Private equity was the original alternative investment, dating back to 1946 with J.H. Whitney and American Research and Development Corp. Private equity gained steam after the passage of the Small Business and Investment Act of 1958. The first investors in private equity were wealthy individuals.
In 1949, Alfred Winslow Jones established the first hedge fund, a private partnership with a 20% incentive fee. Jones' fund was the first to employ an equity market-neutral strategy, and its wild success was documented in a 1966 Fortune magazine article. Other hedge funds soon followed, but many of them closed during the recession of the early 1970s (as they leveraged up but didn't hedge very much).
In the 1980s, hedge funds re-emerged. Many of them followed global, macroeconomic strategies, due to the recent establishment of global currency, interest rate, and stock index futures markets. A few hedge fund managers, such as George Soros, Jim Rogers, and Julian Robertson, rose to fame during this period.
In the 1990s, large institutions such as pension funds and university endowments began actively allocating to alternative investments. The success of the Yale Endowment's chief investment officer David Swenson, who allocated large (often 40% or more) portions to private equity and hedge funds, spurred this trend, which became known as the "endowment model" of investing. This model earned severe criticism post-2008, as the lack of liquidity in alternative investments caused large losses and funding issues for many institutional investors.
Liquid alternative investments--those available in regulated, liquid structures such as mutual funds and ETFs--have been around since the '80s (when equity option and currency strategies became popular), but a second wave began in 1997, after the repeal of the "short-short" rule. The flexibility to short paved the way for market-neutral strategies. After the 2008 financial crisis in which most long-only portfolios experienced large losses, the third and largest wave of alternative mutual funds emerged. These funds boast a variety of different strategies, but all intend to help the average investor achieve better portfolio diversification.
Today, alternative investments fall into three camps: Nontraditional asset classes, such as currencies and commodities; nontraditional strategies, such as shorting and hedging (in both traditional and nontraditional asset classes); and finally, illiquid assets, such as private equity or private debt.
It's important to note that the definition of alternative investments will change over time, as certain alternative investments become mainstream. For example, it is much more common now for investors to hold emerging-markets stocks and bonds than it was 10 years ago (
see Chart 1
). Also, if investments such as publicly traded REITs and 130/30 strategies have correlation and beta characteristics similar to traditional investments, they are generally not considered "alternative."
Prior to 2008, most alternative investments were available only to accredited investors in private, less-liquid vehicles such as hedge funds. As such, the term "hedge fund" became synonymous with "alternative." Now, however, most alternative strategies are available to common investors in public, regulated, liquid structures such as mutual funds (under the Investment Company Act of 1940). Therefore, an investment's legal structure no longer defines it as "alternative."
The Investment Company Act of 1940 allows for a reasonable amount of shorting, leverage, and illiquidity. Shorts or other future obligations to pay must be covered. Shorts and leverage are governed under "senior securities" rules, which require minimum asset coverage (after including short proceeds) of 300% of the amount borrowed. Liquidity rules call for at least 85% of a fund's assets to be invested in liquid securities--those that can be sold within seven days at approximately the last valuation. Despite these limitations, many alternative strategies can be packaged in '40-Act structures, including mutual funds, ETFs, and closed-end funds.
Alternative investments can be classified by their underlying holdings and risk exposure.
See Chart 2
Different asset classes (stocks, bonds, and derivatives such as commodity futures and currency forwards) will behave differently, and so will different risk exposures (directional net long or net short, or non-directional/market neutral strategies). Net exposure is defined as the dollar value of long positions less the value of short positions. Net beta (or delta-adjusted) exposure is the net market risk taken on by the fund.