in markets for deferred | | | | Equity Hedge |
| delivery (futures and forwards markets). Direct | | | | In these strategies, fund managers hold both long |
| investment entails cash market purchase of physical | | | | and short positions mainly in stocks and stock |
| commodities – agricultural products, metals and | | | | derivatives (options). An equity hedge fund may be |
| crude oil – or exposure to changes in spot | | | | global, industry or country-specific, hedging against |
| market values via derivative investments, such as | | | | downturns in stock markets by taking a long position |
| futures. Only investment in commodities via the cash | | | | or shorting stocks or stock indexes that the fund |
| and derivatives markets constitutes alternative | | | | managers believe are overvalued. |
| investing. | | | | Equity Market-Neutral |
| Indirect commodity investment involves acquiring | | | | An investment strategy in which the investor seeks |
| indirect claims on commodities, such as equity (stock) | | | | to obtain the same return regardless of the |
| in companies specializing in commodity production. | | | | performance of the broader market. There is no |
| Because cash market purchases involve actual | | | | single way of executing a market neutral strategy, |
| possession and storage of the physical commodities | | | | but it usually involves taking a combination of a long |
| and incur carrying costs (financing, insurance and | | | | (ownership) position and a short position (the investor |
| transportation) and storage costs, investors have | | | | borrows and sells a security but has not yet replaced |
| generally preferred indirect commodity investments. | | | | it with an equal number of shares). For example, an |
| Private Equity | | | | investor could take a long position on one market |
| The term private equity refers to a stock that is | | | | index while also taking a short position on a similar |
| bought or sold via a private placement rather than | | | | index. |
| through conventional public trading. To qualify as | | | | |
| private placements, securities are generally offered | | | | Merger Arbitrage or Risk Arbitrage |
| for sale to accredited investors (institutions or high | | | | An investment strategy that is meant to generate |
| net-worth investors). Private equity investments can | | | | gains with little or no risk. When a publicly traded |
| be made face to face with the company needing | | | | company is acquired, the acquiring company makes a |
| financing or indirectly through private equity funds. | | | | tender offerto the current shareholders, inviting them |
| Unlike conventional investments, private equity | | | | to sell their stock at a price usually above the quoted |
| securities are not registered with a regulatory | | | | price on the market. As soon as the tender offer is |
| agency. | | | | announced, arbitragers will rush in and purchase the |
| Hedge Funds | | | | security on the open market then turn around and |
| There is no precise or universally accepted definition | | | | sell it directly to the acquiring company for the higher |
| of a hedge fund. However they are usually described | | | | price. |
| as pooled investment vehicles that may employ | | | | Convertible Arbitrage |
| various investment strategies. Although generally | | | | The purpose of convertible arbitrage is to take |
| regarded as loosely regulated, a trend toward | | | | advantage of a market situation where investors |
| greater regulatory oversight of hedge funds is under | | | | believe that the securities are priced lower they are |
| way in the U.S. | | | | worth. It involves two simultaneous moves on |
| London is the leading center for Europe's hedge fund | | | | investments: taking a long position on a company's |
| managers, with three-quarters (about $300 billion) of | | | | convertible security,* while at the same time taking a |
| European hedge fund investments at the end of | | | | short position on the company's stock. |
| 2008. Asia, and more specifically, China, is taking on a | | | | *Any type of security that can be exchanged for |
| more important role as a source of funds for the | | | | other types of securities issued by the same |
| global hedge fund industry. Major offshore hedge | | | | company – for example, bonds issued by a |
| fund centers include Cayman Islands, Dublin (Ireland), | | | | company that are convertible into shares of common |
| Luxembourg, the British Virgin Islands and Bermuda. | | | | stock. |
| The Cayman Islands have been estimated to be | | | | Global Macro |
| home to about 75% of the world's hedge funds, | | | | Macro fund managers anticipate such events and |
| with nearly half the industry's estimated $1.225 trillion | | | | shifts and profit by investing in financial instruments |
| in assets under management. | | | | whose prices are most directly influenced by these |
| Hedge funds have to file accounts and conduct their | | | | trends. Macro funds participate in all major markets |
| business in compliance with the requirements of | | | | (stocks, bonds, currencies, commodities) though not |
| these offshore locations. Typical rules concern | | | | always at the same time, and often use borrowed |
| restrictions on the availability of hedge funds to retail | | | | funds and financial derivatives to enhance the profit |
| investors (Dublin), protection of client confidentiality | | | | potential of market moves. |
| (Luxembourg) and the requirement for the fund to | | | | |