Alternative Investments: Risk and Return

There is a widespread perception among investors that alternative asset classes are somehow extraordinary and exciting—mostly relating to stories of exaggerated gains and exaggerated losses. In reality, alternative investments are anything but extraordinary. The assets traded by alternative investment managers are, by and large, the same stocks and bonds as a traditional fund.

As such, they are subject to the same basic investment principle: that risk and return go hand in hand. In simple terms, investors are paid a return relative to the amount of risk that they take on.

While many investors are attracted to the alternative investment sector because of the potential for high returns, the fact remains that gains are made by risk takers, not risk mitigators. Alternative strategies that focus mainly on hedging, or keeping market risk under control, will almost certainly have lower returns in a bull market than a traditional fund that has a similar portfolio of stocks. Meanwhile, alternative strategies that have higher returns than a traditional fund are almost certainly taking on more risk.

From an investor’s perspective, one of the most important risk factors that must be understood is the concept of leverage. Traditional funds are much less prone to leverage because regulations restrict the financial instruments and techniques that they can use. This is not the case with alternative investments and investors who are considering alternative strategies for the first time may not be familiar with the process of leverage.

In simple terms, leverage is borrowing money to enhance, or gear up, returns. It is relatively expensive to borrow money directly from a bank because of the fees and borrowing costs associated with establishing a credit line. Alternative investment managers therefore typically leverage their investment capital by buying securities on margin.

To trade on margin an investment manager places a deposit with a broker when he is borrowing from the broker to buy securities. The deposit may be in the form of cash or other eligible securities. When an investment manager is selling short, an equal amount of the same securities are borrowed from another broker for a fee to cover the sale, while the proceeds are kept in an escrow account as collateral for the lending broker.

Trading on margin means avoiding having to provide the full capital at the time of the purchase, while still gaining the full exposure. Alternative investment managers may also use derivatives to achieve the same effect.

The leverage of a fund can be measured as the ratio of the total assets of the fund to the amount of investors’ capital under management.

The objective of leverage is to increase the level of exposure alternative investment strategies have to particular markets in order to maximise the return of the fund. However, the higher level of exposure can also magnify losses. Let's look at an example.