Alternative Investments
What you must know
The major categories - hedge funds, private equity (buyout and venture), real estate, infrastructure, commodities and natural resources - and their return sources, liquidity, leverage and fee structures. Understand fund-of-funds layering, due diligence, valuation approaches (market comparable, income/DCF, cost/appraisal), commodity exposure through roll yield, and how alternative investments affect a portfolio's risk and return.
Traps
(1) Hedge fund fee structures: management fee plus incentive fee, often with a hurdle rate and a high-water mark; incentive fees are typically paid on profits above the hurdle and net of the management fee. (2) Smoothed or appraisal-based returns understate volatility and correlation, so reported diversification benefits look better than reality. (3) Hedge fund indexes suffer survivorship and backfill bias. (4) Private equity shows a J-curve, with early negative returns. (5) In contango, a long commodity futures position suffers negative roll yield; backwardation produces positive roll yield.
Worked example
A fund starts at $100 million, charges 2% management fee on the beginning value and 20% incentive fee on returns above an 8% hurdle, with a high-water mark. The fund returns 20%, ending at $120 million. Management fee = $2 million, leaving $118 million. Profit above the hurdle ($108 million) is $10 million, so the incentive fee is $2 million, and investors net $116 million - a 16% net return.