Course:

COMMODITIES AND
ALTERNATIVE INVESTMENTS
Course Instructor: Umang Somani, CAIA (vf-umang@gim.ac.in)

Session 2: Alternative Investments Vs

Traditional Investments
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Comparison

2
Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

3
Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

4
Low Liquidity

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Low Liquidity

• Traditional investments have the institutional structure that they tend to

be frequently traded in financial markets with substantial volume and a
high number of participants. Therefore, their returns tend to be based on
liquid prices observed from reasonably frequent trades at reasonable
levels of volume.

• Many alternative investments are illiquid. In this context, illiquidity means

that the investment trades infrequently and/or with low volume (i.e.,
thinly traded).

• Illiquidity implies that returns are difficult to observe due to lack of trading
and that realized returns may be affected by the trading decisions of a few
participants.
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Low Liquidity

• Other assets, often termed lumpy assets, are assets that can be bought and
sold only in specific quantities, such as a large real estate project. Thin
trading causes a more uncertain relationship between the most recently
observed price and the likely price of the next transaction.

• Generally, alternative investment assets tend to fall under the illiquid

classification, while traditional assets tend to be liquid assets.

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Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

8
Less Regulations

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Less Regulations

• Regulation of investments is motivated by concern for the participants

directly involved, as well as concern for the overall economy.

• Privately organized investment vehicles, such as hedge funds, have

generally received reduced regulatory scrutiny because the participants
involved tend to be sophisticated institutions or individuals perceived to be
less in need of regulatory protection than the general public.

• Especially since the financial crisis that began in 2007, regulators

throughout the world have become increasingly concerned about the role
of hedge funds and other investment vehicles in exacerbating systemic
risk.
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Less Regulations

• Systemic risk is the potential for economy-wide losses attributable to

failures or concerns over potential failures in financial markets, financial
institutions, or major participants.

• For example, the collapse of a very large hedge fund may lead to a
sequence of collapses and failures that disrupt the financial system and
cause widespread economic losses not so much from the direct asset
losses of the collapse as from inability of the other market participants to
trade and manage risks due to the uncertainty that is generated.

• Regulators are concerned that very large investment funds, such as some
hedge funds, or highly complex alternative investment products, such as
collateralized debt obligations, may increase systemic risks.
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Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

12
Lower Transparency

13
Lower Transparency

• Due to confidentiality involved in trade strategies

• Building and maintaining competitive edge on deal execution

14
Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

15
Higher Fee

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Higher Fee

• Due to involvement of Active management strategies

• Availability of exclusive deals (which are not available to retail

investors)

• Generally, Hedge Funds have a fee structure of 2/20 that means

2% shall be charged as the Management fee and 20% shall be
charged as the performance fee

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Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

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Potentially biased and inconsistent historical return data

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Inconsistent historical return data

• Data is available only for the surviving funds and that does tend to
provide a biased view on the industry

• Newer funds doesn’t have much historical data to analyze

• Data is available on a monthly, quarterly, half-yearly or yearly basis

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Key characteristics of Alternatives

• Low Liquidity
• Less regulation
• Lower transparency
• Higher fee
• Potentially biased and limited risk return data
• Unique legal and tax considerations

21
Unique Tax Considerations

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Unique Tax Considerations

• Taxation can substantially affect investment returns, and therefore

alternative investments are often constructed and managed to prevent
additional taxation.

• In other words, investment pools are formed in light of taxation and with
a goal of minimizing the extent to which the pooling of capital increases
taxation for the investors relative to direct ownership of the underlying
assets.

• For example, a hedge fund may be domiciled in a particular location for

the purpose of preventing additional tax burdens on investors relative to
the taxes that would be paid with direct investments using a separately
managed account.
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Unique Tax Considerations

• Some countries tend to have investment income tax regimes that tax
capital gains, dividends, and/or interest rather heavily or lightly
compared to other nations.

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Questions?

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