case study on investment alternatives

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Investment Strategy

The case for alternative investments

We all have different motivations for why we invest. Some individuals hope to generate enough income to sustain their lifestyles. Others may be seeking ways to grow their wealth over decades, whether to fund a legacy for generations or a comfortable retirement. Financial goals are unique for every individual.

That said, many of the challenges facing today’s investors are universal: The revival of inflation calls for the pursuit of higher expected returns to help grow purchasing power over time. Alpha opportunities have generally become harder to find in “traditional” stocks and bonds, and last year’s selloff in bonds left investors seeking more reliable portfolio factors. Also, the appetite for steady income generation is ever-present.

Alternative investments can help investors solve for many of these challenges. Below, we explore three primary roles they can play in portfolios: Access to broader opportunity sets, enhanced diversification and premium income generation hedges.

1. Access to a broader opportunity set of long-term growth potential 

Historically, equities have enabled investors to grow their capital over time. However, we have seen a 26% decline in the number of publicly traded companies since 2000, 1 and there are now over 32x more private companies than public companies with more than 100 employees. 2 Limiting your investment approach to public markets means missing out on the vast opportunity set in private markets.

Private equity managers often take a hands-on approach, driving operational improvements in portfolio companies. With this expanded access and more comprehensive toolkit, private equity has consistently outperformed global public equity markets by 4-12% annually (see chart below).

Historical annualized returns of Global Buyout & Growth Equity Index vs. MSCI ACWI PME

2.   Portfolio diversification for when the going gets tough

Portfolio diversification can come in many forms. Regarding private credit, higher base rates, we believe wider spreads and protective loan covenants could support attractive private credit returns into 2024 and beyond, on an absolute basis and relative to public credit and equity markets. We  also expect to see transaction activity fueled by an uptick in defaults & distressed exchanges in the leveraged loan & high yield bond markets and exacerbated by a growing debt maturity wall.

For further diversification, hedge funds can be used as a tool in portfolios. Hedge funds may help reduce portfolio volatility by using hedging strategies and accessing niche exposures that may generate uncorrelated return streams. Therefore, hedge funds may help a portfolio to compound more efficiently.

Real assets, too, can act as powerful diversifiers in a portfolio. Infrastructure assets, in particular, can offer exposure to essential services with resilient demand and inflation-linked revenue. Similarly, real estate tend to offer historically low correlation to public markets, including publicly traded REITs. 

3. Attractive yield generation

J.P. Morgan’s 2024 Long-Term Capital Market Assumptions estimate that total returns in U.S. investment grade bonds could average 4.6% per year over a 10-year investment horizon, but with an average inflation assumption of 2.4%, the real return prospects look less compelling. 3

To boot, as the size of the average high yield borrower has grown, many borrowers are too small to tap into public credit markets; conversely, larger companies may not want to risk the uncertainty or lengthy processes that come with accessing traditional capital markets. Private lenders can fill this financing gap, offering their investors the chance to collect a premium for providing capital where it’s scarce.

Asset class yields

Global infrastructure investment

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Those with the desire—or need—to overcome today’s investment challenges would be remiss not to consider alternative investments.

As always—but especially in alternatives—due diligence and selectivity are essential, as performance can vary widely. 4

Many investors choose to partner with us to narrow the alternative investment universe because of our rigorous scrutiny of managers. Our in-house team conducts on-site visits, examining the structure, operations, incentives and individuals on a manager’s team. 

As one of the largest alternatives platforms, we set out to continually bring a carefully curated set of high-conviction opportunities to help you realize your goals. 

If you’re interested in learning more about our alternative investment platform, the latest opportunities, and how they may fit in your financial plan, speak with your J.P. Morgan team, or let us reach out to you by filling out the form below.

1 “A Guide to Private Markets,” Hamilton Lane, as of September 2021 for Year 2000. The World Bank, as of November 2023 for Year 2023.

2  Source: U.S. Bureau of Labor Statistics, “Number of Business Establishments by Size of Establishment in Selected Private Industries.” Number of private companies is comprised of U.S. business establishments with 100 or more employees in natural resources and mining, construction, manufacturing, trade, transportation and utilities, information, financial activities, professional and business services, education and health services, leisure and hospitality, and other services as of March 2023. Number of public companies is the sum of companies listed on NYSE and NASDAQ, as of November 2023.

3 J.P. Morgan Asset Management’s Long-Term Capital Market Assumptions 2024. Data as of December 2023.

4  Top-and-bottom-quartile private equity managers, for example, have had, on average, a 21% performance differential. In hedge funds, the difference is 14% between top-quartile and bottom-quartile performing managers. Sources: Burgiss, NCREIF, Morningstar, PivotalPath, J.P. Morgan Asset Management. Data as of November 30, 2023. Manager dispersion for hedge funds is based on annual returns over a 10-year period ending 3Q 2023. Global private equity is represented by the 10-year horizon internal rate of return (IRR) ending 2Q 2023. Past performance is no guarantee of future results. It is not possible to invest in an index.

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• Michael Cembalest
• Access to a broader opportunity set of long-term growth potential
• Portfolio diversification for when the going gets tough
• Attractive yield generation

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Contact us to discuss how we can help you experience the full possibility of your wealth. Please tell us about yourself, and our team will contact you. 

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JPMAM Long-Term Capital Market Assumptions

Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only – they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations.

“Expected” or “alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class are conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact the future returns. The model assumptions are passive only – they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control.

The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own financial professional, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield are not a reliable indicator of current and future results.

General/Macro Reference only

Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are generally not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested.

Real Estate/Hedge Funds/Other Private Investments

Real estate, hedge funds, and other private investments may not be suitable for all individual investors, may present significant risks, and may be sold or redeemed at more or less than the original amount invested. Private investments are offered only by offering memoranda, which more fully describe the possible risks. There are no assurances that the stated investment objectives of any investment product will be met. Hedge funds (or funds of hedge funds): often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any hedge fund.

Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax-efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise, and investors may get back less than they invested. Diversification and asset allocation does not ensure a profit or protect against loss.

Private investments are subject to special risks. Individuals must meet specific suitability standards before investing. This information does not constitute an offer to sell or a solicitation of an offer to buy. As a reminder, hedge funds (or funds of hedge funds), private equity funds and real estate funds often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments can be highly illiquid, and are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information. These investments are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any such fund. For complete information, please refer to the applicable offering memorandum.

As a reminder, hedge funds (or funds of hedge funds) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments can be highly illiquid, and are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information. These investments are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any such fund. For complete information, please refer to the applicable offering memorandum.​

Real Estate Investments Trusts may be subject to a high degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate investments may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower.

This material is for informational purposes only, and may inform you of certain products and services offered by private banking businesses, part of JPMorgan Chase & Co. (“JPM”). Products and services described, as well as associated fees, charges and interest rates, are subject to change in accordance with the applicable account agreements and may differ among geographic locations. Not all products and services are offered at all locations. If you are a person with a disability and need additional support accessing this material, please contact your J.P. Morgan team or email us at [email protected]  for assistance. Please read all Important Information.

General Risks & Considerations

Any views, strategies or products discussed in this material may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results.  Asset allocation/diversification does not guarantee a profit or protect against loss. Nothing in this material should be relied upon in isolation for the purpose of making an investment decision. You are urged to consider carefully whether the services, products, asset classes (e.g. equities, fixed income, alternative investments, commodities, etc.) or strategies discussed are suitable to your needs. You must also consider the objectives, risks, charges, and expenses associated with an investment service, product or strategy prior to making an investment decision. For this and more complete information, including discussion of your goals/situation, contact your J.P. Morgan team.

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Case Study: Alternative Investment Funds Scorecard

Equity Issuance Proceeds Increase in Q1; IPO Performance Improves

Investment Banking Essentials: April 17

Investment Banking Essentials: April 3

Investment Banking Essentials: March 6

• 23 Jul, 2021
• Author Suming Xue
• Theme Capital Markets Credit Analysis
• Segment Investment Banking Investment Management Private Equity
• Tags Credit Assessment Scorecards Alternative Investment Funds

Alternative Investment Funds (AIFs) provide an option to invest in different asset classes − such as venture capital, private credit, and hedge funds − primarily for Limited Partners (LPs) that are typically large pension funds, endowments, and family offices. The trend toward fund financing for AIFs, where a lender takes risk against the uncalled capital of the underlying investors, has become popular since it can help aid a fund's liquidity and boost the Internal Rate of Return (IRR).

Fund financing continues to grow in popularity. It is especially attractive in today’s environment as funds actively seek liquidity due to the economic slowdown caused by the COVID-19 pandemic and lenders look to enhance yield given low interest rates. Fund financing methods include subscription-line facilities, Net Asset Value (NAV) or asset-backed facilities, and a range of other structures at the fund level. This increased leverage within the AIF universe poses potential credit risks to various lenders to the funds.

This case study looks at how to enable the credit risk and fund finance teams at financial institutions and other lending organizations to assess the creditworthiness of AIFs.

Learn more about Alternative Investment Funds (AIFs)

• DOWNLOAD THE FULL REPORT

Leveraging a Comprehensive Alternative Investment Funds (AIFs) Scorecard

Fund financing through a credit lens understanding the basics of alternative investment funds aifs.

• Capital Markets Credit Analysis
• Investment Banking Investment Management Private Equity
• Credit Assessment Scorecards Alternative Investment Funds

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The (Limited) Case for Investing in Alternatives

Does Vanguard’s recent private-equity announcement bolster the argument for alts?

Vanguard's recent announcement that it is launching a private-equity strategy brings front and center (not for the first time) the question of whether (and to what degree) individuals should allocate some portion of their portfolio to alternatives. Granted, Vanguard is initially making the product available only to institutional clients, but given Vanguard's vast retail presence, not to mention CEO Tim Buckley's statement that its partnership with HarbourVest Partners "will present an incredible opportunity" for individuals investors, one suspects that it's only a matter of time.

The notion of “hedge funds for the masses” is hardly new. The boom in liquid alternative mutual funds after the 2008 financial crisis was supposed to provide individual investors with a tantalizing opportunity to access the same types of strategies typically reserved for institutions and the ultra-wealthy, all at a fraction of the cost and with increased transparency and liquidity. Has the reality matched the hype? Should investors look to take advantage of alternative asset classes, whether in liquid public or illiquid private investment structures?

