Understanding Alternative Assets
We define “alternative assets” as follows: (a) assets whose fundamental intrinsic properties are different from those of traditional equity and fixed income securities, and/or (b) poolings of assets – which poolings may include traditional equity and fixed income securities – such that the return-risk-correlation characteristics of the pooled assets are distinct from those of traditional debt or equity pooled vehicles.
A practical illustration of an alternative asset under the definition of (a) above is a commodity futures contract. The futures contract represents an obligation to take delivery of an underlying store of value (be that soybeans, heating oil or Japanese yen) at a specified point in the future. The intrinsic value of a futures contract derives from the perceived market value of the underlying asset, the value of the collateral backing the futures contract (usually US Treasury bonds or TIPS) and the price relationship between the futures market and the spot market (i.e. backwardation or contango).
An alternative asset is intrinsically different from equity and fixed income in that its value relates to something other than a specific claim on the assets of an issuing entity. A fixed income obligation is a contractual, legally binding claim from a creditor to the claim’s issuer to pay a specified amount of principal and interest income at defined points in time. A common share of stock is a residual claim on the assets of a company after satisfying all precedent senior and subordinated debt and preferred stock claims.
When assets are combined into pooled vehicles they may continue to collectively exhibit the characteristics of the underlying assets comprising the pool – for example long-only mutual funds invested in large cap stocks or investment grade corporate bonds – or they may be constructed in a way to have very little in common with the properties of any of the underlying assets. Long-short equity or convertible arbitrage funds are examples of this and fall under the definition of “alternative assets” provided in (b) above. For example a pooled investment vehicle comprised entirely of long positions in stocks with an average price/book value under 2.0 would be considered an equity investment. However another pooled investment vehicle with 48% comprised of short positions in three industry sectors, with long positions in the same three industry sectors comprising the remaining 52%, would be considered an alternative investment even though 100% of the portfolio is made up of equities. Over time it would exhibit fundamentally different risk-return-correlation characteristics when compared to the long-only value portfolio.