In
a previous article, we introduced the CFA Institute Investment Foundation
Program (Read
more here). It is a free program
designed for anyone who wants to enter or advance within the investment
management industry, including IT, operations, accounting, administration, and
marketing. Candidates who successfully
pass the online exam earn the CFA Institute Investment Foundations Certificate.
There
are total of 20 Chapters in 7 modules, covering all the essential topics in
finance, economics, ethics and regulations.
This series of articles will highlight the core knowledge of each
chapter.
Chapter
12 provides an overview of alternative investments. The learning outcome of
chapter 12 is as follows:
·
Describe
advantages and limitations of alternative investments;
·
Describe
private equity investments;
·
Describe
real estate investments;
·
Describe
commodity investments.
If
a public company needs funds to invest in a project, perhaps to build a new
production facility or to expand its operations abroad, it may turn to the
financial markets and issue the types of debt and equity securities discussed
in the Debt Securities and Equity Securities chapters. But what if an
entrepreneur needs money to start a promising new business? Or what if a young
company needs funds to grow, but it is not established well enough to seek an
initial public offering? The entrepreneur and the young company are not
established well enough to issue debt or equity securities to the public. In
addition, although they may seek loans from banks, the amount of money they can
borrow is often limited. Banks often do not finance new and young companies
because the risk of not getting the money back is too high. So, entrepreneurs
or young companies may turn to the venture capital sector to obtain the money
they need. Venture capitalists specialise in financing new and young companies.
They provide entrepreneurs and young companies with both the capital and the
expertise to launch and grow their businesses.
Venture
capital is a form of private equity, which is itself a type of alternative
investment. From an investor’s point of view, alternative investments are
diverse and typically include the following:
·
Private
equity: investments in
private companies—that is, companies that are not listed on a stock exchange
·
Real
estate: direct or
indirect investments in land and buildings
·
Commodities: investments in physical products, such
as precious and base metals (e.g., gold, copper), energy products (e.g., oil),
and agricultural products that are typically consumed (e.g., corn, cattle,
wheat) or used in the manufacture of goods (e.g., lumber, cotton, sugar)
Private
equity, real estate, and commodities are all considered alternative because
they represent an alternative to investing exclusively in “traditional” asset
classes, such as debt and equity securities. Although alternative investments
have gained prominence in the 21st century, they are not new; in fact, real
estate and commodities are among the oldest types of investments.
Exhibit
1 shows the results of a global survey of institutional investors regarding
their holdings of different assets. As of March 2012, almost 100% of
respondents invest in equity and debt. But 94% of them also hold some type of
alternative investments. On average, 22.4% of the respondents’ portfolios are
invested in alternative investments, with the most popular types being private
equity and private real estate.
Investors
add alternative investments to their portfolios for two main reasons:
·
to
enhance returns and
·
to reduce
risk by obtaining diversification benefits.
Although
alternative investments have the potential to enhance returns and reduce risk,
they also have limitations. Typically, alternative investments are
·
less
regulated and less transparent than traditional investments,
·
illiquid,
and
·
difficult
to value.
Exhibit
2 shows historical returns for various asset classes between 1990 and 2009. It
indicates that over the 20-year period, investments in private equity and real
estate have outperformed investments in equity and debt securities. However,
you should not conclude from this exhibit that alternative investments always
offer higher returns than other asset classes. During the global financial
crisis that started in 2008, many investors suffered losses on their private
equity and real estate investments and some of these losses were worse than
those on traditional investments, such as publicly traded equity.
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