Glossary

For a fund to be considered as an alternative investment fund, it does not have to meet specific criteria, except that it does not meet the requirements of conventional funds. This means that it is not an undertaking for collective investment in transferable securities (UCITS).

Alternative investment funds

ORGANIZATION FOR COMMON INVESTMENTS IN SECURITIES

Only one fund is considered to be a fund which complies with UCITS guidelines. This Directive, which was reformed by the EU in 2008, includes, among other things, the types of securities and shares authorized. In addition, funds covered by the Directive are obliged to issue sales prospectuses in which their offer is presented and publish at least three reports (two half-yearly reports, one annual report) annually. Furthermore, an undertaking for collective investment in securities requires the approval of the respective financial supervisory authority, for example the Federal Financial Supervisory Authority (BaFin) in Germany. Through the EU-wide standardization, the fund is easier to handle international transactions. After approval in one of the member countries, the fund may be offered anywhere in the European Union.

ALTERNATIVE INVESTMENT FUNDS – EXAMPLES

There is a large amount of different AIF. These are usually closed funds, which are only open to a certain number of investors and often only pursue a project.

Closed property fund

A closed real estate fund is the best example for alternative investment funds: Investors buy real estate in a project, such as building a property. At the time the fund is launched, construction has often not begun. It begins then during the collection of the capital of the investors, which is supplemented by credits. When the property is completed, the property is sold and the proceeds are distributed among the shareholders according to the size of the shareholding. Such funds involve risks, since the shares are difficult to sell and diversification is not possible since the capital is concentrated in a closed fund on a single project. If the sale of shares does not occur in a timely manner, delays can occur, which can have fatal consequences because short-term loans may have to be used.

Aviation Fund

The principle of aircraft funds is quite similar to the closed real estate fund: the number of investors is limited and the issuer does not withdraw the shares. However, it is rather unusual for aircraft funds to be sold immediately after completion of the aircraft. Rather, a return is achieved by using the finished aircraft economically. In most cases, it is leased by airlines. In the case of closed aircraft funds, the aircraft is finally sold after a period of use of five, ten, or fifteen years.

Microfinance fund

Microfinance funds, just as environmental funds, can be created for various reasons. On the one hand, there are those who are based on development policy interests to boost the economy in a particular country, for example. On the other hand, there are those which are created from a purely commercial interest. And, last but not least, those in which both approaches are represented. Microfinance funds invest in microfinance credit institutions, which, as the name implies, allocate micro credits. These are generally at a value of less than 100 US dollars. There are several ways for the fund to invest in microfinance institutions, by giving loans to them, or by investing directly in the capital, and thus also have prospects for profit sharing.

In addition to the above-mentioned investment funds, energy funds, mezzanine funds, private equity and venture capital funds, hedge funds and commodity funds also belong to the category of alternative investment funds.

AIFM – DIRECTIVE ON THE MANAGEMENT OF AIF

As alternative investment funds have not been subject to regulation by financial authorities so far, the European Parliament passed 2010 directives for the managers of such alternative investment funds. Before 2013, the Investmentgesetz regulated the handling of closed-end funds, since 22 July 2013 the German Investment Act (KAGB) has fulfilled this task.

Since the entry into force of the AIFM guidelines, the managers, ie the representatives of the respective capital management company, have been regulated much more strictly in the European Union and can be held liable in certain cases, similar to the managing director of a GmbH. The purpose of the regulations was to protect investors more strongly and ensure greater regulation of the so-called “gray capital market”, ie the legal but not regulated market.

Alternative investments are innovative investment products. These are characterized by increased yield potential and complexity.

Why are Alternative Investments Trendy?

Investors have been looking for profit and suitable investments for years. Are there alternatives to low interest rates? This approach is followed by the definition of alternative investments: these are investments which differ significantly from traditional, conventional money investments such as funds and easy-to-use financial assets such as shares, bonds or real estate. However, there is no uniform definition for this.
What are alternative investments?