What We Talk About When We Talk About Alternatives There's no single agreed-upon definition of what constitutes alternatives, but broadly speaking we can think of alternatives as strategies or asset classes that provide low correlations to the traditional portfolio building blocks of stocks and bonds, and thus serve to diversify a portfolio and improve its risk-adjusted performance (or its portfolio efficiency, in the lingo of Markowitzian Modern Portfolio Theory). A somewhat more expansive version of the definition incorporates illiquidity as a trait of alternatives, thus bringing private equity into the fold, despite its meaningful correlations with growth equity (as AQR's Cliff Asness recently argued , PE can be thought of as analogous to a leveraged small-cap growth portfolio). While some hedge fund strategies, such as merger-arbitrage, equity market-neutral, and managed-futures, have proved readily adaptable to liquid structures (minus excessive leverage), less-liquid strategies such as private equity and distressed debt do not work so well in open-end vehicles.

The Endowment Effect Alternatives have achieved their current reputation and mystique in large part because of the success of the Yale endowment under David Swensen, in what has come to be known as the endowment model. Beginning in the 1980s, Swensen eschewed the typical practice of investing heavily in bonds and stocks, turning instead to private equity, hedge funds, and real assets such as timberland. Other major university endowments adopted the model, and soon enough many pensions also turned copycat. According to the NACUBO-TIAA 2019 study of endowments, the dollar-weighted average allocation to alternatives across all endowments and foundations it surveys was nearly 40%, with another 12% in real assets.

It is understandable that people would look at the track record and tactics of the best institutional investors and say, "Hey, let’s adopt that model for individuals!" It’s also an oversimplification. There are several critical distinctions that make the endowment model less relevant for individuals, including:

1) Time horizon . Endowments have a perpetual time horizon, giving them an unusual capacity to withstand volatility and illiquidity, an advantage that you, dear reader, likely do not possess. If you are investing for retirement in your 401(k), then you do at least have a time horizon and objective comparable to a pension fund, but if your goals are nearer-term, the case is considerably weaker for incorporating alternatives.

2) Expertise. Hedge fund strategies (as well as their liquid-alternative counterparts) and private equity are more complex and less transparent than traditional investments. Larger endowments and pensions have extensive research groups equipped to do due diligence in these areas, while smaller outfits typically hire out the work to specialist consultants.

3) Access. Most private funds are available only to institutions or individuals who meet accredited investor definitions of income or total wealth (the SEC is currently reviewing some of the existing criteria for accredited investors). Moreover, even for those who meet the criteria, getting access to top-tier funds is often very much an insider's game, limited to investors with previous relationships with the managers.

Theory Versus Practice Putting aside (momentarily) the practical obstacles, the theoretical case for alternatives remains strong--adding noncorrelated assets with positive expected performance to a portfolio should, all things being equal, reduce drawdowns during market sell-offs and improve your overall risk-adjusted results, while some less-liquid assets offer the potential to outperform equities in the long term. Moreover, the anecdotal evidence of endowments and pensions taking up the cause for alternatives further bolsters the case.

But how strong is the case in practice? Here we run into some data-related challenges. Liquid alternatives are a relatively new innovation; of currently surviving liquid alts funds, only around 115 have 10-year records. Hedge fund and private-equity databases and indexes are subject to many well-documented biases, data-validity questions, and performance calculation debates. Still, we can only do the best with the data we have and make decisions based on those findings.

The story told by the available data is, at best, uninspiring. Let’s begin with correlations. Exhibit 1 shows five-year correlations to the S&P 500 and Bloomberg Barclays Aggregate Bond indexes, based on monthly return for Morningstar alternative categories (too few alts funds have 10-year records to produce a robust cohort), plus a few others sometimes considered as alternatives, including nontraditional bond and several real-asset groups. Relative to the stock index, very few categories provided significant correlation benefits. Unsurprisingly, the stock-based long-short equity and options-based categories generate very high correlations with stocks; more surprising is the correspondence of multalternative funds, which are supposed to offer exposure to a range of alternative strategies.

Real estate funds did provide moderate diversification benefits, with a 0.53 correlation over the period, while the 0.58 correlation of market-neutral funds is disconcertingly elevated for a group of funds that are supposed to minimize market exposure (however, a subset of the category, including event-driven and merger-arbitrage funds, does have net long exposure). The only true diversifiers were managed-futures, multicurrency, and bear-market funds, the latter of which bet directly against the market through short positions. The correlations to fixed-income are far lower, but the risk that most investors likely need to diversify away from is equity risk.

I also looked at the correlations of several private market indexes. Because several of these data providers report performance only quarterly, I used correlation based on quarterly returns through June 30, 2019, but going back 10 years. There was a similar divide here. The two real asset indexes, which are based on direct investments in timberland and property, exhibit very low correlations (however, smoothing characteristics of those indexes may lead to artificially suppressed correlations); at the same time, the hedge fund and private-equity indexes show relatively high correspondences with stocks.

Averages can mask significant variation, of course. These figures don’t mean you cannot get the desired diversification benefits from an alternative fund, but you’ll have to put some work into it. There can be significant dispersion within categories. For example, five-year correlations in the market-neutral category run from 0.87 at the top end to negative 0.81 at the low end, while in the multialternative category, despite high average correlations, one fourth of the funds with five-year track records have correlations of less than 0.30.

Correlation is only part of the story. Whether offering greater or lesser degrees of correlation, have alternative strategies been additive from a risk-adjusted performance perspective? One way to check this is by eyeballing funds’ Sharpe ratios. Again, the results aren’t particularly persuasive (see Exhibit 3). For comparison purposes, a 60/40 global blended benchmark earned a Sharpe ratio of 0.90 over the five-year period. The only category to beat that benchmark’s Sharpe (admittedly, a strong period for stocks and core bonds) was the nontraditional bond category. Several of the alternative categories produced negligible or even negative Sharpe ratios, disappointingly including lower-correlation areas such as managed-futures and market-neutral.

The private alternative indexes, again using 10-year quarterly returns, generated more attractive performance results. The blended index had a 0.98 Sharpe ratio for the period (slightly better than its five-year result), which was nearly matched by the Credit Suisse Hedge Fund Index, matched by the timberland index, and surpassed by the property and private equity indexes. I take those results with a dash of salt, as the volatility levels (the denominator in the Sharpe formula) are likely suppressed because of smoothing effects (a result of the lagged reporting of values with such investments), inflating the Sharpe as a result. Still, it does seem likely that the private equity and direct real estate, in particular, have provided strong performance and diversification benefits during the past decade.

The generally disappointing results observed in these metrics are reinforced by a study conducted in 2018 by my colleagues Jason Kephart and Maciej Kowara, which used an optimizer to analyze the effects of adding alternatives to a hypothetical 60/40 portfolio. They found that “most liquid alternatives would have failed to improve the starting portfolio” over the three- and five-year periods covered.

Further external confirmation comes by way of CEM Benchmarking's " Hedge Fund Reality Check " study from May 2018. Rather than using hedge funds' own self-reported benchmarks, CEM created customized, investable blended global balanced benchmarks that had high correlations to hedge fund performance, then looked at the excess returns produced by the hedge funds over a 17-year period. On average, the researchers found a net negative value-add of 1.27% annualized relative to those benchmarks; 36% of funds did exceed their benchmarks, but the majority of those did so by only 1% to 3%. The overall result indicates that most hedge funds perform no better than straightforward passive balanced portfolios.

Conclusions and Caveats The empirical case for including alternatives as a diversifier to equity risk and as a return enhancer is less persuasive than the theoretical case. Private funds may offer better results, but access to them is limited, and even then the benefits are often uncertain. Private equity likely offers the best long-term potential, but access is limited and lockup periods are long (at least until more retail-friendly options emerge from Vanguard or other innovators). Real assets offer some diversification potential, but their value may lie more in their value as an inflation hedge, an area I have not pursued in this article but plan to in the future.

One big caveat lies behind all of the above. These results are based on historical (and often limited) data, and the future could look very different. In particular, it is worth noting that the past decade has seen a virtually uninterrupted equity bull market, along with a strong market propelled by declining interest rates, featuring unusually low and stable volatility. Alternative strategies tend to fare better during periods of elevated volatility and market stress, and many are further boosted by higher interest rates. Whether or how long the past decade’s market conditions can continue is anyone’s guess. One lingering concern, however, is the heightened correlations noted above and in the Kephart/Kowara study, raising the question of whether they will offer protection in a drawdown scenario. Many reasons have been suggested for the rise in correlations; one could be that managers have increased beta exposure in light of the strong equity markets and could easily shift back, given their wide mandates. Other explanations point to structural factors that might make it more difficult to disentangle certain hedge fund strategies from the broader markets.

This is not to say that individual investors should never make allocations to alternatives. Given the greater complexities, risks, fees, and potential for adverse selection with alternatives, the bar should be much higher for deciding to invest. Unlike the 30%-plus allocations to alternatives seen with many endowments, or the 15% to 20% allocations typical of pension funds, individuals would be better off restricting allocations to the 3% to 10% range--enough to have some impact on the portfolio but not so high as to potentially imperil the portfolio. Selecting a range of strategy types, or a multistrategy fund, will help mitigate the risk of idiosyncratic events. Focusing on funds that earn Morningstar Analyst Ratings of Bronze or better and which offer low correlations to equities or fixed income (depending on which risk you wish to diversify away from) can also help lead to better outcomes. If you meet accredited investor criteria and have access to private products through a wealth advisor, the case for alternatives may be yet stronger.

If you are investing through your 401(k), you likely won’t find stand-alone alternatives as an option, as their fees and idiosyncrasies make them unpalatable to most plan sponsors. To my mind, allocation or target-date funds that incorporate alternatives would be the most sensible route for individual investors; unfortunately, there aren’t that many options that do so. Vanguard Managed Payout VPGDX allocates about 12% of assets to Vanguard Alternative Strategies VASFX Other firms have incorporated direct real estate into CIT versions of their target-date products, while Vantagepoint announced last year that it would gradually incorporate private equity into its CIT target-date funds. Some large U.S. firms have taken a more innovative tack with custom retirement offerings, incorporating hedge funds and private equity into such products, leveraging work they have already done on the defined-benefit side of their investment committees. Such products can make sense because the long time horizon for retirement investing aligns with the less-liquid nature of many alternatives, and investors in defined-contribution plans have shown little tendency to trade out of investments like target-date funds, even during the 2008 bear market.

More in Alternative Investments

How to Use Alternatives in Your Portfolio

Will the Institutional Private Equity Push Leave Investors With Scraps?

What’s unique about private equity, about the author, josh charlson.

Josh Charlson, CFA, is a director, manager selection, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. Charlson provides fiduciary services for retirement plans and is responsible for selecting portfolio managers and mutual funds.

Previously, Charlson was a director of manager research focused on alternatives research. He was an editor of the Alternative Investments Observer, a quarterly newsletter. Charlson was also a member of Morningstar's ratings committee for alternative strategies and the stewardship committee that oversees the manager research team's assessment of fund companies.

