20 “alternative” definitions

November 20, 2019

5 minute read

Understanding alternative investments

Here are our top 20 words to learn about alternatives. #FinancialEducation

Alpha means excess returns, for example, the excess return of a fund in relation to a benchmark, also defined as the added value of an investment manager. Alpha can also be generated by adding solutions that focus on different investment styles, market segments or regions.

Alternative assets are basically investments that aren’t traditional stocks and bonds. Here are some common examples: Real estate / REITS, Infrastructure, Commodities, Private Equity, and Private Debt.

Beta describes the sensitivity of an asset’s return to the market’s return.

Correlation measures how two securities move in relation to one another. Positive correlation means that they move together – either up or down. Negative correlation means they move in opposite directions – when one moves up, the other moves down or vice versa.

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset or set of assets. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks.

Derivatives are an important component of alternative strategies as managers can use derivatives to create investment opportunities that would otherwise be unavailable to them as well as obtaining leverage and reducing transaction costs. Options, futures, forwards and swaps are all commonly used by Liquid Alt managers, depending on the strategy and constraints.

Hedging is a risk-management policy used to reduce the exposure to another investment. If you have an insurance policy on your house or car, you’ve hedged against losses you may incur on that investment.

Leveraging uses borrowed money to increase the potential return of an investment.

Liquid alt funds allow investors to access alternative assets and strategies through mutual funds or ETFs, combining many of the benefits of alternatives with the daily liquidity (i.e. ability to buy and sell) many retail investors desire.

Investors often describe the speed and ease with which an asset can be sold and converted into cash as its liquidity. Most of the investments owned by a fund can usually be sold promptly at a fair price and therefore can be described as fairly liquid. But some funds may also hold a portion of their portfolio in investments that are illiquid, which means they cannot be sold quickly or easily.

Alternative investment strategies that take both long and short positions while maintaining overall long exposure in the portfolio. The objective of these strategies is to profit from price appreciation from long securities and price declines from short securities.

Margin financing allows an investor to borrow money to invest in securities, using the purchased securities as collateral on the loan and paying interest for the period of the loan. The account is marked to market daily to ensure that enough collateral is maintained. The investor is also responsible for interest on the loan, accrued daily and paid monthly. Margin financing is beneficial if the investor anticipates earning a higher rate of return on the investment versus what they are paying in interest on the loan.

Alternative investment strategies that involve taking long or short positions in global equity, fixed income, currency or commodity markets using derivative products including futures, forwards, options or swaps. Managed futures strategies often follow market trends or signals, for example price momentum.

Alternative investment strategies that take both long and short positions in equal weights, in an effort to reduce or eliminate exposure to systematic risk so that returns are unrelated to those of the overall stock market.

Max drawdown is measured as the biggest drop in return of a given investment from the highest point it reached to the lowest point. Reducing drawdowns has the potential to contribute to long-term performance.

To execute alternative investment strategies, managers require prime brokerage services, an integrated suite of services that many brokerages provide for clients with more complex financial needs.

A prime broker can
(i) facilitate short positions,
(ii) provide margin financing on long assets, and
(iii) act as the derivative financing counterparty to swap transactions for equity or credit exposures for investment fund managers.

Returns – absolute vs. relative vs. risk-adjusted

Absolute return is the return of a security of a specific time period. Relative return is the return of that security over the time period compared to its benchmark. Risk-adjusted return takes into account how much risk was involved in producing that return.

Sharpe ratio measures the return of an investment relative to the risk. The greater an investment’s Sharpe ratio, the better its risk-adjusted performance has been.

“Short-selling” is when an investor borrows securities and immediately sells them in the market, hoping to buy them back at a later time at a lower price, retaining the difference in price as profit. This action allows the investor to benefit from a decline in the security’s price but can also result in losses if the price increases beyond the original purchase price. Short-selling has significant risk associated with it because if the borrowed security’s price increases, losses can theoretically be unlimited. Investors must also consider additional costs that will reduce their profit including interest owed on the securities loan, accrued daily and paid monthly.

Standard deviation measures how much the value of a security deviates from its average over a specific time period.

Volatility measures how much the price of a security – or even the stock market as a whole – fluctuates.

To learn more about alternative strategies, visit agf.com/alternative or contact your financial advisor.