Alternative investment funds - What are they and who regulates AIF?

Alternative investment funds are growing in popularity due to the growth of alternative financing. Contrary to traditional investments which include assets like stocks, bonds, and cash, alternative investment funds mostly delve into physical assets and some financial tools. Although there are no recommendations for or against it, alternative investment assets and tools can be utilised by both investors and companies to diversify their investment portfolios for greater returns and to pool capital. Compared to traditional investments, alternatives have interesting characteristics that work in the favour of investors. However, like all investments, they also carry risks.

Here, we explore the features of alternative investments, who regulates them, their advantages, and their risks for investors:

1. What are alternative investment funds and how do they work?

Alternative assets include tangible assets like real estate and metals and financial tools like hedge funds, exchange traded funds (ETFs), mutual funds, venture capital and many more. Their functions depend on the characteristics of each kind of asset. For example, real estate investment can be residential for private use to grow equity or for rental income. Investors can also invest in real estate by buying a fixer-upper for a cheaper price to renovate it and to sell it at a profit. Different assets work differently and they cannot be encapsulated briefly.

Apart from alternative financing, alternative investment grew popular because of its relative ease of access to the market for individuals. Institutional investors are still holding most of the well-known alternative investment assets, like real-estate, hedge funds, and venture capital. Individual investors are leaning more on newer and more innovative alternative investments, such as, peer to peer lending, exchange-traded funds, and anything that is available to invest in easily on digital platforms for minimum capital. The structure for each investment asset also differs. For instance, some have a high capital requirement to invest, barring many individuals from taking advantage of the assets. While others are very convenient to get into (for example, ETFs).

2. Who regulates alternative investment funds?

In Europe, alternative investments are regulated by The Alternative Investment Fund Managers Directive 2011/61/EU. It was passed after the 2008-09 crisis after realizing that alternative investments needed regulatory measures. There are two main objectives of the directive:

  • The first is to protect investors from the risk of alternative investments by setting strict rules on how information can be given to them. This includes all information about asset valuations, liquidity, conflict of interest and etc. Individual investors are to be protected with additional measures.
  • The second is to regulate fund managers, rather than the funds themselves by removing systematic risks of alternative investments. This includes interest policies so that individual investors do not take excessive risks, reporting to European Systemic Risk Board, and managing risks in a manner that factors liquidity.

Initially, it only applied to hedge funds, real estate investment funds, and private equity funds. Now, more regulatory measures are being considered for newer forms of alternative investments, like crowdfunding and peer-to-peer lending. The Regulation (EU) 2020/1503 on European Crowdfunding Services Providers for Business is a new law on crowdfunding that came out very recently. This long-awaited regulation is aimed solve conflicting laws on business crowdfunding in all European states. It will be in force from November 2021. Investors will be required to show their understanding of crowdfunding through a knowledge test by providing information on their financial circumstances, experience, and whether they understand the risks. Platforms must run these tests once every two years.

3. What are the pros and risks of alternative investments?

Alternative investments have a low correlation with traditional assets like bonds and stocks. It makes them an attractive tool for diversifying portfolios. Some alternative investments hedge effectively against inflation, like gold and land. This is the reason why so many institutional investors allocate their capital to alternative assets. Although riskier, the rewards are also greater.

Just because alternative investments have low correlation, they are still exposed to specific risks related to the assets themselves. For instance, some alternative investments are illiquid (real-estate), some are unregulated (newer variants of peer-to-peer lending) and some cannot be valued because their transactions are so rare (like stamps or wine). Investors are encouraged to do their own research to pick assets that are more suitable to their financial situations.

Alternative investments encapsulate a wide variety of assets that are very different from each other. Some of the older and more stable assets under alternative investments have proven themselves to be reliable and profitable at the same time, like that of ETFs and funds. Other newer forms of alternative investments still need more financial regulations to make them safer for investors. What investors should do, prior to picking alternative investments, is observe their knowledge of the particular assets and their risk tolerance.

Last update: 02/06/2021