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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: 

What is an alternative investment fund?

An alternative investment fund (AIF) is a collective investment in non-traditional and intangible assets in which investors' capital and profits are pooled. 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. Real estate is frequently categorised as an alternative investment. 

Alternative investments have grown popular because of their 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 in, barring many individuals from taking advantage of the assets. While others are very convenient to get into (for example, ETFs).

Understanding alternative investment funds

Understanding alternative investments requires understanding the characteristics of each type of asset. For instance, 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, renovating it, and selling it at a profit. Different assets work differently, and they cannot be encapsulated briefly.

Alternatives are typically used to diversify an investment portfolio and give return profiles that may differ from those of standard assets due to their weaker correlations to traditional investments. Therefore, they are not suitable for every investor. Because of their distinct risk-return profile and complex investment features, they are more suited for sophisticated and high-net-worth investors who are able to afford losses, should they occur.

Common features of alternative investment funds

Alternative investments encompass a diverse variety of assets and methods, each with its own risk profile that should be acknowledged before investing. However, in general, they are distinguished by the following:

  • Their low correlation to traditional assets such as stocks and bonds
  • They have a higher potential for return than typical investments
  • They are more specialised and frequently illiquid assets
  • They typically have longer lock-up periods, which means that holdings may not be redeemed/sold on a daily basis. This enables exposure to less liquid assets
  • They frequently have complicated investment structures and risk-return characteristics
  • They often have larger minimum investment requirements, but others have extremely low minimum capital needs

According to the Yale University Endowment 2017 Annual Report, alternative investments are attractive because of their return potential and diversification capability. This diversification power is intended to result in lower volatility for the portfolio as a whole, in addition to returns. Alternative investments are less efficiently valued in the market than standard marketable instruments, such as equities and fixed income securities, allowing for the possibility of exorbitant profits.

What is the alternative investments fund structure?

Over time, the alternative asset market has grown to include a diverse spectrum of industry participants, including investors, fund managers, investment consultants, and a variety of other service providers. The participants are similar in most of the alternative investments. categories, but their titles may differ. Among the key industry participants are:

  • Investors: Investors are the source of capital for alternative asset investments. Pension funds, endowment plans, insurance companies, foundations, sovereign wealth funds, and family offices are examples of important investor categories in alternative assets. Investors pledge capital to funds after conducting due diligence to decide which fund managers to work with. This can be a lengthy process with multiple stages that include quantitative and qualitative due investigation, an evaluation of fund management performance track record, and legal due diligence.
  • Fund Managers: Fund managers are in charge of investing and managing the capital of asset owners. A portion of the invested money may belong to the manager in some investments, while with newer alternative investments, investors control 100% of the principal. Managers may earn fees from investors in the form of a management fee and a performance fee that compensates them for exceptional performance, or they may earn revenue from other sources. A 
  • Other service providers: The phrase "service provider" refers to the parties who provide services to a fund as a group. Service providers may include consultants, legal representatives, auditors, or even an online platform for investments like peer-to-peer lending, crowdfunding, and other variants.

Who regulates alternative investment funds?

Alternative investment fund regulations include 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 on crowdfunding was passed aimed at solving conflicting laws on business crowdfunding in all European states. Under the regulation, investors are 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.

Categories of alternative investment funds (AIFs)

Alternative investments have become increasingly popular in recent years. Today they cover a wide range of categories, each with its own risk-reward profile and intended to promote a certain goal. The alternative investment does not have an exhaustive list and some overlap one another. Regardless, the following explains the common types of alternative investment fund:

Private equity 

Private equities are investments in firms or assets that are not normally listed on a public stock exchange. The goal is to enhance value by investing in new businesses and reforming current firms with operational inefficiencies that have the potential to yield large long-term returns. The equity-based category is divided into three subcategories: 

  • Bear market funds that focuses on making a profit from a market downtrend through strategies like short selling.
  • Long/short funds that have a net long position but use short calls to protect against downside risk.
  • Market neutral funds that aims to profit from markets that trade sideways and have little volatility.

Bear and market neutral funds are intended for short-term investment and should not be included in a long-term portfolio.

