Foundation — Traditional, alternative and the dual category

2.1 Traditional versus alternative

Globally, alternative investment industry evolved over time, hence there is no uniform classification or limitation to what constitutes such assets. Alternative investments are therefore defined generally by several sources as investments other than traditional investments.

The footnote gives the definition sample question 4 is drawn from: According to Investopedia, "An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash."

Note the words — a FINANCIAL ASSET that does not fall into one of the conventional investment categories. Not a mutual fund, not personal property, not financial planning.

What counts as traditional

Traditional investments (as distinguished from savings in bank deposits, government schemes, ornamental gold and residential property for living purposes) are confined to the domain of financial securities such as stocks and bonds from primary and secondary capital market, purchase of general categories of mutual fund units and Exchange Traded Funds (ETFs). Traditional investments cater to general investors who seek investment options which provide better returns than mere savings schemes.

Note the parenthesis carefully — bank deposits, government schemes, ornamental gold and residential property for living purposes are treated as savings, distinct from traditional investments.

Why alternatives exist

Alternative investments evolved over time to cater to the requirements of sophisticated investors such as institutional investors managing pools of funds and High net-worth individual investors (HNIs) who have higher risk-taking capability and need more sophisticated avenues than traditional investment options.

Unlike traditional investments, alternative investments are about investing in opportunities that can potentially generate higher returns but entail higher risk-taking as well. However, given their nature, alternative investments are only meant for risk-taking sophisticated investors who are either fund managers with institutional experience or portfolio managers for HNIs.

And the purpose, stated precisely:

Alternative investments are meant to complement traditional investments for such investors by improving their risk-adjusted returns over the long term.

Complement, not replace. And the measure is risk-adjusted returns over the long term, not raw returns.

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Table 2.1 — the three columns

The workbook explains what the special situations column entry means: These are complex corporate transactions where one company takes ownership control of another company or goes through a reorganisation of its assets and liabilities due to financial difficulties.

What actually divides the columns — liquidity

This is the single most important paragraph in the section:

traditional investments are primarily on-market opportunities that whose common feature is liquidity, i.e. nearness to cash because they can be exited through the market or by anytime redemption offered by an open ended mutual fund.

The essential characteristic of alternative investments is 'illiquidity', i.e. they are not readily convertible into cash as they are either off-market investments or because they are complex structures that do not have a ready market.

The dual class could include structures that have underlying illiquid assets but the instruments per se may be liquid as they are either listed on the stock exchanges or are redeemable through the mutual fund route with some restrictions.

Traditional = liquidity. Alternative = illiquidity. Dual = illiquid underlying, liquid instrument.

That third line explains why REITs and InvITs sit in the dual column. The underlying is a building or a toll road — about as illiquid as an asset can be — but the unit is listed and tradable.

A footnote reinforces the point: traditional investments are primarily meant to provide high liquidity to investors through the capital market trading mechanism. Therefore, listed shares and bonds, units of mutual funds and exchange traded funds fit this requirement very well.

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2.2 The types of traditional investment

Broadly, investments can be classified into financial or non-financial investments. Non-financial investments include real estate, gold, commodities etc. Non-financial investments are also called Real Investments.

Financial instruments are essentially claims on future cash flows. On the basis of claims on the cash flows, there are two generic types of financial instruments—debt and equity.

Debt and equity — the two generic types. That is sample question 2, and the reason is given: instruments are classified on the basis of claims on the cash flows.

A second way to classify:

Financial investments can also be classified on the basis of transferability of ownership in the secondary market, as security and non-security form of investments. Security form of investments, like shares, bonds, notes, etc., are easily transferable in the secondary markets. Whereas non-security form of investments like, fixed deposits, insurance, etc., cannot be transferable to any other investor and they do not have secondary markets. Security form of financial investments are actively traded on both capital and money markets.

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2.2.1 Equity shares

Equity Shares represent ownership in a company that entitles its holders a share in profits and the right to vote on the company's affairs. Equity shareholders are residual owners of firm's profit after other contractual claims on the firm are satisfied and they have the ultimate control over how the firm is operated.

Investments in equity shares reward investors in two ways: dividend and capital appreciation.

Two ideas sit together there and they explain each other. Equity holders are residual owners... after other contractual claims on the firm are satisfied — last in the queue — and they have the ultimate control over how the firm is operated. Last claim, first control.

