Alternative Investments: Investing in Alternatives

Finally, once all the quantitative and qualitative analysis is out of the way, investors will need to make one last assessment, before parting with their money. They will need to look at the fees being charged by the manager to judge what impact, if any, it will have on the performance of the investment.

Most investors are familiar enough with annual management fees, where the manager takes a small percentage of the assets entrusted in payment for the investment services. Alternative investment managers usually charge an annual management fee plus an additional performance fee. The performance fee charged is usually around 15-20% of the returns generated by the manager. In theory, the performance fee is an incentive for the manager to generate the maximum return on the money invested.

Some incentive fee structures go one step further imposing thresholds before the performance fee kicks in. The most common of these structures are the high water mark and the hurdle rate. A performance fee with a high water mark usually means that the fee is only paid when the value of the fund's shares exceed the maximum share value in previous months when the manager has been compensated. Typically, if the manager makes any losses, those accumulated losses have to be recouped before the performance fee is paid.

A hurdle rate means that the manager has to achieve returns over a baseline of, say 5%, before the performance fee is paid. Clearly, incentivising managers to increase returns goes somewhat against the risk management principles behind alternative investment strategies. Either the manager will take on more risk to achieve higher returns, or the manager may switch to a lower risk strategy once the benchmark is achieved. Occasionally, managers will use a risk-adjusted performance fees, linked to the volatility of the fund, in order to iron out this discrepancy.

Excessively high performance fees can have an impact on the overall performance of a strategy. Investors also need to be wary of layering of fees. Layering usually occurs when there are a number of counterparties or intermediaries involved with structuring and selling a fund or product. Intermediaries, like banks and brokers, may charge for advising and structuring a portfolio for an investor, or even providing "guarantees" on the product. These fees are on top of the fees charged by the individual alternative investment managers. Some alternative investments may have four or five layers of fees embedded in the cost before they are sold to investors

In summary, while alternative investments have significant differences from traditional funds, the three steps to successful investing are the same.

1. Analyse your investment objectives in terms of risk, reward and time horizon. From here you can start to create your optimal portfolio.
2. Do your homework. Look at the risk/return characteristics of different strategies. In most cases, the allocation to alternative investments is achieved from the top down allocating first to strategies and then to individual managers.
3. Seek the advice of a professional advisor, who can assist with the portfolio modelling and may also help with the selection and allocation to individual managers. Working with an advisor is partly an issue of common sense, but in some countries it is also a requirement by law.