Hedge Funds

Hedge funds are financial vehicles that earn returns for their owners by pooling money and employing a range of strategies. They employ a variety of unconventional tactics in order to optimise a portfolio's overall return potential and diversification. The following are some of the strategies hedge funds use:

  • Alternative risk premia aims to generate attractive returns by charging a "premium" for exposing themselves to observable and exploitable risk variables. Long and short positions in traditional asset classes are typically used in these strategies.
  • Managed futures is a trend-following investment approach in which quantitative signals are used to determine when stocks are trending. These signals frequently compare an asset's current price to its trailing moving average, and then make investments based on those trends. The security is in an uptrend if the spot price is above the moving averages, and vice versa.
  • Global macro strategies invest globally in a variety of asset classes and markets, adopting relative value and directional positions based on broad economic and political analyses. Systematic global macro strategies use computer algorithms to evaluate and predict market movements, whereas discretionary strategies rely on portfolio managers to make buy and sell decisions.

Derivatives

A derivative is a financial instrument whose value is determined by the movement of one or more underlying assets. They provide investors with a simple option: hedging out exposure to a fund or portfolio to lock in a fixed return. Managed futures, volatility funds, and inverse/leveraged funds are some of the options, just like equities funds and it may overlap with hedge funds and private equity. Managed futures are similar to ETFs in that they invest directly in futures but are packaged in a more user-friendly asset class that allows them to be traded as easily as equities. Volatility funds trade the VIX for long or short positions. Finally, inverse/leveraged funds are the most common type of alternative fund, allowing investors to take inverse or leveraged positions in a wide range of assets.

Other alternative assets

As alternative investments are non-exhaustive in list, the following are other alternative assets that are trending:

  • Alternative credit investments are illiquid loans made to borrowers who are unable to access traditional credit markets or who require non-standard, tailored terms. Direct lending, mezzanine, distressed debt, and specialty financing are all types of alternative credit lending.
  • Real estate has grown into a diverse asset class that includes publicly traded and privately held real estate investment trusts (REITs), as well as private commercial real estate loans. Not only does real estate have a low correlation with equities, but it is also frequently seen as an inflation hedge.
  • Commodities can be bought and sold in a variety of ways. Investors can invest directly in futures or use exchange-traded funds (ETFs) to profit from particular commodities or categories of commodities, such as agriculture. Investors might also opt for stocks that are heavily correlated to a commodity, such as mining businesses.
  • Digital assets are digital representations of various objects and their monetary value. They make it possible to issue and transfer ownership without the use of paper documents. They can be traded through online platform. Examples of some of the most popular digital assets are cryptocurrency, non-fungible tokens and virtual properties like game skins and real estate. 

What are the safest alternative investments?

There are no examples for the best alternative investment fund and alternative investments are not risk-free. Many assets are extremely popular and trendy despite being very risky. And not all investors agree on the same assets to be safest for alternative investment. However, some common assets are generally considered safer than others.

For instance, commodities are a preferred choice for many because of its volatility which makes it better for long-term time horizon. Market crashes like that of 2008 drove up prices for many commodities, like oil, food and precious materials, which many investors profited from. The best way to invest in commodities is through buying ETFs. Rather of focusing on one commodity, the safest ETFs buy a variety of them. ETFs can take some of the guesswork out of deciding which commodities will rise and decrease at any particular time.

Real estate is the second most preferred asset to invest in, despite its high barriers to entry and the housing bubble of 2008. This is due to the fact that real-estate has been exposed to the market long enough to be held as a valuable asset. Even though real-estate requires a large minimum capital, it has been made easier for new investors to enter the market through REITs.

Bullion coins are another popular investment option. National governments issue it, usually in gold. These coins aren't collectible because their worth isn't derived from scarcity. They can be bought and sold for a price that is close to the commodity price of gold through trustworthy gold dealers. Gold bullion is considered to be a relatively secure investment, especially now. 

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, illiquidity is part of most of the alternative investment fund risks, like 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.

Summary

Alternative investments are regularly mentioned as solutions for investors wishing to diversify their risk exposure and maybe produce additional profits beyond stocks and bonds. Due to its low correlation with other assets and higher potential returns, many investors are looking to diversify their portfolio with alternative investments. Depending on the kind of alternative asset, its structure may vary, but the general participants include the investors, the fund manager, and other service providers. Alternative investments are risky due to its lack of regulation and illiquidity. Alternative investment is regulated by a variety of laws depending on the asset class and the structure, but the two most known include Directive 2011/61 and the Regulation 2020/1503. These laws aim to protect investors from the risks of alternative investments and hold alternative investment companies more accountable for due diligence. Alternative investments have a variety of assets which cannot be made into an exhaustive list, however, we can generally divide it into several common assets, such as, private equity, hedge funds, derivatives and other alternative assets. None of them are risk free, but some are safer than the others. 

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. 

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