Before assuming the role overseeing the alternatives team in 2014, Charlson was a strategist for the manager research team, covering a number of risk parity, target-date, and other fund-of-funds strategies. He oversaw Morningstar's annual target-date series research white papers as well as its quarterly target-date series reports and ratings.

Prior to Charlson's role as a strategist, he served as a hedge fund analyst for Morningstar for two years and as a senior editor for Morningstar Associates for seven years, where he focused on retirement planning and advice solutions. Charlson began his career at Morningstar as a mutual fund analyst.

Charlson holds a bachelor's degree in English from the University of Michigan, as well as a master's degree and doctorate in English from Northwestern University. He also holds the Chartered Financial Analyst® designation.

Target-Date Funds Have Suffered Losses. What Should Near-Retirees Do?

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Welcome to Portfolio for the Future™!  

Alternative Investments: Investment Allocations 5 Questions to Ask

• Manager Selection
• Risk Management

Chris Carsley CFA | CAIA:  Chief Investment Officer & Managing Partner, Kirkland Capital ; Group & Chief Investment Officer & Managing Partner Arch River Capital

John Canorro CFA | CAIA:  Director of Operational Due Diligence, Pathstone

Introduction

Enclosed is the second edition of our white paper mini-series on due diligence red flags in alternative investments. As previewed in the introductory paper , this edition will focus on the process managers use to allocate investment opportunities, i.e., how managers decide which investments go into which funds or accounts. This process, referred to as the investment allocation process, or “allocations” for short, is a critical component to the due diligence process because the interests of the manager and investors are not always aligned.  The paper’s case study will delve into BlueCrest Capital Management Limited (“BlueCrest,” “the Manager,” or “the Firm”) and the conflicts of interest that existed as a result of inadequate compliance processes governing the allocation of resources between the Firm’s flagship fund, that held external client capital, and an internal, employees and affiliates only, fund that ultimately resulted in the Firm agreeing to a $170m settlement with the SEC.

Investment firms typically manage multiple funds where the underlying strategies of those funds have some degree of overlap. For example, a manager may manage, on the one hand, a fund focused on investment opportunities in Europe, and on the other hand, a fund focused on investment opportunities globally. Continuing with this example, the manager must decide, in a fair and equitable manner, how to allocate investment opportunities in Europe between A) the European fund, and B) the global fund, which would also include Europe as part of its investment mandate. 

The industry standard, or default, is to allocate investments based on the proportional demand of the underlying strategies. This allocation methodology is commonly referred to as “pro-rata.” Sticking with our current example, if the manager identifies an investment opportunity in Europe with $10m of capacity, and the European fund desires $15m of that opportunity and the Global fund wants $25m of that opportunity, then the European and Global fund will receive allocations of $3.75m and $6.25m, respectively [i] . 

It is imperative for investors to understand the investment allocation process when performing due diligence on an investment manager because interests between the manager and investors can, and often do, conflict within this area. These conflicts of interest can create misalignment between manager and investor, potentially resulting in negative investor outcomes. For investment managers that are registered with the Securities and Exchange Commission “SEC”, they are legally bound by their Fiduciary Duty to fairly allocate trades, and where conflicts of interest may exist, must fully disclose those conflicts. [ii] Provided below are scenarios where conflicts of interest, as they pertain to investment allocations, often come to light:

• The manager charges higher management fees in Fund A vs Fund B : Therefore, the manager is possibly incentivized to place assets with higher expected returns into Fund A vs. Fund B. 
• The manager charges an incentive fee in Fund A, but not Fund B : Fund A might be an unregistered limited partnership, a.k.a. a hedge fund, and Fund B might be a mutual fund or UCIT fund version of the hedge fund. In this scenario, the manager can charge significantly higher fees in Fund A vs Fund B, and because of the potential for higher fee income, may be conflicted in equitably allocating investment opportunities between the funds.
• The manager may have a higher proportion of his or her personal capital invested in Fund A rather than Fund B : Alternatively, the firm may have set up a separate investment vehicle specifically for employees and affiliates of the firm.  In either situation, the manager may be conflicted in equitably allocating the investment between funds where they have differing ownership levels. In the latter situation, where a manager has created a separate, employee only investment vehicle, the manager may have a material conflict of interest in allocating investments between a fund where they have A) an indirect ownership given the fees they collect and B) the vehicle where they directly own the underlying assets (more on this scenario in our case study!). 

Questions to Ask

Given this backdrop, what are some questions that investors can use to either 1) identify scenarios where the allocation of investment opportunities may be an issue, or 2) if an investor has already flagged allocations as an issue, to then determine the severity of the problem? The introductory paper , noted some of these questions.  They are reproduced below with potential remedies that we have used when conducting due diligence: 

• Request and review the manager’s trade allocation policy.  For SEC registered investment advisors, this will likely be disclosed in the manager’s ADV materials.  Additionally, review the allocations of real trades with the manager to see if the actual allocations of various trades are consistent with the policy.  When possible, do not let the manager choose the example transaction(s).  Instead, pick a trade(s) at random, or, if practical, review the entire trade book.
• Ask the question directly to the manager,
• Examine the manager’s regulatory filings for any vehicles that don’t contain investors unaffiliated with the investment manager, and
• Review an allocation of actual trades with the manager to see how it was allocated (as described above).
• There is an ongoing and non-investor friendly trend in the alternative investment space where the limited partnership agreements (“LPAs”) that govern non-registered funds include language that dilutes the manager’s fiduciary duty to its investors by disclosing that the manager may act in its own best interest, rather than its clients’ best interests, in areas where the manager’s interests may conflict with those of its clients or limited partners. Any dilution of a manager’s fiduciary duty is inconsistent with ILPA guidelines. [iii] Furthermore, the SEC is actively looking into these types of activities and may introduce legislation to limit these practices. [iv]  
• Where applicable, use legal counsel with expertise in fund structure and operations to review private fund LPAs.  Furthermore, it is helpful to continually educate your manager due diligence team on changing rules. 
• Review the audits or holdings for the funds where strategies overlap and identify common positions. Then review the trade allocations for trades where a manager traded in commonly held names. This exercise can be particularly helpful when funds either initiate or liquidate a position in a given security or company. 
• Obtain the specifications of what is deemed a “best idea.” Specifically, is labeling a position as a “best idea” made ex-ante on empirical data, or is the manager cherry picking winners on an ex-post basis? 
• It is common for LPAs to provide the investment manager with the right to create parallel funds. These vehicles may trade in the same investments as the primary fund. Therefore, it is important to understand how investments are allocated between the parallel and primary funds. In accordance with the ILPA guidelines, the parallel vehicle should have language and provisions, including those regarding fees, that are materially the same as the original fund. [v] As we will see in our case study below, it is also important to determine the timing of investments between vehicles.

Case Study: BlueCrest Capital Management Limited

BlueCrest Capital Management Limited represents a very clear example of the conflicts of interests and negative outcomes that can arise when a manager creates a separate investment vehicle for the exclusive use of employees, or affiliates of the manager, and the manager does not have an adequate compliance infrastructure to ensure prudent investment allocation policies are being followed. 

BlueCrest, a London-based hedge fund that, at its peak, managed $36 billion, was forced by the SEC to return $170 million to its investors after the Commission said it prioritized an internal, employee / affiliates only hedge fund, named BSMA, over its flagship fund, referred to herein as BCI, where it managed capital for its outside clients.  The following issues are central to understanding the conflicts of interest inherent in this case study [vi] : 

• BlueCrest’s human traders generated most of the firm’s historical performance. From 2011 to 2015, defined herein as the “Relevant Period” of the wrongdoing, the Manager reassigned a majority of its existing best performing traders from BCI to BSMA, and then assigned its most promising new hires to BSMA rather than BCI. 
• While BlueCrest allocated its high performing human traders to BSMA, it replaced those traders in BCI with an algorithm, called Rates Management Trading, or RMT for short. RMT implemented the trades initiated by the human traders, on behalf of BSMA, on a 1-day trading lag. As you will see when we dig further, RMT materially underperformed the human traders. 
• BlueCrest employees and affiliates invested significantly more of their own money in BSMA rather than BCI. Insider ownership of BSMA peaked at $1.79 billion during the Relevant Period, versus $619m in BCI. 
• Most surprisingly, and central to the SEC’s order , BlueCrest failed to adequately disclose 1) the existence of BSMA, 2) the movement of traders from BCI to BSMA, and the use of RMT within BCI. Furthermore, BlueCrest’s executive committee specifically instructed the Firm’s Investor Relations department to not proactively disclose BSMA’s existence.

To summarize, 1) BlueCrest allocated its best traders from BCI to BSMA, 2) it replaced the human traders in BCI with an algorithm, RMT, that traded on a 1-day lag relative to BSMA, 3) employees of the firm allocated a significant portion of their personal capital to BSMA, and 4) none of these activities were clearly disclosed to investors or regulators. In 2014, due diligence consultants discovered BSMA and RMT, and once they clearly understood the conflicts of interests at play, they recommended that clients redeem from BCI. As a result, BCI suffered significant redemptions, and BlueCrest ultimately liquidated BCI and returned capital to investors. Today, BlueCrest does not manage outside capital. 

Let us now delve a bit further into each of the key elements of this case study. The fact pattern displayed below is based upon the SEC’s order :

The Allocation of Traders Between BCI and BSMA: When BlueCrest launched BSMA, it transferred six traders from BCI to BSMA. Subsequently, the Manager continued allocating existing, high-performing traders to BSMA from BCI, and as the Manager hired new traders, it assigned the most promising of those traders to BSMA rather than BCI. By the end of the Relevant Period, nearly half of BlueCrest’s traders had been transferred from BCI to BSMA [vii] .    

BCI’s Allocation to RMT: RMT was designed to replicate the risk profile and profits of BlueCrest’s live traders on a T+1, or next day, basis. However, RMT underperformed the live traders both in terms of profit generation and volatility of returns, i.e., RMT had lower absolute returns combined with a higher standard deviation of returns. For example, BlueCrest’s own reports showed that RMT’s slippage relative to live traders was 60%-75% since inception. In dollar terms, the slippage was $198 million during just the first half of 2014 and $116m during the first five months of 2015 [viii] . Despite the underperformance, BCI’s allocation to live traders decreased from $12.5b in January 2012 to $7.4b in June 2015, and the Fund’s allocation to RMT increased from $0b to $7.2b during that same period. Simultaneously, BSMA’s allocation to live traders increased from $4.5b to over $22b [ix] . 

BlueCrest’s compensation structure created a further incentive for the Manager to allocate investor capital in BCI to RMT. Taking a step back, hedge fund managers typically charge investors 20% of the annual profits generated by a fund. This fee is called the carried interest. BlueCrest paid its live traders approximately 15%-18% of the trading profits they generated as part of their annual bonus. However, BlueCrest did not have to allocate part of BCI’s carried interest to their personnel that managed the RMT trade replication process. As a result, BlueCrest could retain a greater percentage of performance fees [x] . 

