Alternative Investment

Investment through direct or indirect investing is a performance game of different global and local events

Author: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Reviewed By: David Bickerton
David Bickerton
David Bickerton
Asset Management | Financial Analysis

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management, investments and portfolio management.

David holds a BS from Miami University in Finance.

Last Updated:October 29, 2023

What Is an Alternative Investment?

Alternative investments are financial assets that represent claims on securities issuers. These claims can be bought and sold in various financial markets. Individuals can invest in these claims using different options:

1. Direct Investing

Investors buy and sell securities themselves through brokerage accounts. Moreover, investors may invest in non-marketable securities such as saving deposits, certificates of deposits (CD), U.S saving bonds, and money market deposit accounts.

They can also invest in money market accounts which can take the form of treasury bills, commercial paper, repurchase agreements, banker’s acceptances, and negotiable certificates of deposits.

Another option is to invest in capital markets, which include fixed-income assets like treasuries, agencies, municipals, corporates, and equities. They can also partake in derivative markets specializing in options and future contracts.

2. Indirect investing

This investment strategy entails buying and selling the shares of investment companies that hold securities portfolios. It includes hedge funds, unit investment trusts, money market mutual funds, exchange-traded funds, and closed-end funds.

Investment through direct or indirect investing is a performance game of different global and local events. 

There are two types of securities; non-marketable securities that involve personal transactions with banks, and marketable securities with the market of buying and selling away from the issuer, like stocks, bonds, futures, and options.

For example, Coca-Cola is famous for its brand name and marketing skills. Its success, however, heavily depends on what happens in the foreign markets it has increasingly penetrated. 

Thus, an economic slowdown in those markets could negatively impact Coke’s sales. Furthermore, Coke must be able to convert its foreign earnings into dollars at favorable rates and repatriate them. Therefore, investing in Coke involves betting on a variety of foreign events.

Key Takeaways

  • Financial assets are split into non-marketable and marketable securities, each involving personal or market-based transactions.

  • Investing can be done directly via brokerage accounts or indirectly through investment companies like hedge funds and ETFs.

  • Investments are influenced by global and local events, impacting various securities' performance.

  • The article covers non-marketable assets (e.g., savings accounts, CDs) and marketable assets (e.g., Treasury bills, commercial paper).

  • The article explains bonds (government, agency, municipal, corporate), equity securities (preferred, common stock), and derivative securities (futures, options).

Non-Marketable Financial Assets

They represent personal transactions between the owner and the issuer. For example, as the owner of a savings account at a bank, you must open the account personally and deal with the bank to maintain it. In contrast, marketable securities trade impersonal securities between the issuer and the investor.

They are safe investments with high liquidity in terms of disposing and getting all money back without any loss of principal amount.

Some of the non-marketable financial assets are:

1. Saving accounts

Savings accounts in insured institutions offer a high degree of liquidity on the principal and return on that principal. Moreover, given that savings accounts hold money in a secure banking system rather than at home, they guarantee safety.

2. Non-negotiable certificate of deposit

Commercial banks and other institutions offer a variety of savings certificates known as certificates of deposit (CDs). 

These certificates are available for various maturities, with higher rates offered as maturity increases. Deposits may command higher rates, holding the maturity constant through issuing deposits of higher denomination.

3. Money market deposit accounts (MMDAs) 

Financial institutions offer money market deposit accounts (MMDAs) with no interest rate ceilings. However, money market accounts have a required minimum deposit to open, pay competitive money market rates, and are insured.

4. US government savings bond

The non-traded debt of the US government, savings bonds, is non-marketable, non-transferable, non-negotiable, and cannot be used for collateral. They are often purchased from the Treasury through banks and savings institutions.

5. Money Market Securities

Money markets include short-term, highly liquid, relatively low-risk debt instruments sold by governments, financial institutions, and corporations to investors with temporary excess funds to invest. This market is dominated by financial institutions and governments. 

The maturities of money market instruments range from one day to one year and are often less than 90 days.

While some of these instruments are negotiable and actively traded, others are not. Investment in these securities is generally made through money market mutual funds.

Note

We also need to acknowledge using the Treasury bill as a benchmark asset. Although there is no such thing as an entirely risk-free financial asset, the Treasury bill is considered relatively risk-free on a nominal basis.

Investors purchase Treasury bills at weekly auctions at a discount and redeem them at face value, thereby providing investors with their return. The discount yield is calculated as follows:

Dividend yield = (face value - purchase price) × 360 days / face value × maturity in days 

The discount yield understates the investor's actual yield because it uses a 360-day year and divides by the face value instead of the purchase price. The investment yield method can be used to correct these deficiencies.

Investment yield = (face value - purchase price) × 365 days / purchase price × maturity in days

Examples of Money Market Securities

Some of the money market securities are:

1. Treasury bills

The premier money market instrument and fully guaranteed with high liquidity.

