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One of the difficulties that institutions have when investing in alternatives is getting a handle on their definition. Are hedge funds, private equity, credit derivatives and other alternatives a separate asset class or a subset of an existing one? Do they hedge the investment opportunity set or expand it?

In most cases, alternatives are a subset of an existing asset class. Although this may run contrary to the conventional view, I take the position that what many consider separate "classes" are really just different investment strategies within an existing asset class. Additionally, in most cases, alternatives expand the investment opportunity set rather than hedge it. Last, alternative assets are generally purchased in the private markets, outside of any exchange.

Alternative assets typically derive their value from either the debt or equity markets. Most hedge fund strategies, for example, involve the purchase and sale of equity or debt securities. Hedge fund managers may also invest in derivative instruments whose value emanates from the equity or debt markets. These managers do not hedge the stock market. Rather, they are unconstrained — often shorting securities as well as buying them — in trying to extract as much of an advantage as possible.

Next, consider private equity — specifically, leveraged buyouts. In the 1960s the modern LBO market was born, as financiers like KKR co-founder Jerome Kohlberg Jr. (then working for Bear, Stearns & Co.) began taking public companies private. In a typical LBO an investor makes a tender offer for the existing shares of a publicly held company. On completion of the offer, the equity of the company doesn’t disappear. It simply becomes more concentrated in the hands of the private equity manager and is no longer listed on an exchange.

Does the fact that a corporation whose stock once had been publicly traded but now is privately held mean that it has jumped into a new asset class? I maintain that it does not. Furthermore, after a private equity manager provides its value-enhancing services, one of the common exit strategies is a public offering — listing the company once again on an exchange. Within this context private equity can be considered just another point along the equity investment opportunity set. Specifically, private equity does not hedge the equity asset class as a separate class.

Another example is the credit derivatives market. The fixed-income world can be classified simply as a choice between U.S. Treasury securities that are considered to be default-free and spread products that contain an element of default risk. Spread products include any fixed-income investment that doesn’t have a credit rating on par with the government. Such products, which include corporate bonds and mortgage-backed securities, trade at a spread relative to Treasuries that reflects their default risk.

Credit derivatives are a way to diversify and expand the universe for investing in spread products. Historically, fixed-income managers attempted to establish their ideal credit-risk-and-return profile by buying and selling traditional bonds. However, the bond market can be inefficient, and it may be difficult to pinpoint a credit profile to match the risk profile of the investor. Credit derivatives help to plug the gaps in a fixed-income portfolio, accessing credit exposure in a potentially more efficient format.

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