Lack of Disclosures: Prior to 2014, BlueCrest did not disclose the existence of BSMA, nor did they disclose BCI’s increasing reliance on RMT in any of the firm’s due diligence questionnaires (“DDQs”), investor letters, investor presentation or other marketing materials [xi] . Instead, the Manager advertised the performance of its live traders to prospective BCI investors but failed to disclose that many high performing traders had been transferred from BCI to BSMA. For example, BlueCrest’s 2012 DDQ stated that “traders actively manage portfolios and dramatically adjust positions in real-time,” while in actuality, 24% of BCI’s capital at the time was managed through RMT [xii] . 

In terms of regulatory filings, BlueCrest did identify BSMA in Parts 5 and 10 of its Form ADV Part 2A brochure. BlueCrest then omitted BSMA in its next brochure filing on July 10 th , 2012 and continued to omit BSMA in all subsequent filings during the Relevant Period. BlueCrest followed a similar pattern of disclosing BSMA in its Form ADV, i.e., it initially disclosed the Fund in March and July of 2012 but then omitted the Fund from all subsequent filings [xiii] . The reasoning behind the decision by BlueCrest to initially disclose BSMA and then omit the Fund from its regulatory filings is unknown. 

Unearthing of BSMA: A due diligence consultant working on behalf of an institutional investor discovered BSMA while conducting an onsite examination of the Manager in January 2014. A BlueCrest employee told the consultant that BMSA was a “partner retention vehicle” with roughly $1.5b in AUM.  BlueCrest declined to respond to the consultants follow up questions regarding BSMA’s traders and historical performance, and as a result, the consultant downgraded their rating of BlueCrest on the grounds that 1) BlueCrest failed to disclose BSMA, 2) the potential conflicts of interest presented by BSMA, 3) the possibility that high performing traders were being allocated to BSMA, and 4) the potential that investors in BCI were not receiving the full benefit of BlueCrest’s investment expertise, even though, they were paying for their expertise via market rate management fees, carried interest and fund expenses [xiv] .

RMT was subsequently discovered by a second due diligence consultant in March of 2014, as part of BlueCrest’s response to that consultant’s concerns that high-performing traders were being allocated to BSMA. BlueCrest, however, failed to disclose to that consultant that BlueCrest had indeed transferred numerous traders from BCI to BSMA and that RMT had lower returns and higher volatility than live traders [xv] . Both consultants communicated to clients that they were unable to sufficiently assess the conflicts of interest posed by BSMA and downgraded BlueCrest to “uninvestable.” As a result, investors submitted redemptions. AUM in BCI dropped from $13.9 billion to $9.4 billion during 2014. After further redemptions in 2015, assets declined to $2.2 billion, and BlueCrest decided to ultimately shut BCI down and stop managing external client money [xvi] . 

The BlueCrest case study highlights several items of note from a due diligence perspective. Provided below are our key takeaways:

• Onsite Reviews:   Onsite reviews are still important, particularly in open end hedge funds. Due to COVID-19 and the advent of video technology, many managers and investors are increasingly relying on “virtual” due diligence meetings. While meeting virtually is more convenient, and often sufficient, the onsite examination should remain an important part of the due diligence process, particularly in terms of initial investments in hedge funds. 
• GP Commitment: Understand and, to the degree possible, obtain access to where the top employees and portfolio managers of an asset manager have invested their capital. Is their capital invested alongside yours?  As we saw with BlueCrest, this question was central.
• Analyze Trade Allocations: The due diligence process should include a thorough examination of actual trade allocations. Sitting with a trader or middle office professional and seeing actual trade allocations is invaluable.
• Changes to Regulatory Filings: Investors should closely monitor changes to regulatory filings. Thankfully, services now exist that can easily identify the changes to a manager’s ADV filings.
• Trust, but Verify: While this is cliché in due diligence, you shouldn’t take the word of the manager or their IR department as gospel. Review the materials and ask the questions. Due Diligence is hard work, but valuable to a level that can’t always be priced until something goes wrong.

Upcoming Paper - Valuation

“ All successful investment involves trying to get into something where it’s worth more than you’re paying. ” – Charlie Munger.

From the words of famed investor, Charlie Munger, valuation is central to the investment process. Accordingly, it is important to understand the process a manager undertakes to determine that valuation and how that valuation is used in the operation of the fund. In our next segment we will dive into valuation methodology, review Fair Value Measurement, discuss best practices, walk through a few case studies and arm you with questions to consider in your due diligence process so you can better identify potential investor/manager conflicts related to valuation. 

If have any questions or would like to learn more, please contact Chris Carsley [email protected] or John Canorro at [email protected] .

[i] The prorate allocation is defined as the Fund’s demand as a proportion of the total demand for all funds ($40m in this example) under the purview of the manager times the capacity of the opportunity.  European Fund Allocation:  ($10m*($15m/40m))= $3.75m.  Global Fund Allocation:  ($10m*($25m/$40m)) = $6.25m. 

[ii] See “ Commission Interpretation Regarding Standard of Conduct for Investment Advisers ,” Advisers Act Release 5248.

[iii] See ILPA Principles 3.0:  Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners .

[iv] See “ Prepared Remarks At the Institutional Limited Partners Association Summit ”, Chair Gary Gensler. 

[v] See ILPA Principles 3.0:  Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners  

[vi] Please see BlueCrest to return $170m to former investors after SEC settlement , Financial Times, December 8 th , 2020; and The SEC Says your Algorithm is Not Good Enough , Compliance Building, December 10 th , 2020. 

[vii] Please see paragraphs 15-17 of the SEC order .

[viii] Please see paragraph 43 of the SEC order .

[ix] Please see paragraph 24 of the SEC order .

[x] Please see paragraph 28 of the SEC order .

[xi] Please see paragraph 49 of the SEC order .

[xii] Please see paragraphs 52 and 53 of the SEC order .

[xiii] Please see paragraph 45 of the SEC order .

[xiv] Please see paragraphs 55 and 56 of the SEC order .

[xv] Please see paragraph 60 of the SEC order .

[xvi] Please see paragraph 62 of the SEC order .

About the Authors:

John Canorro  is a Partner of Pathstone and Director of Operational Due Diligence.  He is responsible for conducting the operational due diligence on the external managers with whom Pathstone commits capital to.

Previously, John was the Managing Director of Operational Due Diligence at Cornerstone Advisors where he oversaw the operational due diligence efforts across the firm’s $4 billion investment program.  John began his career as an investment banking analyst with Cary Street Partners.

John earned a Bachelor of Science in Commerce from the McIntire School of Commerce at the University of Virginia.  He also holds the Chartered Financial Analyst designation from the CFA Institute, the Chartered Alternative Investment Analyst designation from the CAIA Association, and is a member of the CFA Society of Seattle.

John is a Seattle area native.  He and his young family love spending time at local parks and going on walks around the neighborhood.

Chris Carsley  brings over 25 years of investment industry expertise specializing in portfolio management, risk management, valuation, regulatory compliance practices, corporate and venture finance, business operations efficiency, securities research, arbitrage trading, and hedging.

Chris is the Managing Partner and Chief Investment Officer for Kirkland Capital Group. He is responsible for portfolio management, risk assessment, and fund operations for the Kirkland Income Fund, a micro-balance commercial real estate bridge financing fund. Chris is also a managing partner at Arch River Capital, which manager of a seed/angel fund and other private equity positions. 

Previously, Chris was Managing Director of Bluewater Global Ltd., an international holding company where he performed corporate analysis and invested in a variety of direct and indirect venture capital projects.

Prior to entering venture capital investments, Chris was responsible for the creation of the business risk and operational due diligence program as a senior member of the investment research and analysis team at Benchmark Plus Management. He was also the head execution trader of futures, options and OTC based trades for the Benchmark Funds. Chris was a trader for Paloma Securities where he negotiated and structured ISDAs, securities lending, and financing agreements that targeted global arbitrage opportunities primarily for Canadian and European markets. Chris was also a senior member of the hedge fund security finance team performing due diligence for the Paloma hedge funds to assist in enhanced finance/margin treatment and short coverage costs.

Chris started his professional investment career as a portfolio manager for Key Asset Management managing institutional and private client discretionary accounts and was responsible for sales, asset research/valuation and portfolio management. Chris was a member of the Charles Wright Academy Endowment Committee, serving on the Committee since March 2017. He co-founded the Seattle Alternative Investment Association in 2004 and is Co-Head of the executive board of the Seattle CAIA chapter launched in 2017. He earned his Chartered Financial Analyst (CFA) designation in 1998, Chartered Alternative Investment Analyst designation in 2011, and holds a BBA from the University of Portland.

This article was written for and published on the CAIA blog .

This communication and its content are for informational and educational purposes only and should not be used as the basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to its accuracy, completeness or correctness. No information available through this communication is intended or should be construed as any advice, recommendation or endorsement from us as to any legal, tax, investment or other matters, nor shall be considered a solicitation or offer to buy or sell any security, future, option or other financial instrument or to offer or provide any investment advice or service to any person in any jurisdiction. Nothing contained in this communication constitutes investment advice or offers any opinion with respect to the suitability of any security, and this communication has no regard to the specific investment objectives, financial situation and particular needs of any specific recipient. Past performance is no guarantee of future results. Additional information and disclosure on Pathstone is available via our Form ADV, Part 2A, which is available upon request or at www.adviserinfo.sec.gov.

Any tax advice contained herein, including attachments, is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding tax penalties that may be imposed on the taxpayer or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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• Alternative Investments

What Are Alternative Investments? Definition and Examples

James Chen, CMT is an expert trader, investment adviser, and global market strategist.

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.

Key Takeaways

• An alternative investment is a financial asset that does not fit into the conventional equity/income/cash categories.
• Private equity or venture capital, hedge funds, real property, commodities, and tangible assets are all examples of alternative investments.
• Most alternative investments have fewer regulations from the U.S. Securities and Exchange Commission (SEC) and tend to be somewhat illiquid.
• While traditionally aimed at institutional or accredited investors, alternative investments have become feasible to retail investors via alternative funds.
• Common forms of alternative investments include real estate, commodities, cryptocurrency, and collectibles.

Investopedia / NoNo Flores

Understanding Alternative Investments

Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and degree of risk. Many alternative investments have high minimum investments and fee structures, especially when compared to mutual funds and exchange-traded funds (ETFs) . These investments also have less opportunity to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets due to lower levels of turnover.

Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple Inc. due to a limited number of buyers. Investors may have difficulty even valuing alternative investments, since the assets, and transactions involving them, are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as there are only 11 known to exist and only one can be legally owned.

Types of Alternative Investments

Real estate.

Real estate as an investment includes investing in physical properties or property based securities. It can also include investing in real estate crowdfunding platforms, real estate investment trusts (REITs), and real estate mutual funds. In addition to capital appreciation of tangible assets, investors strive for operating income to potentially provide ongoing, stable cashflow.

Commodities

Commodities are raw materials such as gold, silver, oil, or agricultural products. Investors can invest in these tangible goods that have real world uses and often perpetual demand due to the underlying characteristics of what they are. For example, gold's price is arguably more stable because it used in a variety of industries and is considered a store of value .

A blend of real estate and commodities, investors can turn to farmland as an alternative investment. In addition to reaping the benefits of physical, tangible land, farm owners may also receive ongoing cash proceeds should operations and sales of commodities yield positive results.

Art and Collectibles

Some investments may double as a hobby, with art, sports memorabilia, entertainment memorabilia, or other collectibles acting as alternative investments. These items may have historical worth or develop worth over time as related parties (i.e. the artist, the associated movie star, or the associated athlete) become more historic.

Cryptocurrencies

The emerging form of digital currency, cryptocurrency is seen as an alternative investment as it is outside the traditional scope of stocks and bonds. Though some may claim cryptocurrency does not offer a strong hedge against other risk-on investments, it may provide capital appreciation or passive income due to staking rewards.

Venture Capital/Private Equity

Blurring the lines of an alternative investment, venture capital or private equity are simply a refined branch of stock investments. Instead of trading shares of public companies in an open market, investors may seek alternative avenues to put capital into private companies or start-ups.

Peer-to-Peer Lending

Investing in peer-to-peer lending translates to making loans to individuals or businesses through online platforms that connect borrowers with investors. Peer-to-peer lending takes a very similar form as investing in bonds, though it is done on more private markets and often entails transacting with riskier clients. There is a potential for higher returns, though not always.

The term "alternative investment" simply refers to an investment being alternative to stocks, bonds and cash. Both an unboxed Star Wars figurine with appreciating value and a rundown local warehouse may fall into the definition of an alternative investment.

Regulation of Alternative Investments

Even when they don't involve unique items like coins or art, alternative investments are prone to investment scams and fraud due to the lack of regulations.

Alternative investments are often subject to a less clear legal structure than conventional investments. They do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the U.S. Securities and Exchange Commission (SEC). However, they usually don't have to register with the SEC. As such, they are not overseen or regulated by the SEC as are mutual funds and ETFs.

So, it is essential that investors conduct extensive due diligence when considering alternative investments. In some cases, only accredited investors may invest in alternative offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their primary residence—or with an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals who hold a FINRA Series 7, 65, or 82 license may also qualify as an accredited investor.

Some alternative investments are only available to accredited investors—e.g., those with a net worth above $1 million, or an annual income of at least $200,000.

Advantages and Disadvantages of Alternative Investments

May offer diversification benefits

Often have higher return potential than traditional investments

May offer protection against inflation

May offer investors more specialty investment options

May be less liquid and more difficult to sell in a hurry

Often associated with higher fees and transaction costs

Often have higher risk than traditional investments

Often lacks transparency and may have reduced regulation

May not be right for novice investors due to their complexity

May be illiquid

Pros of Alternative Investments

Because of their unique nature and differences from traditional markets, alternative investments may have low correlations to traditional investments such as stocks and bonds. Therefore, investors most often turn to alternatives to potentially help diversify an investment portfolio and reduce overall portfolio risk.

Since alternatives are considered riskier investments, they often have the potential for higher returns compared to traditional investments. In addition, alternative investments come in different forms and structures, giving investors the flexibility to choose the investment that best suits their preferences, risk appetite, and investment goals. For instance, investors may favor certain cryptocurrencies based on passive income opportunities.

Alternative investments may provide access to markets that are not available through traditional investments. Not only may investors find this more interesting (i.e. a baseball enthusiast may attach more passion in buying an autographed baseball), that investor may find it more difficult to sell that collectible because there are likely to be fewer buyers, making the market less liquid. This may be perceived as a benefit as this may enhance price stability amongst investors as there is less opportunity or panic sell or transact quickly based on emotion.

Cons of Alternative Investments

Because of their limited accessibility, alternative investments often have higher fees and expenses compared to traditional investments. For example, private equity and hedge funds typically charge high management and performance fees, which can significantly reduce investors' returns. Whereas many brokers offer free trades of a number of stocks and bonds, many alternative investment products come at a cost.

As mentioned earlier, alternative investments are often illiquid which may be a benefit. However, consider the situation where an investor needs to quickly sell a rare piece of movie memorabilia because they need the cash. Because there may not be an active or large market, they may not be able to easily or quickly sell the item without incurring significant transaction costs or loss of value.

Because alternative investments may not be commonly publicly traded , it may be more difficult to obtain market data on historical trends or pricing. Whereas public companies must comply with many reporting rules, some alternative investments may be subject to less regulatory oversight and have higher risk of fraud, misconduct, and other abuses. Also mentioned above, alternative investments tend to carry higher returns though this is a function of being riskier investments.

Alternative investments are also more often complex. Some may have complex structures and terms that can be difficult for investors to understand, increasing the risk of making uninformed or inappropriate investment decisions. Others may have no readily available market prices, making it difficult to determine their true value.

The alternative investment industry is expected to grow 53% in 2023 when it is projected to reach $14 trillion in assets under management.

How to Invest in Alternative Investments

Getting started with investing in alternative investments is very different based on the asset you're working with. Some may require substantial capital and research; others may simply require a few clicks of a mouse button. Very broadly speaking, here's how to get started with several types of alternatives.

• Private Equity: Private equity investments typically involve buying shares in a private company or a group of companies. Investors may participate in private equity investments through private equity firms, venture capital funds, or crowdfunding platforms.
• Real Estate: Investors can invest in real estate through various means such as buying rental properties, investing in Real Estate Investment Trusts (REITs), or investing in real estate crowdfunding platforms .
• Hedge Funds: Hedge funds are typically available only to accredited investors, and investors must have a high net worth and a substantial amount of investment capital to qualify. Investors can invest in hedge funds through hedge fund managers or brokers.
• Commodities: Commodity investments involve buying physical assets such as gold, silver, oil, or agricultural products. Investors can also participate in commodity investments through commodity trading platforms, exchange-traded funds (ETFs), or mutual funds.
• Art and Collectibles: Investors can invest in art and collectibles through art dealers, auction houses, or online marketplaces. Due to uniqueness of these goods, consider the reputation of the dealer when exploring avenues to trade.
• Cryptocurrencies: Investors can invest in cryptocurrencies though cryptocurrency exchanges, brokers, or online platforms. Investors must often deposit domestic currency into a digital wallet that will house the private keys and currencies of that investor.

As most alternative investments incur a transaction or processing fee, be mindful of maintenance or one-time fees when pursuing alternatives.

Tax Implications of Alternative Investments

Because they represent an entirely different asset class compared to stocks and bonds, many alternative investment industries have different tax rules. In addition, consider how different alternatives may have different income streams (i.e. capital gain on the sale of a rental property in addition to rent revenue).

Some alternative investments such as collectibles and art may not offer the same tax deductions as traditional investments like stocks and bonds. In addition, collectibles such as art or coins are explicitly defined by the IRS as a collectible, and net capital gains are subject to a maximum 28% tax rate.

Cryptocurrency and other digital asset tax rules continue to evolve. Digital assets such as virtual currency, cryptocurrency, stablecoins , and non-fungible tokens may incur taxable transactions when selling the asset for fiat, exchanging the asset for goods or services, or exchanging the asset for another digital asset. In addition, whereas fluctuations in the value of the U.S. dollar would not incur a taxable event, fluctuations in value of digital assets often results in capital gains or losses.

Some alternative investments such as real estate and certain types of energy investments may offer tax-deferred or tax-free investing options. This may include 1031 exchanges and Opportunity Zone investments where investors can use proceeds from the sale of an alternative asset to invest in a similar or specific asset with those proceeds to avoid taxes.

As you embark on your alternative investment journey, consider talking with a financial advisor in addition to a tax advisor to best understand how to protect your asset and ensure maximum efficiency in protecting returns.

Read about Investopedia's 10 Rules of Investing by picking up a copy of our special issue print edition.

What Are the Key Characteristics of Alternative Investments?

Alternative investments tend to have high fees and minimum investment requirements, compared to retail-oriented mutual funds and ETFs. They also tend to have lower transaction costs, and it can be harder to get verifiable financial data for these assets. Alternative investments also tend to be less liquid than conventional securities, meaning that it may be difficult to value some of the more unique assets because they are so thinly traded.

How Can Alternative Investments Be Useful to Investors?

Some investors seek out alternative investments because they have a low correlation with the stock and bond markets, meaning that they may maintain their values in a market downturn. Also, hard assets such as gold, oil, and real property are effective hedges against inflation. For these reasons, many large institutions such as pension funds and family offices seek to diversify some of their holdings into alternative investment vehicles.

What Are the Regulatory Standards for Alternative Investments?

Regulations for alternative investments are less clear than they are for more traditional securities. Although alternative investment vehicles are regulated by the SEC, their securities do not have to be registered. As a result, most of these investment vehicles are only available to institutions or wealthy accredited investors .

The Bottom Line

Alternative investments are investment options outside of traditional investments such as stocks, bonds, and cash. Alternative investments may include a wide range of assets such as real estate, commodities, private equity, hedge funds, art, collectibles, or cryptocurrencies. These investments are generally less liquid than traditional investments, though they may boast diversification and higher returns compared to more popular forms of investing.

U.S. Mint. " United States Mint Makes History with Display of Ten 1933 Double Eagles ."

U.S. Mint. " The United States Government to Sell the Famed 1933 Double Eagle, the Most Valuable Gold Coin in the World ."

U.S. Congress. " H.R.4173 - Dodd-Frank Wall Street Reform and Consumer Protection Act: Summary ."

U.S. Securities and Exchange Commission. " Mutual Funds and ETFs: A Guide for Investors ," Page 8.

U.S. Securities and Exchange Commission. " Accredited Investors – Updated Investor Bulletin ."

U.S. Securities and Exchange Commission. " Prepared Remarks At the Institutional Limited Partners Association Summit: Chair, Gary Gensler ."

Harvard Business School Online. "Online.hbs.edu."

Internal Revenue Service. " Topic No. 409, Capital Gains and Losses ."

Internal Revenue Service. " Digital Assets ."

Internal Revenue Service. " Opportunity Zones ."

Internal Revenue Service. " Like-Kind Exchanges Under IRS Section 1031 ."

