The CFA Institute published a primer on alternatives. It defines alternative investments as anything that is not an ordinary stock or bond.
Alternatives, then, have three primary attributes, any one of which can cause an asset to be classified as an alternative asset:
- The investment’s returns are driven by exposures to underlying assets with nontraditional cash flows—that is, cash flows that are not highly correlated with those that underlie traditional stocks and bonds. Although traditional investments are funded by cash flows from traditional operating firms, many alternative investments are funded by cash flows from nontraditional sources, such as venture capital, life insurance contracts, art, and farmland, which causes their returns to be less correlated with the returns of the overall stock market.
- The investment’s returns are driven by complex trading strategies involving leverage, short sales, and financial derivatives, causing unusual risk exposures, even though the underlying asset might be traditional securities.
- The investment’s returns are structured to generate nontraditional payouts, such as those found in collateralized debt obligations.
Near the end of the book, it describes what makes the endowment model unique.
The salient features of the endowment model are that the allocations:
- favor illiquid investments, such as private equity over public equity;
- favor alternative investments, such as hedge funds and natural resources;
- underweight most or all types of liquid bonds; and
- favor real assets for inflation protection against rising nominal expenditures.
The endowment model tends to be aggressive in holding positions that are illiquid and relatively high risk, based on the idea that the endowment can thereby earn higher long-term returns. Advocates contend that most major endowments are in a better position to tolerate illiquidity and short-term portfolio fluctuations than other investors, because of their reduced immediate cash flow needs and thus their ability to invest for the long term.
What also makes the endowment model unique is that it was designed to support higher education.
Post by Marcelino Pantoja