New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: Alternative Investments and Long/Short Equity Explained. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
8.1 What Makes an Investment “Alternative”
The idea in plain words
An alternative investment is anything outside listed stocks, bonds and cash: hedge funds, private equity, private credit, real assets and the pools that own them. You give up easy selling and clear price information, and the law limits access to accredited investors or qualified purchasers. Reported returns from assets that rarely trade are smoothed, so their true ups and downs are bigger than they look.
Key points
■US private funds sell to accredited investors ($1 million net worth excluding the home, or $200,000/$300,000 income) or, under section 3(c)(7), qualified purchasers ($5 million of investments).
■Liquidity is contractual: lock-ups of a year or more, redemption four times a year or less, and gates.
■Smoothing hides risk: true volatility = reported × √[(1 + φ) ÷ (1 − φ)], 1.73 times at φ = 0.5.
A closer look
Volume I’s Part 3 named the shadow banking universe as a broad category of non-bank finance without detailing what actually happens inside it. Alternative investments is the umbrella term for everything outside traditional publicly-traded stocks and bonds — hedge funds, private equity (already covered in Part 2: M&A, Private Equity & LBOs), real assets, private credit, and the large private capital pools that invest in all of them. They share three defining characteristics: lower liquidity (money is typically locked up for a defined period), lower transparency (less standardized, less frequent public disclosure than listed securities), and, in exchange for both, the potential for returns less correlated with traditional stock and bond markets.
Decision rule
Before you compare an alternative with a listed fund, put both on the same footing: use returns after all fees, unsmooth the alternative’s volatility (multiply by √[(1 + φ) ÷ (1 − φ)], with φ the first-order autocorrelation of its monthly returns), and then ask whether the extra return pays for the lock-up. If φ is above about 0.2, treat the reported Sharpe ratio and correlation as flattering.
The costliest mistake
Sizing an allocation on smoothed numbers. An optimizer fed the 6% reported volatility above sees a Sharpe ratio of 0.50 and a near-zero stock correlation, so it loads up; the economic volatility is 10.4% and the Sharpe ratio 0.29. In a sell-off the illiquid sleeve is marked down a quarter or two late, its share of the portfolio jumps (the denominator effect), and the investor must sell liquid assets at the bottom to rebalance or meet calls. Unsmooth first, then size.
8.2 Long/Short Equity
The idea in plain words
A long/short equity fund buys some stocks and bets against others at the same time, so how much market risk it carries depends on its net exposure, best measured after adjusting for each stock’s beta. What investors keep depends heavily on fees. Under a 2-and-20 structure, a fund must earn 12% gross to deliver 8% net. The high-water mark, the hurdle and how often fees are locked in decide how much of a bumpy return the manager takes.
Key points
■Gross exposure (longs + shorts) measures leverage; net exposure (longs − shorts) measures market direction.
■Beta-adjusted net exposure was 48% in the example against a headline 30%.
■On a +20%, −15%, +15% path, 2-and-20 took 57% of the gross profit even with a high-water mark.
Decision rule
Gross up the fee before judging the manager: under 2-and-20 charged on opening NAV, a fund must earn 12% gross to hand you 8% net (0.8 × (12% − 2%) = 8%). If a beta-matched index blend can be expected to return within that 4-point gap of the manager’s expected gross return, the fees consume the edge. Insist on a high-water mark and annual crystallization, and ask for a hurdle at the cash rate when beta-adjusted net exposure is low, since cash-like returns should not earn a performance fee.
The costliest mistake
Reading “2-and-20” as “about 2% a year”. In the three-year example a 5.5% gross annual return became 2.4% net: fees took 57% of the gross profit, and without a high-water mark the investor would have paid another $2.47 million while still below the peak. The share rises as gross returns fall, because the 2% is charged regardless. Model the fees on a down-up path before signing.
What the full article covers
In the full article I take you through these sections:
■8.1 What Makes an Investment “Alternative”
■8.2 Long/Short Equity
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Alternative Investments and Long/Short Equity Explained, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance