Explain what sets alternative investments apart from traditional ones
The idea
Alternatives differ from listed stocks and bonds on several axes at once: they are illiquid, often with multi-year lock-ups; they are valued infrequently and sometimes by appraisal rather than by trade; they use leverage and derivatives more freely; and their fee structures include performance participation as well as a management charge. They are also far less regulated and disclose less. The consequence for analysis is that reported volatility and correlation understate the true figures, because appraisal-based valuation smooths the series.
A practice question
Which feature is characteristic of alternative investments?
- Daily liquidity at a published net asset valueWhy not: The defining feature of open-ended public funds, and the opposite of a lock-up.
- Illiquidity, often with a multi-year lock-up period — correct
- Fee structures limited to a management chargeWhy not: A performance share alongside the management fee is the characteristic arrangement.
Capital committed to a private fund is typically unavailable for years. That illiquidity is the structural feature from which most of the others follow.
A harder one
Why do reported correlations between alternatives and public markets tend to understate the true relationship?
- Because alternative returns are reported net of feesWhy not: Fees reduce the level of returns without systematically altering how they co-move with equities.
- Because alternatives use derivativesWhy not: Some do and most do not, and derivative use would not produce a general downward bias in correlation.
- Because appraisal-based valuations lag and smooth actual changes in value — correct
A valuation set by periodic appraisal moves less and later than a market price. Statistics computed on the smoothed series show lower volatility and weaker correlation than the underlying economics justify.
The hardest tier
An investor compares a private real estate fund's reported Sharpe ratio with a listed REIT index's. Why is the comparison misleading?
- Because the private fund's smoothed valuations depress measured volatility, inflating the ratio — correct
- Because REITs pay dividends and private funds do notWhy not: Both distribute income, and a total return series captures it either way.
- Because Sharpe ratios cannot be computed for real estateWhy not: They are computed readily; the difficulty is that one of the two denominators is artificially small.
The denominator is understated by the appraisal process, not by superior risk management. Unsmoothing the series typically brings the two much closer together.
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