2. Negotiable certificates of deposit (CDs)

The deposit is maintained in the bank until maturity, when the holder receives the deposit plus interest. 

However, these CDs are negotiable, meaning they can be sold in the open market before maturity. Dealers make a market in these unmatured CDs. 

Maturities typically range from 14 days (the minimum maturity permitted) to one year. The minimum deposit is $100,000.

3. Commercial paper

This is a short-term, unsecured promissory note issued by large, well-known, and financially strong corporations (including finance companies). Denominations start at $100,000, with a maturity of 270 days or less.

4. Eurodollars

These are dollar-denominated deposits held in foreign banks with maturities often less than six months. The eurodollar market is primarily a wholesale market, with large deposits and loans. 

5. Repurchase agreements (RPs)

These are agreements between a borrower and a lender to sell and repurchase US government securities. 

The borrower initiates an RP by contracting to sell securities to a lender and agreeing to repurchase these securities at a prespecified price on stated data. 

Note

The maturity of RPs is generally very short, from three to 14 days, and sometimes overnight. The minimum denomination is typically around $100,000.

6. Banker's acceptance

This is a time draft drawn on a bank by a customer, whereby the bank agrees to pay a particular amount at a specified future date.

The banker's acceptances are negotiable instruments because the holder can sell them for less than face value in the money market. 

They are normally used in international trade with a minimum denomination of $100,000. Maturities typically range from 30 to 180 days, with 90 days being the most common.

Fixed-Income Securities

Capital markets consist of fixed-income and equity securities with a maturity greater than one year.

Fixed-income securities have a determined payment on a specified date, known as the term bond. It also includes asset-backed securities issued against some assets linked with debt, such as credit card receivables or mortgages. 

These securities are attractive due to high yields and short maturity periods with investment-grade bond ratings.

Bonds are fixed-income securities, as the interest and principal payments are specified when the bond is issued and fixed for the life of a bond. They are long-term debt instruments with a fixed stream of cash flows to be received.

Zero coupon bonds are bonds with no interest or coupons but are issued at less than the par value and redeemed at par value on maturity. 

The difference between the two values is known as the effective interest rate. Issuers of these bonds are corporations, municipalities, government agencies, and the US treasury.

But “can the issuer redeem the bonds before maturity?”

The answer to yes. Issuers are given a right to call in security and retire it by paying off the obligation, called the call provision. This option is attractive when the market interest rate drops sufficiently below the coupon rate on the outstanding bonds.

Note

Bonds have different call features ranging from calling a short notice of 30 or 60 days to a “deferred call” feature.

A bond has ramifications. For example, failure to pay either interest or principal on a bond constitutes a default on obligations and may lead to bankruptcy.

Also, interest rates on fixed-income securities fluctuate widely over the years as inflationary expectations and demand and supply conditions for long-term funds change. 

Lastly, corporate bond rates may exceed Treasury rates because of the possible risk of default, causing lower-rated corporates to yield more than higher-rated bonds.

Types of Bonds

There are four major types of bonds based on the issuer involved (U.S. government, federal agency, municipal, and corporate bonds), and variations exist within each major type.

1. Federal government securities

The US government finances its operation through the treasury department, which issues numerous notes and bonds with maturities greater than one year. 

It is considered to have the safest credit risk because of its power to print money. Thus, investors do not consider the possibility of default.

Since 1997, the Treasury has sold Treasury Inflation-Indexed Securities (TIPS), which protects investors against losses resulting from inflation. 

Based on the consumer price index (CPI), the value of the bond is adjusted every six months by the amount of inflation.

Are TIPS a good bet? Many investors these days think so. 

Effectively, holding other things constant, TIPS yields 1.7 percentage points less than a comparable Treasury bond. Therefore, over the life of the bond, if inflation exceeds 1.7 percent a year, a TIPS bond will do better than the regular Treasury. 

2. Government agency's securities

The federal government has created various federal agencies to help some sectors of the economy through direct loans or guaranteed private loans. 

There are two types of federal credit agencies:

  • federal agencies and
  • federally sponsored credit agencies. 

Federal agencies are part of the federal government, and their securities are fully guaranteed by the Treasury. 

Federally sponsored credit agencies are privately owned institutions that sell their own securities in the marketplace to raise funds for their specific purposes. However, these securities are not guaranteed by the government as principal or interest. 

Note

From the investor’s standpoint, federal agency securities can be considered an alternative to US treasury securities.

3. Municipal Securities

Bonds sold by states, countries, cities, and other entities (e.g., airport authorities, school districts) other than the federal government and its agencies are called municipal bonds. 

Two basic types of municipalities are general obligation bonds, which are backed by the "full faith and credit" of the issuer, and revenue bonds, which are repaid from the revenues generated by the project they were sold to finance. 