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Global Investment Strategist

By Talia Gersch

Head of Alternative Investments, U.S. Southeast Region and JPMA

By Elyse Ausenbaugh , Talia Gersch

We all have different motivations for why we invest. Some individuals hope to generate enough income to sustain their lifestyles. Others may be seeking ways to grow their wealth over decades, whether to fund a legacy for generations or a comfortable retirement. Financial goals are unique for every individual.

That said, many of the challenges facing today’s investors are universal: The revival of inflation calls for the pursuit of higher expected returns to grow purchasing power over time. Alpha opportunities have generally become harder to find in “traditional” stocks and bonds, and last year’s selloff in bonds left investors seeking more reliable portfolio protectors. Also, the appetite for steady income generation is ever-present.

Alternative investments can help investors solve for many of these challenges. Below, we explore three primary roles they can play in portfolios: Access to broader opportunity sets, enhanced diversification and premium income generation potential.

1. Access to a broader opportunity set of long-term growth potential

Historically, equities have enabled investors to grow their capital over time. However, we have seen a 45% decline in the number of publicly traded companies since 2000, 1  and there are now over 7x more private companies than public companies with $100 million in revenue. 2   Limiting your investment approach to public markets means missing out on the vast opportunity set in private markets.

Private equity managers often take a hands-on approach, driving operational improvements in portfolio companies. With this expanded access and more comprehensive toolkit, private equity has consistently outperformed global public equity markets by 5–10% annually (see chart below).

Visual chart displaying historical annualized returns of the global buyout and growth equity index versus MSCI All Country World public market equivalent index.  

2. Portfolio diversification for when the going gets tough

2022 brought the worst year for the stock market since 2008, and the worst year for core bonds on record, leaving many investors seeking ways to better diversify their portfolios.

Enter hedge funds. Hedge funds may help reduce portfolio volatility by using hedging strategies and accessing niche exposures that may generate uncorrelated return streams. Therefore, hedge funds may help a portfolio to compound more efficiently.

Real assets, too, can act as powerful diversifiers in a portfolio. Infrastructure assets, in particular, can offer exposure to essential services with resilient demand and inflation-linked revenue. Similarly, real estate tend to offer historically low correlation to public markets, including publicly traded REITs. 

3. Attractive yield generation

J.P. Morgan’s 2023 Long-Term Capital Market Assumptions estimate that total returns in U.S. investment grade bonds could average 4.6% per year over a 10-year investment horizon, but with an average inflation assumption of 2.6%, the real return prospects look less compelling. 3

Investors navigating the universe of publicly traded bonds must often accept lower credit quality if they seek higher return potential. For those investors, private credit may be worth a look. Private credit historically has offered premium yields and returns with greater structural protections relative to other fixed income opportunities. 4

To boot, as the size of the average high yield borrower has grown, many borrowers are too small to tap into public credit markets; conversely, larger companies may not want to risk the uncertainty or lengthy processes that come with accessing traditional capital markets. Private lenders can fill this financing gap, offering their investors the chance to collect a premium for providing capital where it’s scarce.

Visual depicting the historical asset class yields of Direct Lending as an asset class in comparison to U.S. high yield, Commercial real estate (CRE) mezzanine yield, U.S. investment grade, Commercial mortgage loans-senior and U.S. 10-year Treasury yield, respectively.  

Past performance is not indicative of future results.

We can help

Those with the desire—or need—to overcome today’s investment challenges would be remiss not to consider alternative investments.

As always—but especially in alternatives—due diligence and selectivity are essential, as performance can vary widely. 5

Many investors choose to partner with us to narrow the alternative investment universe because of our rigorous scrutiny of managers. Our in-house team conducts on-site visits, examining the structure, operations, incentives and individuals on a manager’s team. 

As one of the largest alternatives platforms, we set out to continually bring a carefully curated set of high-conviction opportunities to help you realize your goals. If you’re interested in learning more about our alternative investment platform, the latest opportunities, and how they may fit in your financial plan, speak with your J.P. Morgan team.

IMPORTANT INFORMATION

Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax-efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise, and investors may get back less than they invested. Diversification and asset allocation does not ensure a profit or protect against loss.

Private investments are subject to special risks. Individuals must meet specific suitability standards before investing. This information does not constitute an offer to sell or a solicitation of an offer to buy. As a reminder, hedge funds (or funds of hedge funds), private equity funds and real estate funds often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments can be highly illiquid, and are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information. These investments are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any such fund. For complete information, please refer to the applicable offering memorandum.

As a reminder, hedge funds (or funds of hedge funds) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments can be highly illiquid, and are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information. These investments are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any such fund. For complete information, please refer to the applicable offering memorandum.​

Real Estate Investments Trusts may be subject to a high degree of market risk because of concentration in a specific industry, sector or geographical sector. Real estate investments may be subject to risks including, but not limited to, declines in the value of real estate, risks related to general and economic conditions, changes in the value of the underlying property owned by the trust and defaults by borrower.

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Alternative Investments in Community Development: A Case Study of Pension Fund Investments in Multifamily Affordable Housing

Demand for affordable housing far outstrips supply. The New York Fed’s Community Development team is studying institutional investments in affordable apartments to understand how private capital investments may affect rents. Its latest publication on the topic, “Alternative Investments in Community Development: A Case Study of Pension Fund Investments in Multifamily Affordable Housing,” examines pension fund investments in affordable rentals.

The case study is based on a non-representative sample of seven pension funds. The funds surveyed made commitments totaling over $2.7 billion for investments in affordable apartments during a five-and-a-half-year period ending June 2023.

The case study found 91% of respondents’ committed capital for affordable apartments went to closed-end investment funds rather than open-end funds. Unlike open-end funds that remain under the same ownership without an end date, closed-end funds have a defined time horizon, typically ten years, before the properties in their portfolios are sold again. This means the type of investment fund used has implications for the future affordability of a property, since affordability could change under a new investor.

“Because demand for affordable apartments outstrips the current supply, we are studying private investments in affordable housing, including investments by pension funds,” said Jonathan Kivell, director of community investments at the New York Fed. “A growing number of affordable apartments may be at risk of higher rents as affordability restrictions expire. We’re seeing affordable housing developers, owners, and investors creatively leverage public subsidies to keep rents affordable for low- and moderate-income individuals and families.”

The case study also found:

• For the period from January 2018 to June 2023, respondents committed an average of about $388 million for affordable housing investments.
• For the two-year period ending in June 2025, respondents anticipate committing $178 million, on average, for affordable housing investments.
• Respondents said affordable apartments represent about 4.4% of their real estate portfolios, on average. Respondents anticipate that proportion will be roughly the same for the next two years.

The case study, based on survey responses collected between July and December 2023, is the second in a series focused on investments in affordable housing. The first, “ Alternative Investments in Community Development: A Case Study of Managers of Multifamily Affordable Housing Private Investment Vehicles ,” focused on how investment managers source and deploy capital for affordable apartments. That case study found that more than two-thirds of equity capital raised by investment manager respondents was from nonbank institutional investors, including pension funds.

“There’s a lack of data about private capital investments in affordable housing,” Kivell said. “Our goal is to begin to fill in that gap.”

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Finance Case Studies

Featured finance case studies:.

Canary Wharf: Financing and Placemaking

Fondaco dei Tedeschi: A New Luxury Shopping Destination for Venice

Nathan Cummings Foundation: Mission-Driven Investing

The Decline of Malls

Expand the sections below to read more about each case study:, nathan cummings foundation, ellie campion, dwayne edwards, brad wayman, anna williams, william goetzmann, and jean rosenthal.

Asset Management, Investor/Finance, Leadership & Teamwork, Social Enterprise, Sourcing/Managing Funds

The Nathan Cummings Foundation Investment Committee and Board of Trustees had studied the decision to go “all in” on a mission-related investment approach. The Board voted 100% to support this new direction and new goals for financial investments, but many questions remained. How could NCF operationalize and integrate this new strategy? What changes would it need to make to support the investment strategies' long-term success? How could NCF measure and track its progress and success with this new strategy?

William Goetzmann, Jean Rosenthal, Jaan Elias, Edoardo Pasinato, Lukas Cejnar, Ellie Campion

Business History, Competitor/Strategy, Customer/Marketing, Innovation & Design, Investor/Finance, Sourcing/Managing Funds, State & Society

The renovation of the Fondaco dei Tedeschi in Venice represented a grand experiment. Should an ancient building in the midst of a world heritage site be transformed into a modern mall for luxury goods? How best to achieve the transformation and make it economically sustainable? Would tourists walk to the mall? And would they buy or just look? What could each stakeholder learn from their experiences with the Fondaco dei Tedeschi?

Gardner Denver

James quinn, adam blumenthal, and jaan elias.

Asset Management, Employee/HR, Investor/Finance, Leadership & Teamwork

As KKR, a private equity firm, prepared to take Gardner-Denver, one of its portfolio companies, public in mid-2017, a discussion arose on the Gardner-Denver board about the implications of granting approximately $110 million in equity to its global employee base as part of its innovative "broad-based employee ownership program." Was the generous equity package that Pete Stavros proposed be allotted to 6,100 employees the wisest move and the right timing for Gardner Denver and its new shareholders?

Home Health Care

Jean rosenthal, jaan elias, adam blumenthal, and jeremy kogler.

Asset Management, Competitor/Strategy, Healthcare, Investor/Finance

Blue Wolf Capital Partners was making major investments in the home health care sector. The private equity fund had purchased two U.S. regional companies in the space. The plan was to merge the two organizations, creating opportunities for shared expertise and synergies in reducing management costs. Two years later, the management team was considering adding a third company. Projected revenues for the combined organization would top $1 billion annually. What was the likelihood that this opportunity would succeed?

Suwanee Lumber Company

Jaan elias, adam blumenthal, james shovlin, and heather e. tookes.

Asset Management, Investor/Finance, Sustainability

In 2016, Blue Wolf, a private equity firm headquartered in New York City, confronted a number of options when it came to its lumber business. They could put their holdings in the Suwanee Lumber Company (SLC), a sawmill they had purchased in 2013, up for sale. Or they could continue to hold onto SLC and run it as a standalone business. Or they could double down on the lumber business by buying an idle mill in Arkansas to run along with SLC.

Alternative Meat Industry: How Should Beyond Meat be Valued?

Nikki springer, leon van wyk, jacob thomas, k. geert rouwenhorst and jaan elias.

Competitor/Strategy, Customer/Marketing, Investor/Finance, Sourcing/Managing Funds, Sustainability

In 2009, when experienced entrepreneur Ethan Brown decided to build a better veggie burger, he set his sights on an exceptional goal – create a plant-based McDonald’s equally beloved by the American appetite. To do this, he knew he needed to transform the idea of plant-based meat alternatives from the sleepy few veggie burger options in the grocer’s freezer case into a fundamentally different product. Would further investments in research and development help give Beyond Meat an edge? Would Americans continue to embrace meat alternatives, or would the initial fanfare subside below investor expectations?