They are not a separate asset class, but innovative investment products. These are characterized by exceptional potential for return on investment, complexity, a complex performance analysis and risk measurement as well as the use of leverage products and derivative financial instruments. These bonds are associated with less transparency and low liquidity. Nevertheless, they are well suited to optimize the return on a portfolio with a given risk structure. In addition, the risk can be reduced with the same returns. They are an excellent instrument for portfolio allocation and can significantly improve their risk / return ratio. Alternative investments have the advantage that they are hardly correlated with conventional investment forms and thus enable better diversification. This includes the following investments: the Federal Association of Alternative Investments (BAI):

Hedge funds
Private equity
Real Estate
Infrastructure projects such as transport, transport, water, health, mobile radio, educational facilities, renewable energies
Commodities / commodities such as precious metals, industrial metals, oil, gas, agricultural raw materials
Other alternative investments such as art, antiques, forest, wine.

What is behind the investment?

Hedge funds are actively managed investment funds, which invest in traditional asset classes, but use unconventional, divergent and highly complex investment strategies to achieve their return on investment. They use leverage for investment and trading purposes. Hedge funds use market incentives and price differences as well as event-related strategies and microanalyses for yield maximization.

For example, hedge funds speculate on falling stock markets by borrowing shares from index funds in order to return them at a later date more favorably. This category also includes managed futures / CTAs. Managed futures are special hedge fund investment instruments that, like the US commodity trading advisors, invest as regulated asset managers exclusively in futures markets such as futures and options.

Private equity means that equity is provided by investors over the counter. In contrast to equity capital, this form of investment cannot be offered and sought in a regulated market such as the stock exchange. The reason is that the companies are not listed on the stock exchange.

The investor often buys the company shares with a high quota of borrowed capital, for example bank loans or bond issues, or with the aid of private equity funds. The aim is to achieve future high distributions or a considerable return through the subsequent sale of the company’s participation. Capital is invested in company formation, in the growth phase, during turnaround or takeover. In start-ups, private equity is referred to as venture capital because of the higher risk.

The real estate sector invests directly or indirectly in real estate in order to generate a financial return. In the meantime, there are numerous forms of alternative real estate investments, such as closed funds and special real estate funds. These, in turn, invest in real estate or in shares of real estate companies and REITs. REITs are corporations that generate profits from the leasing, leasing and sale of real estate and land. Alternative investments include crowding investment for real estate, which allows attractive yields to be realized in the short term by property developers.

However, REITs might conceive significant risks and very high fees for the investors. If you are interested please read our part of the glossary Why not REIT.

How are Alternative Investments Developed?

Alternative investments are no longer the domain of institutional investors, they are increasingly interested in private investors and small investors. Current customers, for example, can participate in life and annuity insurance. As the promised guarantees are more difficult to generate due to the long-term low-interest phase, the insurance companies are increasingly investing in infrastructure investments and real estate. The high growth of investments in alternative investments in the last decade is undisputed. In 2005, assets invested in Alternative Investments were $ 3.2 trillion worldwide, while in 2013 it was $ 7.9 trillion. With steady growth, around 15.3 trillion dollars of assets under management will be invested in alternative investments in 2020, according to PwC, the auditing firm. Approximately 14 percent of the total assets under management will then be invested in alternative investments.

Secure paper no longer raises positive returns, investors need to take risks for higher profitability. The zero interest rate policy of the ECB has led to negative interest rates for investors in government bonds and savings banks. This results in plant pressure, which gradually opens up new investment forms with lucrative returns. In addition, equity investments are subject to high volatility and uncertainty about future price developments. Thus, it is not an option for all investors. Furthermore, the close interweaving of the global markets has the effect that the development of the value of classical money investments is temporarily similar. This makes the optimal diversification of a portfolio considerably more difficult.

For private investors, the regulatory measures since 2010 have created better conditions for making investments in alternative investments. Thus, the establishment of the crowdfunding industry allowed small investors to acquire selected investments. Investments in high-yield properties do not require a large fortune to participate directly in the profits, thanks to crowding. By collecting many small amounts through a Crowdinvesting platform, attractive objects can be funded jointly. This allows small investors not only to avoid the negative interest, but also to divide their money intelligently. They thus have different investments which are not related to the development of traditional financial investments. These can more effectively protect against high losses in periods of crisis.

