Foundation — Traditional against alternative, and the traditional investment types

Think of three ways to own furniture.

Buy it from a shop. You can walk in, buy, and if you change your mind a second-hand dealer will take it back at a price. That is the traditional class: 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 offered by an open ended mutual fund.

Commission a carpenter to build a wardrobe to your measurements. It may be worth more than the shop piece. But there is no market for it — not readily convertible into cash, because it is an OFF-MARKET arrangement. That is the alternative class, whose essential characteristic is ILLIQUIDITY.

And then the third case, which is the one people forget. A showroom sells a certificate entitling you to a share of the rent from a warehouse full of custom furniture. The furniture is unsellable; the certificate trades daily. That is the dual class: 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.

The workbook's examples make the point exactly. REITs and InvITs hold real estate and infrastructure — as illiquid as assets get — yet the units are listed. Security Receipts issued by securitisation companies, SPVs and ARCs hold distressed debt and yet are exchange traded.

So the test is applied to the INSTRUMENT, not to what sits underneath it — and that single observation resolves most classification questions in this chapter.

Two ways to reach the same office.

The bus runs on a published route. Anyone can board, the fare is displayed, and the transport corporation stands behind the service. The private car pool is an arrangement among four colleagues — no timetable, no published fare, and if one of them stops coming you must negotiate with the others directly.

Table 2.2 draws the same contrasts across seven rows, and three of them repay attention.

Counter-party risk. For listed equity the answer is NO, since CLEARING CORPORATION IS THE COUNTERPARTY. You never have to know or trust whoever sold you the shares. For unlisted it is YES, because it is traded BILATERALLY on OTC basis — your only protection is the person on the other side of the contract.

Valuation. Listed equity is derived through MARKET PRICE for retail investments or LAST TRADED PRICE. Unlisted is determined through a VALUATION PROCESS — a person has to work it out, which is why an entire chapter of this workbook is devoted to valuation and why third-party registered valuers exist.

Transferability. Unlisted companies usually put RESTRICTIONS on transferability of their shares THROUGH THEIR ARTICLES OF ASSOCIATION. So it is not merely that a market is absent; the company has often made transfer difficult on purpose.

And note the one qualification on the listed side. Listed equity is HIGHLY LIQUID — SUBJECT TO NOT BEING AN INFREQUENTLY TRADED SHARE. Listing is a necessary condition for liquidity, not a sufficient one.

A man will lend his friend Rs 50,000. Asked for one month, he wants 9 per cent. Asked for seven years, he wants 12 per cent.

The friend has not changed. The friend's job has not changed. Only the length of the promise has.

That extra 3 percentage points is the TERM PREMIUM, and the workbook explains it in one sentence: 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".

Note that this is a different thing from the risk premium of Chapter 1, though both are compensations for uncertainty. The risk premium in Chapter 1 was compensation for the uncertainty of future payments from a particular borrower. The term premium arises purely from LENGTH — seven years contains more that can go wrong than one month does, even with an identical borrower.

It is also what divides the two markets in this section. Money market securities have maturities of ONE YEAR OR LESS; the capital market is a place for LONG TERM fund mobilisation. The dividing line is one year, and the term premium is the price of crossing it.

For an alternative investment manager this matters more than for a market investor, because AIF commitments run for years with no exit. The illiquidity the workbook calls the essential characteristic of alternative investments has a term premium built into every return expectation.

A young company has raised equity and is growing fast. Between one funding round and the next there is a gap — orders are arriving, staff must be paid, and the next equity cheque is four months away.

Raising equity now would mean selling a large share of the company at today's price, which is far below what it will be worth after four more months of growth.

That gap is what venture debt is for, and the workbook describes it precisely: a specialised form of lending to start-ups THAT HAVE SUCCESSFULLY RAISED INSTITUTIONAL VENTURE CAPITAL EQUITY. It is usually taken to meet the requirements of SPIKES IN CASH REQUIREMENTS of high growth start-ups WITHOUT THE NEED TO DILUTE FURTHER EQUITY.

And it can serve a second purpose: a BRIDGE FINANCING SOURCE when further equity rounds of financing are getting delayed or the company is facing the risk of a DOWNROUND.

Its terms follow from its position. It usually carries a HIGHER RATE OF INTEREST than normal commercial loans to reflect start-up risk, is typically UNSECURED, and is usually paid back in about 2-3 YEARS by financing the repayment with subsequent rounds of equity financing.

Two regulatory and conceptual points matter for the examination. The workbook states that the SEBI (AIF) Regulations do NOT classify venture debt funds as a SEPARATE CATEGORY but as A PART OF VENTURE CAPITAL FUNDS. And it explains the economic gap being filled: venture debt serves to fulfil a debt financing gap for start-up companies that MAY NOT BE ABLE TO OFFER HIGH COLLATERALS as required in conventional bank financing.

So it is not a cheaper substitute for equity. It is a different instrument for a different moment — and the workbook says it complements venture equity financing very effectively and helps to MITIGATE EQUITY DOWNSIDE RISK as well.

A cloth merchant in a market town does something unusual. He stocks umbrellas, and at the same time he agrees to supply a rival with umbrellas at a fixed price next month. If the monsoon is heavy he gains on the stock and loses on the contract; if it fails, the reverse. He is not trying to predict the monsoon at all. He is trying to profit from a gap he has spotted between two prices.

That two-directional capability is what gives hedge funds their name, and the workbook says so: 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 workbook lists three factors that differentiate hedge funds from other AIFs, and all three are examinable.

(a) They invest ACROSS DIFFERENT CLASSES OF ASSETS — financial assets, currencies, complex derivatives.

