New “alternative” investments are emerging. They are structured away from the typical limited partnership or limited liability company into the more open ended mutual fund structures, Investment Company Act of 1940 closed end funds, and separately managed accounts.

This is the beginning of a much-needed change in this segment of the investment industry and will appropriately lead to more distinction between these types of investment strategies. However, the continuing practice of grouping such investment strategies into a single bucket called “alternatives” is inappropriate. The practice has allowed for the development of unnecessary portfolio buckets for asset allocation purposes and unknowingly leads to poor asset allocation decisions and should be stopped. The labeling of “alternatives” as a separate asset class should be eliminated. Here’s why.

Over the last 15 years the financial services industry has evolved the concept of “alternative” investments to describe an investment as something other than a stock or bond. This practice was meant to differentiate assets for simplicity purposes and was not intended to distinguish the investment merits of such investments for the investing community.

Unfortunately, the investing public developed a perception of “alternative” investments as a homogeneous group of investment options. This is clearly not the case. In fact, the evolution of “alternative” investments as a separate asset class has created incorrect expectations on the part of the investing public. Often,
alternative investments are similar only in terms of their uniqueness.

Take Berkshire Hathaway (Warren Buffet’s company) as an example. Many people and institutions own shares in this great company traded publicly on the NYSE. Yet, this company, as with many others, manages their business in similar ways as “alternative” investment managers, but the industry doesn’t classify BRK as an “alternative”. We only know it as a great company that generates consistent ROIC for investors by investing and operating in a collection of businesses as well as through the use of derivatives across the company to help manage the risk in their overall portfolio.

Berkshire Hathaway From 10-Q Sept 30-2012 (shown in millions)

As the 10Q information shows, Warren Buffet has masterfully shown over the last 50 years the ability to find value in companies, determine the optimal part of the capital structure to own, and implement a risk management process to help deliver consistent and efficient return on invested capital. The following chart illustrates the long-term value of three broad investment strategies with an equal weight portfolio. The “alternative” investment group shown in the illustration includes the hedge fund manager universe (represented by the HFRI Hedge Fund index) and the Commodity Trading Advisors and Global Macro Traders universe (represented by the HFN CTA index), and the equity markets (represented by the S&P 500 index).

The bottom line for investors is to look at “alternatives” the same way they look at any investment; stocks, bonds, real estate, commodities, and all others. That is, as an investment you make when you wish to own a collection of investments that have attractive return and risk characteristics that work well together for the investor.

The typical investments identified as “alternatives” are hedge funds and private equity funds with the managers of these funds focused on sourcing and diligencing attractive investment opportunities in companies and then investing some place (or multiple places) within the capital structure of the business to isolate the investment opportunity they seek. The main difference in the investment profile of such an investment manager is the variety of methods or security types used to effectuate the position they desire. This does not make it an “alternative” – all it does is make it look a little different than owning only the stock or bond of that particular company.

In conclusion, “alternatives” are not a separate asset class, but a collection of investment funds and professionals who are granted a broader toolset to use when investing their client’s capital.

As a result, it is important for financial advisors and their clients to focus on three key factors:

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