CHAPTER 1
What Is an Alternative Investment?

Definitions of what constitutes an alternative investment vary considerably. One reason for these differences lies in the purposes for which the definitions are being used. But definitions also vary because alternative investing is largely a new field for which consensus has not emerged, as well as a rapidly changing field for which consensus will probably always remain elusive. Analyzing these various definitions provides a useful starting point to understanding alternative investments. So we begin this introductory chapter by examining commonly used methods of defining alternative investments.

1.1 Alternative Investments by Exclusion

Alternative investments are sometimes viewed as including any investment that is not simply a long position in traditional investments. Typically, traditional investments include publicly traded equities, fixed-income securities, and cash. For example, if an investment such as private equity is not commonly covered in detail in most books on investing, then many people would view it as an alternative investment.

The alternative-investments-by-exclusion definition is overly broad for the purposes of the CAIA curriculum. First, the term investment covers a very broad spectrum. A good definition of an investment is that it is deferred consumption. Any net outlay of cash made with the prospect of receiving future benefits might be considered an investment. So investments can range from planting a tree to buying stocks to acquiring a college education. As such, a more accurate definition of alternative investments requires more specificity than simply that of being nontraditional.

This book and the overall CAIA curriculum are focused on institutional-quality alternative investments. An institutional-quality investment is the type of investment that financial institutions such as pension funds or endowments might include in their holdings because they are expected to deliver reasonable returns at an acceptable level of risk. For example, a pension fund would consider holding the publicly traded equities of a major corporation but may be reluctant to hold collectibles such as baseball cards or stamps. Also, investments in very small and very speculative projects are typically viewed as being inappropriate for such an institution due to its responsibility to select investments that offer suitable risk levels and financial return prospects for its clients.

Not every financial institution, or even every type of financial institution, invests in alternative investments. Some financial institutions, such as some brokerage firms, are not focused on making long-term investments; rather, they hold securities to provide services to their clients. Other financial institutions, such as deposit-taking institutions like banks (especially smaller banks) might invest in only traditional investments because of government regulations or because of lack of expertise.

Of course, institutional-quality alternative investments are also held by entities other than financial institutions. Chapter 2 of this book discusses the alternative investment environment, including the various entities that commonly hold them (e.g., endowment funds and wealthy individuals).

1.2 Alternative Investments by Inclusion

Another method of identifying alternative investments is to define explicitly which investments are considered to be alternative. In this book, we classify four types of alternative investments:

1. Real assets (including natural resources, commodities, real estate, infrastructure, and intellectual property)
2. Hedge funds (including managed futures)
3. Private equity and private credit
4. Structured products (including credit derivatives)

These four categories correspond to Parts 2 to 5 of this book. Our list is not an exhaustive list of all alternative investments, especially because the CAIA curriculum is focused on institutional-quality investments. Furthermore, some of the investments on the list can be classified as traditional investments rather than alternative investments. For example, real estate and especially real estate investment trusts are frequently viewed as being traditional institutional-quality investments. Nevertheless, this list includes most institutional-quality investments that are currently commonly viewed as alternative. Exhibit 1.1 illustrates the relative proportion of these four categories of alternative investments.

The following sections provide brief introductions to the four categories.

1.2.1 Real Assets

Real assets are investments in which the underlying assets involve direct ownership of nonfinancial assets rather than ownership through financial assets, such as the securities of manufacturing or service enterprises. Real assets tend to represent more direct claims on consumption than do common stocks, and they tend to do so with less reliance on factors that create value in a company, such as intangible assets and managerial skill. So while a corporation such as Google holds real estate and other real assets, the value to its common stock is highly reliant on perceptions of the ability of the firm's management to oversee creation and sales of its goods and services. An aspect that distinguishes types of real assets is the extent to which the ownership of the real assets involves operational aspects, such as day-to-day management decisions that have substantial impacts on the performance of the assets. For example, in many instances, direct ownership of oil reserves or stockpiles of copper involve substantially less day-to-day managerial attention than does direct ownership of real estate, infrastructure, or intellectual property.

Exhibit 1.1 Major Alternative Asset Categories (percentages approximate), 2017 

Source: Global Alternatives Survey 2017, Willis Towers Watson; CAIA Association estimates.

Natural resources focus on direct ownership of real assets that have received little or no alteration by humans, such as mineral and energy rights or reserves. Commodities are differentiated from natural resources by their emphasis on having been extracted or produced. Commodities are homogeneous goods available in large quantities, such as energy products, agricultural products, metals, and building materials. Most of the investments covered in the commodities section of the CAIA curriculum involve futures contracts, so understanding futures contracts is an important part of understanding commodities. Futures contracts are regulated distinctly and have well-defined economic characteristics. For example, the analysis of futures contracts typically emphasizes notional amounts rather than the amount of money posted as collateral or margin to acquire positions.

Commodities as an investment class refer to investment products with somewhat passive (i.e., buy-and-hold) exposure to commodity prices. This exposure can be obtained through futures contracts, physical commodities, natural resource companies, and exchange-traded funds.

Some real assets are operationally focused. For the purposes of the CAIA curriculum, operationally focused real assets include real estate, land, infrastructure, and intellectual property. The performance of these types of real assets is substantially affected by the skill and success of regular and relatively frequent managerial decision-making. Traditional common stocks are typically even more highly operationally focused.

Real estate focuses on land and improvements that are permanently affixed, like buildings. Real estate was a significant asset class long before stocks and bonds became important. Prior to the Industrial Age, land was the single most valuable asset class. Only a century ago, real estate was the most valuable asset of most individuals, because ownership of a primary residence was more common than ownership of financial investments.

Land comprises a variety of forms, including undeveloped land, timberland, and farmland. Although undeveloped land might appear to belong under the category of natural resources rather than operationally focused real assets, the option to develop land often requires substantial and ongoing managerial decision-making. Timberland includes both the land and the timber of forests of tree species typically used in the forest products industry. While the underlying land is a natural resource, timberland requires some level of ongoing management. Finally, farmland consists of land cultivated for row crops (e.g., vegetables and grains) and permanent crops (e.g., orchards and vineyards). Farmland necessitates substantial operations and managerial decisions.

Infrastructure investments are claims on the income of toll roads, regulated utilities, ports, airports, and other real assets that are traditionally held and controlled by the public sector (i.e., various levels of government). Investable infrastructure opportunities include securities generated by the privatization of existing infrastructure or by the private creation of new infrastructure via private financing.

Finally, while some descriptions of real assets limit the category to tangible assets, we define real assets to include intangible assets, such as intellectual property (e.g., patents, copyrights, and trademarks, as well as music, film, and publishing royalties). The opposite of a real...