Foundation — What makes an investment "alternative"

A shop on a busy main road can be sold in a week — twenty buyers know what it is worth. A plot of farmland behind a village may be worth more, but selling it takes months and depends entirely on finding the one buyer who wants that particular field.

⚠️ That is the dividing line the chapter draws. Traditional investments are "ON-MARKET OPPORTUNITIES whose COMMON FEATURE IS LIQUIDITY, i.e. NEARNESS TO CASH, because they can be EXITED THROUGH THE MARKET OR BY ANYTIME REDEMPTION."

Two different reasons for the same illiquidity, and the distinction is worth holding. A stake in an unlisted company is illiquid because it is off-market — nobody quotes a price. A collateralised debt obligation is illiquid because it is complex — even a willing buyer would struggle to value it.

A building is the most immovable thing there is. Yet a share in a housing society that owns it can change hands over a phone call. The asset has not become liquid; only the claim on it has.

⚠️ That is exactly what the DUAL category means: "structures that have UNDERLYING ILLIQUID ASSETS BUT THE INSTRUMENTS PER SE MAY BE LIQUID, as they are either LISTED ON THE STOCK EXCHANGE OR ARE REDEEMABLE THROUGH THE MUTUAL FUND ROUTE WITH SOME RESTRICTIONS."

The dual column holds four such things: ⚠️ closed-ended debt funds with illiquid assets like real estate · exchange traded stable cash flow instruments such as SECURITY RECEIPTS from SECURITISATION COMPANIES, SPVs and ASSET RECONSTRUCTION COMPANIES · units of REITs AND INVITs · and mutual funds running ALTERNATIVE OR CONTRARIAN STRATEGIES.

This is why the workbook says of REITs that "since REITs are LIQUID DUE TO THEIR LISTED STATUS, they are sometimes considered EITHER TRADITIONAL ASSETS OR IN THE DUAL CATEGORY." The building has not changed. The wrapper around it has.

A chit fund advertised in the newspaper and open to anybody is a public offering. Twelve colleagues who pool money among themselves under agreed rules are doing something structurally similar and legally quite different.

⚠️ That difference is what "privately pooled" carries: an AIF is "PRIMARILY A PRIVATELY POOLED INVESTMENT VEHICLE", and "the words PRIVATELY POOLED DENOTE THAT THE FUND IS POOLED FROM SELECT INVESTORS AND NOT FROM THE GENERAL PUBLIC AT LARGE."

⚠️ Who those select investors are: "INSTITUTIONS AND HNIs WHO CAN UNDERSTAND THE NUANCES OF HIGHER RISK TAKING AND COMPLEX INVESTMENT ARRANGEMENTS."

The reasoning runs through the whole regulation. A mutual fund takes money from the general public, so it is regulated for the protection of people who cannot assess what they are buying. An AIF takes money from people who can — which is why it is permitted strategies a mutual fund is not, and why it is expressly excluded from being a mutual fund or collective investment scheme.

Somebody who buys seed is betting that anything at all will grow. Somebody who buys a two-year-old sapling can already see the leaves. Somebody who buys a bearing orchard is buying a business with accounts.

⚠️ Venture capital is the seed: "direct investment in INFANT COMPANIES with businesses that are YET TO GROW OR EVOLVE COMPLETELY... also known as START-UPS OR EARLY STAGE BUSINESSES." Because "these businesses are small, THEY ARE SUSCEPTIBLE TO HIGH MORTALITY RATE" and "assessing their future potential is also A DIFFICULT AND COMPLEX TASK."

⚠️ Private equity is the orchard: the term "is PREDOMINANTLY USED TO DENOTE INVESTMENT IN COMPANIES WITH ESTABLISHED BUSINESS MODEL AND TRACK RECORD (known as LATER STAGE COMPANIES)."

So they are not two parallel categories. VC sits inside PE, distinguished by the stage of the company rather than by the kind of transaction.

A "hedge" in ordinary speech means protection. A hedge fund frequently does the opposite — it takes concentrated, leveraged bets that can lose more than the capital put in.

⚠️ The name survives from a mechanism, not a purpose: "IT IS THE ABILITY OF THESE FUNDS TO GO BOTH LONG AND SHORT IN VARIOUS MARKETS THAT HAS GIVEN THEM THE NAME 'HEDGE FUNDS'."

The three features that distinguish them from other AIFs:

• ⚠️ "The objectives allow them to INVEST ACROSS DIFFERENT CLASSES OF ASSETS — FINANCIAL ASSETS, CURRENCIES, COMPLEX DERIVATIVES"
• ⚠️ "They use COMPLEX INVESTMENT STRATEGIES (such as ARBITRAGE, CARRY TRADE) FOR VARIABLE OUTCOMES AND COMPLEX RISK PATTERNS"
• ⚠️ "They TAKE BOTH LONG AND SHORT POSITIONS AND USE SIGNIFICANT LEVERAGE AT FUND LEVEL"

The footnote explains why fund-level leverage matters so much: "the fund is OBLIGATED TO PAY BACK THE DEBT IRRESPECTIVE OF INVESTMENT GAINS OR LOSSES. Therefore, hedge funds are characteristic of HIGHER RISK TAKING AS COMPARED TO OTHER AIFs THAT DO NOT LEVERAGE AT FUND LEVEL."

A middle-order batsman who gets out cheaply in six innings out of ten would look poor judged on his own. In a team of eleven, his two match-winning centuries may matter more than the six failures — because the others hold up the innings when he does not.

⚠️ That is the portfolio argument for alternatives, and the workbook makes it precisely: "EVALUATED ON A STANDALONE BASIS, MANY OF THESE ALTERNATIVE ASSETS HAD INSUFFICIENTLY RELIABLE INCOME AND WERE EVEN SUBJECT TO THE RISK OF CAPITAL LOSS AS WELL IN SOME CASES. BUT WHEN HELD IN A PORTFOLIO, THESE RELATIVELY HIGH-RISK INVESTMENTS COULD LOWER THE TOTAL RISK OF THE PORTFOLIO BECAUSE OF THEIR ABILITY TO PROVIDE IMPROVED DIVERSIFICATION."

This is why the historical section dwells on the 1950s and 1960s, when "modern portfolio theory made considerable advances which ESTABLISHED THE MECHANICS AND ADVANTAGES OF DIVERSIFICATION, ADVOCATING THE PRINCIPLE THAT RISK FROM ALTERNATIVE INVESTMENTS CAN BE DIVERSIFIED." Until that idea existed, a risky asset was simply a risky asset — and institutions until the 1920s stayed in "government securities, mortgages and preference capital."

The whole industry rests on the insight that risk is a property of the portfolio, not of the individual holding.