Time diversification

Investments in equities have proven time diversification benefits and considered to be a rewarding long-term investment. Time diversification benefits refer to the notion that fluctuation in investment returns tend to cancel out through time, thus more risk is diversified away over longer holding periods. It follows that investment in equities offer better risk-adjusted return if held for long time periods.

Time diversification: fluctuations cancel out through time, so more risk is diversified away over longer holding periods. It is the reason a share that is frightening over a month may be sensible over a decade.

Table 2.2 — listed versus unlisted equity

Two rows are especially examinable. Counter-party risk is absent in listed trading since Clearing Corporation is the counterparty — exactly the role Chapter 1 described, where the clearing corporation acts as a legal counterparty to all trades. And valuation: a listed share has a market price; an unlisted one must be determined through a valuation process.

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2.2.2 Fixed income securities

Debt instruments, also called fixed income instruments, are contracts containing a promise to pay a stream of cashflows during the term of the contract to the investors. The debt contract can be transferable (a feature specified in the contract that permits its sale to another investor) or non-transferable, which prohibits sale to another party.

Generally, the promised cashflow of a debt instrument is a periodic payment, but the parties involved can negotiate almost any sort of cashflow arrangement. A debt contract also establishes the financial requirements and restrictions that the borrower must meet and the rights of the holder of the debt instruments if the borrower defaults.

Who issues debt:

Debt securities are issued by companies, municipalities, states and sovereign governments to raise money to finance a variety of projects and activities. Debt instruments can further be classified on the basis of issuer into government debt securities and corporate debt securities where the issuer is a non-government entity. Government securities form the largest component of debt market in India as well as the world.

Classification by maturity, and the term premium:

fixed income securities can be classified on the basis of their maturities. Money market securities have maturities of one year or less than one year, whereas, capital market is a place for long term fund mobilisation. Since the investment horizon in capital market is longer, the uncertainty about the future cash flows go up. Investors require extra compensation for the same. It is referred as "term premium".

Term premium — the extra compensation demanded because a longer horizon means more uncertainty about future cash flows. Do not confuse it with the risk premium of Chapter 1, which compensates for the uncertainty of the payment itself rather than for its distance in time.

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2.2.3 Derivatives

Derivatives are financial instruments whose value depend upon or are derived from the value of other, more basic underlying variables. These are traded both in the OTC market and on exchanges. The exchange-traded derivatives in India are futures and options.

Futures contracts are agreements between a buyer and seller to buy or sell the underlying asset at a predetermined price and quantity on a predetermined date.

Options are contracts that give the holder of the option the right (but not the obligation) to buy or sell the underlying asset at a predetermined price and in a specified quantity at or before a predetermined date.

Note the difference in one phrase: a future is an agreement to buy or sell; an option gives the right (but not the obligation).

There are two kinds of options: options that allow the holder the right to buy the underlying asset are known as 'call' options; Options that allow the holder the right to sell the underlying asset are known as 'put' options. The predetermined price at which the asset can be bought or sold by the option holder is known as the 'exercise' or 'strike' price. Both futures and option contracts are settled on a predetermined date known as 'expiry' date.

Call = right to buy. Put = right to sell. Strike or exercise price = the predetermined price. Expiry = the settlement date.

And the consequence for an investor:

Thus, derivatives have a short shelf life and as investments they are primarily meant for investors with a short investment horizon. Exchange-traded derivatives are now available for trading on the entire spectrum of assets encompassing equity, debt, currencies and commodities.

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2.2.4 Money market instruments

Money market instruments are used for raising and investing funds for periods ranging from one day up to one year. The purpose of the money market is to enable institutions and companies to meet short-term funding needs by borrowing and lending from each other.

Money market securities consist of repos/reverse repos, certificates of deposits, treasury bills, and commercial papers. All these securities are issued at a discount and redeemed at par, and are zero coupon in structure. The Reserve Bank of India regulates the money market segment.

Three things to fix from that short passage:

• The instruments: repos/reverse repos, certificates of deposits, treasury bills, commercial papers.
• The structure: all are issued at a discount and redeemed at par, and are zero coupon. They pay no periodic interest — the return is the gap between the discounted issue price and the par value at redemption.
• The regulator: the Reserve Bank of India — not SEBI.

And on government issuance, which sample question 3 tests: the Central Government issues both Treasury Bills (money market, up to one year) and Dated Securities (capital market, longer term). A certificate of deposit is issued by banks, not by the Central Government.