Alternative Investments

ALTERNATIVE INVESTMENTS FOR INDIVIDUAL
INVESTORS: A STARTING POINT FOR DISCUSSIONS WITH

YOUR FINANCIAL ADVISER
by Thomas Collimore, CFA, Director, Investor Education
Alternative asset classes can provide you with a means to diversify
your portfolio. As you review your options, you should recognize that
mutual funds often are an efficient vehicle for investing in alternative
assets. They offer professional management, liquidity, and portfolio
diversification that would be difficult and expensive to achieve
through direct investment, futures transactions, or hedge funds.
COMMODITIES
Commodities historically have had low correlations with stocks and
bonds and therefore can be used to reduce the overall volatility in
your portfolio. They also serve as a hedge against inflation. On their
own, however, commodities can be very volatile, exposing investors
to the potential loss of a large part of their investment. An additional
caution is that, as additional investors have sought the advantages
of investing in commodities, one might expect some of the historical
INVESTMENT INSIGHT
Correlation is a statistical measure of how the performance
of one security impacts the performance of another, within a
range of -1 to 1, with 0 indicating no relationship. You generally
look for uncorrelated assets in order to reduce the chance of
sharps drops in portfolio value. The following are examples of
possible correlations:
Correlated securities: stocks of two U.S.

homebuilding companies; both rely on demand for
housing
Uncorrelated securities: a high-grade utility bond and

a gaming stock; no obvious links
Negatively correlated securities: petroleum

exploration and gasoline-powered automobile
manufacturer stocks; as oil prices rise, the shares of
each will likely move in opposite directions.
2013 CFA Institute
strengths of the investment (e.g., strong returns, low correlations) to

diminish.
Mutual funds provide options for individual investors who want
the benefits of the asset class without having to enter the futures
market. You can choose a fund that invests directly in commodities,
in commodity futures, or in natural resource companies.
On the one hand, if you are concerned about expense ratios, you
may choose to invest in commodity ETFs (exchange-traded funds)
or an index mutual fund (a passive strategy). On the other hand, if
you believe the skill of a manager can add value (net of additional
expenses), you can invest with a professional manager (an active
strategy).
Another way to participate in commodities is through investing in
sector funds. A sector fund is a mutual fund that invests in only one
industry or a single country (such as Australia or Canada); some of
the more popular sector funds focus on gold, energy, and precious
metals. You should be alert to differences between commodity
fund investment strategies as well as to possible concentrations in
particular assets and asset types (e.g., gold and energy). Regardless
of the strategy, you may achieve a level of diversification that would
be difficult to achieve on your own, and at a lower cost than through
a hedge fund.
DISTRESSED DEBT
Managers of distressed securities funds invest at a discount in
companies that are operating under financial stress. In mutual fund
terminology, you may see funds that invest in this assets class
referred to as special opportunity or special situation funds. The
companies may have defaulted on an obligation, have filed for bankruptcy (or reorganization), or be on the brink of filing.
Distressed-debt investors believe the securities are undervalued
because the companys prospects are better than generally
understood or that the estimated liquidation value of the company
exceeds its market value. Investors buy these securities at a

discount to the stated, or par, value and hope to earn a coupon or
dividend, plus any appreciation in the security. These securities tend
to be illiquid, and their risk should be seen as elevated and highly
correlated with the overall market during extreme conditions.
As you read the distressed fund prospectus, you will encounter the
following key concepts:
Priority of Payment: The bankrupt company pays senior

creditors ahead of junior, or subordinated, creditors. The
first group can include senior bank debt, senior bonds,
and certain taxes. Pre-bankruptcy obligations are typically
subordinated to post-bankruptcy obligations.
Recovery Value: A key skill for Investors in distressed

companies is to estimate the default probability and then
to estimate, given default, how much their securities will
be worth. A recovery value of 40 means that the investor
expects to receive, over time, 40 percent of the obligations
face value.
Real estate investors often cross over into distressed debt by

buying mortgages at a discount in order to acquire the real estate
collateral.
REAL ESTATE
Real estate, like commodities, is a popular class of sector funds.
There are many funds to choose from in this category, ranging from
actively managed open-ended funds to index funds and ETFs. The
index and exchange-traded funds in this segment typically track
a group of publicly traded real estate companies and real estate
investment trusts, or REITs. A REIT is an investment trust that owns
and operates a pool of commercial properties, mortgages, and other
income-producing real estate assets, such as apartments, shopping centers, offices, and warehouses. REITs may offer investors
high yields, in part because they are required to pay out at least 90
percent of their income to shareholders in the form of dividends.
You can learn more about REITs from the National Association of
Real Estate Investment Trusts (NAREIT) website www.reit.com,
an industry-sponsored group that represents publicly traded real
estate companies.
Something to keep in mind: If your home is currently your
single-largest investment, this asset class may provide minimal
diversification value to your portfolio.
This article highlighted some of the alternative investment options
available to the retail investor. A high degree of volatility can be
involved with some of the options presented, and these investments
arent suitable for all investors. As always, be sure to read the prospectus and speak with trusted experts.
For more information, please consult http://www.cfainstitute.org/about/investor/

The information contained in this piece is not intended to and does not provide legal, tax, or investment advice. It is provided for informational and educational
use only. Please consult a qualified professional for consideration of your specific situation.
2013 CFA Institute

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ALTERNATIVE INVESTMENTS FOR INDIVIDUAL

INVESTORS: A STARTING POINT FOR DISCUSSIONS WITH

Correlated securities: stocks of two U.S.

Uncorrelated securities: a high-grade utility bond and

Negatively correlated securities: petroleum

2013 CFA Institute

strengths of the investment (e.g., strong returns, low correlations) to

exceeds its market value. Investors buy these securities at a

Priority of Payment: The bankrupt company pays senior

Recovery Value: A key skill for Investors in distressed

Real estate investors often cross over into distressed debt by

For more information, please consult http://www.cfainstitute.org/about/investor/

2013 CFA Institute

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