(b) They use COMPLEX INVESTMENT STRATEGIES such as ARBITRAGE and CARRY TRADE, for VARIABLE OUTCOMES AND COMPLEX RISK PATTERNS.

(c) They take BOTH LONG AND SHORT POSITIONS and use SIGNIFICANT LEVERAGE AT FUND LEVEL.

The third factor carries a footnote worth reading closely. Leveraging at fund level means the FUND ENTITY will BORROW FROM MARKET SOURCES in order to make investments. The idea is to generate arbitrage return by using debt (which costs lesser) to make investment gains (which are meant to be higher). But — and this is the sting — this strategy also INCREASES OVERALL INVESTMENT RISK as the fund is OBLIGATED TO PAY BACK THE DEBT IRRESPECTIVE OF INVESTMENT GAINS OR LOSSES.

That is why the workbook concludes hedge funds are characteristic of HIGHER RISK TAKING as compared to other AIFs THAT DO NOT LEVERAGE AT FUND LEVEL — and why it calls this breadth of platform speculative and highly susceptible to capital at risk.

A caterer with a large order does not try to master every cuisine. He engages four specialists — one for the north Indian, one for the south, one for the sweets, one for the breads. He adds no cooking of his own. What he adds is the choice of cooks.

That is a fund of funds, and the workbook defines it exactly: AIFs that DO NOT INVEST DIRECTLY IN INVESTEE COMPANIES. Instead, they INVEST IN OTHER AIFs (a practice that is MORE COMMON WITH HEDGE FUNDS).

And it states what the FoF is actually selling: such funds may NOT HAVE A SPECIALISED INVESTMENT THEME. Rather the investment is about RISK DIVERSIFICATION BY INVESTING IN SEVERAL THEMATIC FUNDS. FoFs choose to RELY ON THE EXPERTISE OF OTHER AIFs and generate returns by investing in them.

Note the absence of a theme is a feature, not a gap. A thematic fund lives or dies with its theme. A fund of funds is deliberately spread across themes, and what it contributes is manager selection and diversification rather than sector insight.

The workbook adds one practical reason they exist, and it is a genuinely useful fact: FoFs are also suitable for OFFSHORE AIFs THAT DO NOT HAVE A PERMANENT ESTABLISHMENT IN INDIA for pursuing active fund management.

A foreign fund wanting Indian exposure but unwilling to build an Indian team can invest through a fund of funds — gaining access without establishing a presence. That is not a diversification argument at all; it is a structural one, and it explains a good deal of the offshore money in the Indian AIF ecosystem.

A collector buys a painting for Rs 18 lakh. Ask him what it is worth today and he cannot tell you, because there is no other painting exactly like it anywhere in the world.

The workbook is unusually candid about this asset class, and its list of features reads almost as a list of warnings.

On the positive side: art, paintings and rare collectibles have been generating MODERATE RETURNS IN THE LONG TERM, and — the real argument — it also has LOW CORRELATION WITH FINANCIAL INVESTMENTS SUCH AS EQUITIES AND BONDS. Hence, it provides GOOD RISK DIVERSIFICATION BENEFIT.

On the other side, six limitations, and each is examinable. These are BIG TICKET investments. Art is NOT A STANDARD INVESTMENT PRODUCT as EACH WORK IS UNIQUE. The market for the same is UNREGULATED. These investments DO NOT PROVIDE ANY INCOME and just like GOLD, CAPITAL APPRECIATION IS THE ONLY WAY OF REWARD. In terms of liquidity, this category is RELATIVELY MORE ILLIQUID. And the subtlest: to make rewarding investment decisions, SPECIALISED KNOWLEDGE IN ARTS IS MORE CRUCIAL than in traditional financial assets due to HIGHER LEVELS OF INFORMATION ASYMMETRY AND ADVERSE SELECTION PROBLEMS.

Information asymmetry and adverse selection are the terms to hold. In a market where one side knows far more than the other and no price screen exists, the pieces most readily offered for sale tend to be the ones the seller most wants to be rid of — which is precisely the adverse selection problem.

The workbook does note the route in for those without expertise: there are ART AND PAINTING BASED INVESTMENT FUNDS. Investors can take exposure through these funds.

For decades a family kept everything in fixed deposits and government paper. It worked. Then the returns fell, prices kept rising, and the same discipline that had protected them started quietly costing them.

Institutional investors travelled the same road, and section 2.6 traces it. In the early days of investing, the traditional approach advocated SAFETY OVER DIVERSITY, due to which, TILL THE 1920s, institutional investors invested in GOVERNMENT SECURITIES, MORTGAGES AND PREFERENCE CAPITAL.

What changed was an idea, not a market. Beginning with the 1950s and 1960s, 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.

And the consequence is the single most important sentence in the section: evaluated ON A STANDALONE BASIS, many alternative assets had insufficiently reliable income and were even subject to the risk of CAPITAL LOSS. 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.

A risky asset can reduce portfolio risk. That is counter-intuitive and it is the entire intellectual foundation of the alternative investment industry — the same insight Chapter 19 of the X-B workbook expresses as low or negative correlation.

The timeline is examinable too. Venture capital began after the INDUSTRIAL REVOLUTION of the 18th century, confined to WEALTHY INDIVIDUALS; the EARLY MERCHANT BANKS OF UK became the FIRST INSTITUTIONAL FINANCIERS. Around the 1940-50s, the US witnessed its FIRST BATCH OF INSTITUTIONAL VENTURE FUNDS. The 1980s saw enormous flows, with SETBACKS DURING THE LATE 1980s and again in the DOTCOM BUST IN 2001, after which both venture capital and later stage private equity HIT THE HIGH GROWTH CURVE AFTER 2004.