Note

Most long-term municipalities are sold as serial bonds. A specified number of the original issue matures yearly until the final maturity date.

4. Corporate bonds

Most large corporations issue corporate bonds to help finance their operations. Corporate bonds are senior securities, meaning they are senior to any preferred stocks and the common stocks in terms of priority of payment in case of bankruptcy or corporate liquidation.

Equity Securities

Equity securities represent an ownership interest in a corporation. These securities provide a residual claim after paying all obligations to fixed-income claims. There are two types of equities: preferred stock and common stock.

1. Preferred stock

It is considered hybrid security because it resembles both equity and fixed-income instruments. 

Preferred stock resembles fixed-income securities as its dividend is fixed in amount. 

Preferred stockholders are paid after the bondholders but before the common stockholders in terms of priority of payment of income and in case the corporation is liquidated.

Preferred stock dividends are not legally binding but must be voted on each period by a corporation's board of directors. 

A large number of preferred stocks have dividend rates tied to market interest rates. The price fluctuations in these stocks are more than those in bonds.

Note

Corporations are the largest buyer of preferred because of a unique tax advantage. This is because 70% of their dividends are not taxed, resulting in an effective tax rate of only 10.2%.

2. Common stock

It represents the ownership interest of corporations. Institutions and individual investors buy a firm's shares to become part-owners. If a company goes public, it will sell common stock to the general public.

It depends primarily on the additional capital needed by the firm. A corporation may choose to be listed on one or more exchanges if it meets certain requirements. Otherwise, it will be listed in the over-the-counter exchange (OTC).

As an owner of the common stock, they are entitled to elect the corporation's directors and vote on major issues. Each owner can cast votes equal to the number of shares they own.

Note

Stockholders have limited liability, meaning they cannot lose more than their investment in their corporation.

Dividends are the only cash payment made to the stockholders regularly. Therefore, the dividend yield is the income component of a stock's return on a percentage basis. 

The payout ratio is the ratio of dividends to earnings. It indicates the percentage of a firm's earnings paid out in cash to its stockholders.

Derivative securities

A derivative is a product that does not have any value. Instead, it derives value from the following.

1. Future contract

These are organized contracts for quantity, delivery date, validity period, and delivery point traded on exchanges to help with secondary market trading. 

NYSE and NASDAQ provide the settlement guarantee for each trade to buy and sell commodities at a predetermined future date at the specified price. In addition, minimum price fluctuations (“tick”) may be fixed.

The buyers and sellers have to deposit some margin in the form of cash to ensure the honoring of the deal. 

In this market, profits and losses are calculated daily. If there is profit, one will receive it. On the other hand, if one loses money, one needs to pay for the exchange. 

Since both serve the same function and work through a contract between counterparties, one may wonder if future contracts are similar to forward contracts. 

Note

The difference is in terms of standardization (contract size) and method of operation (organized exchange trade). 

Futures contracts could be used to hedge risk. However, in forward contracts, the seller must deliver to the buyer on the due date, and the buyer will pay the seller the agreed price 

2. Options

It represents claims on an underlying common stock created by investors and sold to other investors. 

There are two types of options: call option and put option. Call option (option to buy) gives a holder a ‘right to buy’ an underlying asset by a certain date. Put option (option to sell) gives the holder a ‘right to sell’ an underlying asset.

An investor who writes a call option against stock held in his portfolio is said to be selling a covered option. An option sold without the stock to back it up is called a naked option. NYSE and NASDAQ guarantee performance. Thus, no risk of default.

Summary

Important investment alternatives for investors include:

  • Non-marketable assets
  • Money market instruments
  • Capital market securities (divided into fixed-income and equity securities)
  • Derivative securities
  • Indirect investments in the form of investment company shares

 Non-marketable financial assets, widely owned by investors, include:

  • Savings deposits
  • Non-negotiable certificates of deposit
  • Money market deposit accounts
  • U.S. savings bonds

Money market investments, characterized as short-term, highly liquid, and safe investments, include (but are not limited to):

  • Treasury bills
  • Negotiable certificates of deposit (C.D.s)
  • Commercial paper 
  • Eurodollars
  • Repurchase agreements
  • Banker's acceptances

Capital market investments have maturities of over one year. In addition, fixed-income securities, one of the two principal types of capital market securities, have a specified payment and repayment schedule. 

They include four types of bonds: the U.S. government, a federal agency, municipal, and corporate bonds. Equity securities consist of preferred stock and common stock (equity), which represent the ownership of a corporation.

Options allow buyers and sellers (writers) to speculate on or hedge the price movements of stocks for which these claims are available. Calls (puts) are multiple-month rights to purchase (sell) common stock at a specified price.

Futures contracts provide for the future exchange of a particular asset between a buyer and a seller. A recent innovation is options on futures.

Research and authored by Riya Choudhary Linkedin

Reviewed and Edited by Max Guan |  Linkedin 

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