Hertz Global Holdings (A): Uses of Debt and Equity

Jean rosenthal, geert rouwenhorst, jacob thomas, allen xu.

Asset Management, Financial Regulation, Sourcing/Managing Funds

By 2019, Hertz CEO Kathyrn Marinello and CFO Jamere Jackson had managed to streamline the venerable car rental firm's operations. Their next steps were to consider ways to fine-tune Hertz's capital structure. Would it make sense for Marinello and Jackson to lead Hertz to issue more equity to re-balance the structure? One possibility was a stock rights offering, but an established company issuing equity was not generally well-received by investors. How well would the market respond to an attempt by Hertz management to increase shareholder equity?

Twining-Hadley Incorporated

Jaan elias, k geert rouwenhorst, jacob thomas.

Employee/HR, Investor/Finance, Metrics & Data, Sourcing/Managing Funds

Jessica Austin has been asked to compute THI's Weighted Average Cost of Capital, a key measure for making investments and deciding executive compensation. What should she consider in making her calculation?

Shake Shack IPO

Vero bourg-meyer, jaan elias, jake thomas and geert rouwenhorst.

Competitor/Strategy, Innovation & Design, Investor/Finance, Leadership & Teamwork, Sourcing/Managing Funds, Sustainability

Shake Shack's long lines of devoted fans made investors salivate when the company went public in 2015 and shares soared above expectations. Was the enthusiasm justified? Could the company maintain its edge in the long run?

Strategy for Norway's Pension Fund Global

Jean rosenthal, william n. goetzmann, olav sorenson, andrew ang, and jaan elias.

Asset Management, Investor/Finance, Sourcing/Managing Funds

Norway's Pension Fund Global was the largest sovereign wealth fund in the world. With questions in 2014 on policies, ethical investment, and other concerns, what was the appropriate investment strategy for the Fund?

Factor Investing for Retirement

Jean rosenthal, jaan elias and william goetzmann.

Asset Management, Investor/Finance

Should this investor look for a portfolio of factor funds to meet his goals for his 401(k) Retirement Plan?

Bank of Ireland

Jean w. rosenthal, eamonn walsh, matt spiegel, will goetzmann, david bach, damien p. mcloughlin, fernando fernandez, gayle allard, and jaan elias.

Asset Management, Financial Regulation, Investor/Finance, Leadership & Teamwork, Macroeconomics, State & Society

In August 2011, Wilbur Ross, an American investor specializing in distressed and bankrupt companies, purchased 35% of the stock of Bank of Ireland. Even for Ross, investing in an Irish bank seemed risky. Observers wondered if the investment made sense.

Commonfund ESG

Jaan elias, sarah friedman hersh, maggie chau, logan ashcraft, and pamela jao.

Asset Management, Investor/Finance, Metrics & Data, Social Enterprise

ESG (Environmental Social and Governance) investing had become an increasingly hot topic in the financial community. Could Commonfund offer its endowment clients some investment vehicle that would satisfy ESG concerns while producing sufficient returns?

Glory, Glory Man United!

Charles euvhner, jacob thomas, k. geert rouwenhorst, and jaan elias.

Competitor/Strategy, Employee/HR, Investor/Finance, Leadership & Teamwork, Sourcing/Managing Funds

Manchester United might be the greatest English sports dynasty of all time. But valuation poses unique challenges. How much should a team's success on the pitch count toward its net worth?

Walmart de México: Investing in Renewable Energy

Jean rosenthal, k. geert rouwenhorst, isabel studer, jaan elias, and juan carlos rivera.

Investor/Finance, Operations, State & Society, Sustainability

Walmart de México y Centroamérica contracted for power from EVM's wind farm, saving energy costs and improving sustainability. What should the company's next steps be to advance its goals?

Voltaire, Casanova, and 18th-Century Lotteries

Jean rosenthal and william n. goetzmann.

Business History, State & Society

Gambling has been a part of human activity since earliest recorded history, and governments have often attempted to turn that impulse to benefit the state.  The development of lotteries in the 18th century helped to develop the study of probabilities and enabled the financial success of some of the leading figures of that era.

Alexander Hamilton and the Origin of American Finance

Andrea nagy smith, william goetzmann, and jeffrey levick.

Business History, Financial Regulation, Investor/Finance

Alexander Hamilton is said to have invented the future. At a time when the young United States of America was disorganized and bankrupt, Hamilton could see that the nation would become a powerful economy.

Kmart Bankruptcy

Jean rosenthal, heather tookes, henry s. miller, and jaan elias.

Asset Management, Financial Regulation, Investor/Finance

Less than 18 months after Kmart entered Chapter 11, the company emerged and its stocked soared. Why had the chain entered Chapter 11 in the first place and how had the bankruptcy process allowed the company to right itself?

Oil, ETFs, and Speculation

So alex roelof, k. geert rouwenhorst, and jaan elias.

Since the markets' origins, traders sought standardized wares to increase market liquidity. In the 1960s and later, they sought assets uncorrelated to traditional bonds and equities. By late 2004, commodity-based exchange-traded securities emerged.

Newhall Ranch Land Parcel

Acquired by a partnership of two closely intertwined homebuilders, Newhall Ranch was the last major tract of undeveloped land in Los Angeles County in 2003.

Brandeis and the Rose Museum

Arts Management, Asset Management, Investor/Finance, Social Enterprise, Sourcing/Managing Funds

The question of the role museums should play in university life became urgent for Brandeis in early 2009. Standard portfolios of investments had just taken a beating. Given that environment, should Brandeis sell art in order to save its other programs?

Taking EOP Private

Allison mitkowski, william goetzmann, and jaan elias.

Asset Management, Financial Regulation, Investor/Finance, Leadership & Teamwork

With 594 properties nationwide, EOP was the nation’s largest office landlord.  Despite EOP's dominance of the REIT market, analysts had historically undervalued EOP. However, Blackstone saw something in EOP that the analysts didn’t, and in November, Blackstone offered to buy EOP for $48.50 per share. What did Blackstone and Vornado see that the market didn’t?

Subprime Lending Crisis

Jaan elias and william n. goetzmann.

Asset Management, Financial Regulation, Investor/Finance, State & Society

To understand the collapse of the subprime mortgage market, we look at a failing Mortgage Backed Security (MBS) and then drill down to look at a single loan that has gone bad.

William N. Goetzmann, Jean Rosenthal, and Jaan Elias

Asset Management, Business History, Customer/Marketing, Entrepreneurship, Innovation & Design, Investor/Finance, Sourcing/Managing Funds, State & Society

The financial engineering of London's Canary Wharf was as impressive as the structural engineering. However, Brexit and the rise of fintech represented new challenges. Would financial firms leave the U.K.? Would fintech firms seek new kinds of space? How should the Canary Wharf Group respond?

The Future of Malls: Was Decline Inevitable?

Jean rosenthal, anna williams, brandon colon, robert park, william goetzmann, jessica helfand  .

Business History, Customer/Marketing, Innovation & Design, Investor/Finance

Shopping malls became the "Main Street" of US suburbs beginning in the mid-20th century. But will they persist into the 21st?

Hirtle Callaghan & Co

James quinn, jaan elias, and adam blumenthal.

Asset Management, Investor/Finance, Leadership & Teamwork

In August 2019, Stephen Vaccaro, Yale MBA ‘03, became the director of private equity at Hirtle, Callaghan & Co., LLC (HC), a leading investment management firm associated with pioneering the outsourced chief investment office (OCIO) model for college endowments, foundations, and wealthy families. Vaccaro was tasked with spearheading efforts to grow HC’s private equity (PE) market value from $1 billion to a new target of roughly $3 billion in order to contribute to the effort of generating higher long-term returns for clients. Would investment committees overseeing endowments typically in the 10s or 100s of millions embrace this shift, and, more pointedly, was this the best move for client portfolios?

The Federal Reserve Response to 9-11

Jean rosenthal, william b. english, jaan elias.

Financial Regulation, Investor/Finance, Leadership & Teamwork, State & Society

The attacks on New York City and the Pentagon in Washington, DC, on September 11, 2001, shocked the nation and the world. The attacks crippled the nerve center of the U.S. financial system. Information flow among banks, traders in multiple markets, and regulators was interrupted. Under Roger Ferguson's leadership, the Federal Reserve made a series of decisions designed to provide confidence and increase liquidity in a severely damaged financial system. In hindsight, were these the best approaches? Were there other options that could have taken place?

Suwanee Lumber Company (B)

In early 2018, Blue Wolf Capital Management received an offer to sell both its mill in Arkansas (Caddo) and its mill in Florida (Suwanee) to Conifex, an upstart Canadian lumber company. Blue Wolf hadn’t planned to put both mills up for sale yet, but was the deal too good to pass up? Blue Wolf had invested nearly $36.5 million into rehabilitating the Suwanee and Caddo mills. However, neither was fully operational yet. Did the offer price fairly value the prospects of the mills? How should Blue Wolf consider the Conifex stock? Should Blue Wolf conduct a more extensive sales process rather than settle for this somewhat unexpected offer?

Occidental Petroleum's Acquisition of Anadarko

Jaan elias, piyush kabra, jacob thomas, k. geert rouwenhorst.

Asset Management, Competitor/Strategy, Investor/Finance, Sourcing/Managing Funds

In May of 2019, Vicki Hollub, the CEO of Occidental Petroleum (Oxy), pulled off a blockbuster. Bidding against Chevron, one of the world's largest oil firms, she had managed to buy Anadarko, another oil company that was roughly the size of Oxy. Hollub believed that the combination of the two firms brought the possibility for billions of dollars in synergies, more than offsetting the cost of the acquisition. Had Hollub hurt shareholder value with Oxy's ambitious deal, or had she bolstered a mid-size oil firm and made it a major player in the petroleum industry? Why didn't investors see the tremendous synergies in which Hollub fervently believed?

Hertz Global Holdings (B): Uses of Debt and Equity 2020

In 2019, Hertz held a successful rights offering and restructured some of its debt. CEO Kathyrn Marinello and CFO Jamere Jackson were moving the company toward what seemed to be sustainable profitability, having implemented major structural and financial reforms. Analysts predicted a rosy future. Travel, particularly corporate travel, was increasing as the economy grew. With all the creativity that the company had shown in its financial arrangements, did it have any options remaining, even while under the court-led reorganization?

Prodigy Finance

Vero bourg-meyer, javier gimeno, jaan elias, florian ederer.