What is a REIT?

If you haven’t heard of REITs, they are companies that manage portfolios of direct real estate for you. For that convenience, they charge a fee. Instead of having to learn about real estate (like you’re doing right now), a professional manager does it for you.

In addition, one type of REIT (publicly listed REIT) trades on public exchanges. This means you can move your money in and out at any time. In the previous article we discussed one of the main disadvantages of direct real estate is its lack of liquidity. Publicly listed REITs don’t have this limitation, which is a strong advantage if you have an emergency and need the funds quickly.

So on the surface, it seems like a REIT is the perfect way to invest in real estate. However, if you look deeper, you’ll see many limitations, that make REITs unsuitable as a core real estate investment vehicle, for most investors.

What can go wrong with a REIT?

There are three different types of REITs, and each has its own unique limitations when compared to direct real estate investment.

Investing in private REITs is like dating your dream celebrity of choice. On paper, it’s everything you could possibly want. In reality, they’re unlikely to let you do it.

Nonlisted REITs have exorbitant fees, a track record of extremely poor performance, and FINRA warnings about Ponzi schemes resulting in “zombie REITs”.

Publicly listed REITs may have a place in your real estate portfolio. But due to key limitations, they are rarely an ideal core investment.

Here’s the details…

Private REITs: The celebrity you’ll never date.

Private REITs are nonpublic, and are not traded on the stock exchange.

Many novice investors and inexperienced advisors confuse them with nonlisted REITs (which are completely different, and we’ll talk about next).

The top private REITs have billions/trillions of dollars in assets. Due to their massive economies of scale, their management fees are amazingly low (for an investment requiring such active management): often around 1%.   They have no load fees nor broker fees. And the top private REITs don’t just try to match their benchmark index (NPI or NFI-ODCE). They make up the index.

With their perfect trifecta of low fees, economies of scale and world-class managers, investing in a private REIT is the real estate equivalent of dating your favorite celebrity.

Unfortunately, just like your favorite celebrity, your odds of being accepted by them are extremely slim. Most won’t accept money from individuals, and deal exclusively with billion-dollar institutions and pension funds. The few that will, require minimum investments of $5 million.

This makes them a non-option for most investors

Nonlisted REITs: Broker’s dream/investor’s nightmare

Nonlisted REITs (also called nontraded REITs) are also nonpublic, and also not traded on the stock exchange. Unlike private REITs, they are known for exorbitant fees (annual fees, load fees, broker fees), and poor returns.

Front end fees can be as painfully high as 15%. Brokers take an additional pound of flesh as high as 10%. And yearly management fees are often exorbitant as well.

Since they pay such high commissions, brokers recommended over $20 billion of these to unsuspecting clients, between 2009 and 2013 alone. Many nonlisted REITs lured in investors with rates higher than they could afford to pay. Ultimately, many investors lost money.  And worse, as the Wall Street Journal described in 2015 in their article “Property Investors’ Latest Horror: Zombie REITs”: a significant number still haven’t gotten their money back, and don’t know if and when they ever will.

So many nonlisted REITs have gone zombie, that FINRA (the Financial Industry Regulatory Authority) issued a warning about them:

“Furthermore, the periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal”

This is exactly how Bernie Madoff operated his Ponzi scheme.

Nonlisted REITs are excellent moneymakers for your broker and the fund itself. In my opinion, they are a completely unsuitable investment for any  investor that has any other options.

Publicly listed REITs

Publicly listed REITs trade on the stock exchange. As a result, you can cash in and cash out of your investment at any time. This is a significant advantage over the other types of REITs, and direct real estate investment. All of these require you to lock up your money for some period of time.

But this liquidity comes at a cost: volatility, loss of diversification protection and liquidity premium. As a result, public REITs can be useful, but usually not as a core investment.