Competitor/Strategy, Investor/Finance, Social Enterprise, State & Society, Sustainability

Having pioneered a successful financing model for student loans, Prodigy also was considering other financial services that could make use of the company’s risk model. What new products could Prodigy offer to support its student borrowers? What strategy should guide the company’s new product development? Or should the company stick to the educational loans it pioneered and knew best?

tronc: Valuing the Future of Newspapers

Jean rosenthal, heather e. tookes, and jaan elias.

Business History, Competitor/Strategy, Investor/Finance, Leadership & Teamwork

Gannet offered Tribune Publishing an all-cash buyout offer. Tribune then made a strategic pivot: new stock listing, new name "tronc," and a goal of posting 1,000 videos/day. Should the Tribune board take the buyout opportunity? What was the right price?

Role of Hedge Funds in Institutional Portfolios: Florida Retirement System

Jaan elias, william goetzmann and lloyd baskin.

Asset Management, Financial Regulation, Investor/Finance, Metrics & Data, State & Society

The Florida Retirement System, one of the country’s largest state pensions, had been slow to embrace hedge funds, but by 2015, they had 7% of their assets in the category. How should they manage their program?

Social Security 1935

Jean rosenthal, william n. goetzmann, and jaan elias.

Business History, Financial Regulation, Innovation & Design, Investor/Finance, State & Society

Frances Perkins, Franklin Roosevelt's Secretary of Labor, shaped the Social Security Act of 1935, changing America’s pension landscape. What might she have done differently?

Ant Financial: Flourishing Farmer Loans at MYbank

Jingyue xu, jean rosenthal, k. sudhir, hua song, xia zhang, yuanfang song, xiaoxi liu, and jaan elias.

Competitor/Strategy, Customer/Marketing, Entrepreneurship, Innovation & Design, Investor/Finance, Leadership & Teamwork, Operations, State & Society

In 2015 Ant Financial's MYbank (an offshoot of Jack Ma’s Alibaba company) created the Flourishing Farmer Loan program, an all-internet banking service for China's rural areas. Could MYbank use financial technology to create a program with competitive costs and risk management?

Low-Carbon Investing: Commonfund & GPSU

Jaan elias, william goetzmann, and k. geert rouwenhorst.

Asset Management, Ethics & Religion, Investor/Finance, Social Enterprise, State & Society, Sustainability

In August of 2014, the movement to divest fossil fuel investments from endowment portfolios was sweeping campuses across the United States, including Gifford Pinchot State University (GPSU). How should GPSU and its investment partner Commonfund react?

360 State Street: Real Options

Andrea nagy smith and mathew spiegel.

Asset Management, Investor/Finance, Metrics & Data, Sourcing/Managing Funds

360 State Street proved successful, but what could Bruce Becker construct on the 6,000-square-foot vacant lot at the southwest corner of the project? Under what set of circumstances and at what time would it be most advantageous to proceed? Or should he build anything at all?

Centerbridge

Jean rosenthal and olav sorensen.

When Jeffrey Aronson and Mark Gallogly founded Centerbridge, they hoped to grow the firm, but not to a point that it would lose its culture. Having added an office in London, could the firm add more locations and maintain its collegial character?

George Hudson and the 1840s Railway Mania

Andrea nagy smith, james chanos, and james spellman.

Business History, Financial Regulation, Investor/Finance, Metrics & Data

Railways were one of the original disruptive technologies: they transformed England from an island of slow, agricultural villages into a fast, urban, industrialized nation.  George Hudson was the central figure in the mania for railroad shares in England. After the share value crashed, some analysts blamed Hudson, others pointed to irrational investors and still others maintained the crash was due to macroeconomic factors.

Demosthenes and Athenian Finance

Andrea nagy smith and william goetzmann.

Business History, Financial Regulation, Law & Contracts

Demosthenes' Oration 35, "Against Lacritus," contains the only surviving maritime loan contract from the fourth century B.C., proving that the ancient Greeks had devised a commercial code to link the economic lives of people from all over the Greek world.   Athenians and non-Athenians alike came to the port of Piraeus to trade freely.

South Sea Bubble

Frank newman and william goetzmann.

Business History, Financial Regulation

The story of the South Sea Company and its seemingly absurd stock price levels always enters into conversations about modern valuation bubbles.  Because of its modern application, discerning what was at the root of the world's first stock market crash merits considerable attention. What about the South Sea Company and the political, economic and social context in which it operated led to its stunning collapse?

Jean W. Rosenthal, Jaan Elias, William N. Goetzmann, Stanley Garstka, and Jacob Thomas

Asset Management, Healthcare, Investor/Finance, Sourcing/Managing Funds, State & Society

A centerpiece of the 2007 contract negotiations between the UAW and GM - and later with Chrysler and Ford - was establishing a Voluntary Employee Beneficiary Association (VEBA) to provide for retiree healthcare costs. The implications were substantial.

Northern Pulp: A Private Equity Firm Resurrects a Troubled Paper Company

Heather tookes, peter schott, francesco bova, jaan elias and andrea nagy smith.

Investor/Finance, Macroeconomics, State & Society, Sustainability

In 2008, the lumber industry was in a severe recession, yet Blue Wolf Capital Management was considering investment in a paper mill in Nova Scotia. How should they proceed?

Lahey Clinic: North Shore Expansion

Jaan elias, andrea r. nagy, jessica p. strauss, and william n. goetzmann.

Asset Management, Financial Regulation, Healthcare, Investor/Finance

In early 2007 the Lahey Clinic in Massachusetts believed that expansion of its North Shore facility was not only a smart strategy but also a business necessity.  The two years of turmoil in the Massachusetts health care market prompted observers to question Lahey's 2007 decisions. Did the expansion strategy still make sense?

Carry Trade ETF

K. geert rouwenhorst, jean w. rosenthal, and jaan elias.

Innovation & Design, Investor/Finance, Macroeconomics, Sourcing/Managing Funds

In 2006 Deutsche Bank (DB) brought a new product to market – an exchange traded fund (ETF) based on the carry trade, a strategy of buying and selling currency futures. The offering received the William F. Sharpe Indexing Achievement Award for “Most Innovative Index Fund or ETF” at the 2006 Sharpe Awards. These awards are presented annually by IndexUniverse.com and Information Management Network for innovative advances in the indexing industry. The carry trade ETF shared the award with another DB/PowerShares offering, a Commodity Index Tracking Fund. Jim Wiandt, publisher of IndexUniverse.com, said, "These innovators are shaping the course of the index industry, creating new tools and providing new insights for the benefit of all investors." What was it that made this financial innovation successful?

William Goetzmann and Jaan Elias

Asset Management, Business History

Hawara is the site of the massive pyramid of Amenemhat III, a XII Dynasty [Middle Kingdom, 1204 – 1604 B.C.E.] pharaoh.  The Hawara Labyrinth and Pyramid Complex present a wealth of information about the Middle Kingdom.  Among its treasures are papyri covering property rights and transfers of ownership.

Case study: Choosing a qualified default investment alternative (QDIA)

Issue: Ensuring compliance with the PPA

An institutional client sponsoring a large qualified 401(k) plan historically had a default option that consisted of a balanced fund structured as a mix of 74% stable value and 26% equity. This client wanted to qualify for fiduciary protection under the Pension Protection Act of 2006 (PPA). However, to qualify for this protection, the Plan's committee had to adopt the guidance put forth by the Pension Protection Act of 2006 (PPA). Section 404(c)(5) of the act provides that, in situations where members have an opportunity to direct their investments but fail to do so, the fiduciaries will be entitled to fiduciary protection if those members are invested in a qualified default investment alternative (QDIA).

However, the final regulation does not identify acceptable investment products. Rather, it simply describes mechanisms for investing participant contributions. Our understanding of the final regulation put forth by the Department of Labor (DOL) in October 2007 is that it aims to ensure that an investment qualifying as a QDIA is appropriate as a single investment capable of meeting a worker's long-term retirement savings needs. The final regulation provides for three types of QDIAs, two individually-based mechanisms and one group-based mechanism:

• A product with a mix of investments that takes into account the individual's age or retirement date (i.e., a life-cycle or targeted retirement-date fund)
• An investment service that allocates contributions among existing plan options to provide a mix that takes into account the individual’s age or retirement date (i.e., a professionally managed account)
• A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (i.e., a balanced fund)

According to the plan's legal counsel, the current default option did not appear to meet the guidance from the DOL.

Solution: Creating better balance in the balanced fund

After reviewing possible QDIAs, the client's committee and the plan's legal counsel wanted to continue to utilize a balanced fund option as its QDIA. As such, Evaluation Associates was asked to provide a process and the quantitative justification for using a balanced option for the QDIA under the PPA.

Under the new DOL regulatory language, a plan fiduciary may utilize a balanced option as an appropriate default vehicle as long as the underlying investment structure (equity versus bonds) is appropriate based on the overall demographics of the plan, rather than an individual. Evaluation Associates worked closely with the plan’s actuary to determine the demographics of the plan's participant population. Based on information from the plan's actuary, the average age of the participants within the plan was 44.23 years. The retirement age under the plan is 60, so, on average, participants were approximately 16 years from retirement.

Under those assumptions, EAI conducted an analysis of offerings from institutional service providers of life-cycle funds that were currently available in the institutional marketplace. The analysis concluded that the current institutional offerings had an equity allocation range of 65% to 79%, with a corresponding bond allocation range of 21% to 35%.

In the end, given the conservative nature of the client's committee, Evaluation Associates recommended that the balanced fund be reconstructed utilizing the conservative ends of the equity/fixed-income targets that were identified through the analysis.

The committee and representing counsel for the oversight of this particular qualified plan determined that the analysis and recommendation put forth by Evaluation Associates was justified and appropriate as a QDIA under the PPA. As such, the default fund was reconstructed to a 65% equity and 35% fixed income asset mix. With this mix, the committee, representing counsel, and the consultant felt that the balanced fund would increase the probability that participants would meet their retirement goals over the long term.

Outcome: Creating a new and improved QDIA option

By understanding PPA and DOL guidance, Evaluation Associates was able to create a solution that satisfied the client's needs by offering a group-level QDIA option. This involved reconstructing the existing structure from a stable value solution to an equity/fixed-income mix that was more in-line with balanced fund options available in the market place, and readily used to satisfy QDIA requirements.

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Evaluation Associates develops a strategy to help a client qualify for fiduciary protection under the PPA.

WaterEquity: Alternative Investment

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Learning objectives.

• apply the Markowitz efficient frontier analysis and optimal portfolio allocation models to real-time market data;
• describe the effect of diversification on portfolio risk and return;
• delineate the differences between financial and social returns; and
• rationalize an investment strategy recommendation when standard utility functions are modified.

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