Capital assets are defined by their claim on the future cash flows of an enterprise. They provide a source of ongoing value. As a result, capital assets may be valued based on the net present value of their expected returns.

Under the classic theory of Modigliani and Miller (1958), a corporation cannot change its value (in the absence of tax benefits) by changing the method of its financing. Modigliani and Miller demonstrated that the value of the firm is dependent on its cash flows. How those cash flows are divided up between shareholders and bondholders is irrelevant to firm value.

Capital assets, then, are distinguished not by their possession of physical assets, but rather, by their claim on the cash flows of an underlying enterprise. Hedge funds, private equity funds, credit derivatives, and corporate governance funds all fall within the super asset class of capital assets because the value of their funds are all determined by the present value of expected future cash flows from the securities in which they invest.

As a result, we can conclude that it is not the types of securities in which they invest that distinguishes hedge funds, private equity funds, credit derivatives, or corporate governance funds from traditional asset classes. Rather, it is the alternative investment strategies that they pursue that distinguishes them from traditional stock and bond investments.

Certain assets can be consumed as part of the production cycle. Consumable or transformable assets can be converted into another asset. Generally, this class of asset consists of the physical commodities: grains, metals, energy products, and livestock. These assets are used as economic inputs into the production cycle to produce other assets, such as automobiles, skyscrapers, new homes, and appliances.

These assets generally cannot be valued using a net present value analysis. For example, a pound of copper, by itself, does not yield an economic stream of revenues. Nor does it have much value for capital appreciation. However, the copper can be transformed into copper piping that is used in an office building or as part of the circuitry of an electronic appliance.

While consumable assets cannot produce a stream of cash flows, we demonstrate in our section on commodities that this asset class has excellent diversification properties for an investment portfolio. In fact, the lack of dependency on future cash flows to generate value is one of the reasons why commodities have important diversification potential vis-à-vis capital assets.

Art is considered the classic asset that stores value. It is not a capital asset because there are no cash flows associated with owning a painting or a sculpture. Consequently, art cannot be valued in a discounted cash flow analysis. It is also not an asset that is used as an economic input because it is a finished product.

Art requires ownership and possession. Its value can be realized only through its sale and transfer of possession. In the meantime, the owner retains the artwork with the expectation that it will yield a price at least equal to that which the owner paid for it.

There is no rational way to gauge whether the price of art will increase or decrease because its value is derived purely from the subjective (and private) visual enjoyment that the right of ownership conveys. Therefore, to an owner, art is a store of value. It neither conveys economic benefits nor is used as an economic input, but retains the value paid for it.

Gold and precious metals are another example of a store-of-value asset. In the emerging parts of the world, gold and silver are a significant means of maintaining wealth. In these countries, residents do not have access to the same range of financial products that are available to residents of more developed nations. Consequently, they accumulate their wealth through a tangible asset as opposed to a capital asset.

However, the lines between the three super classes of assets can become blurred. For example, gold can be leased to jewelry and other metal manufacturers. Jewelry makers lease gold during periods of seasonal demand, expecting to purchase the gold on the open market and return it to the lessor before the lease term ends. The gold lease provides a stream of cash flows that can be valued using net present value analysis.

Precious metals can also be used as a transformable/consumable asset because they have the highest level of thermal and electrical conductivity among the metals. Silver, for example, is used in the circuitry for most telephones and light switches. Gold is used in the circuitry for televisions, cars, airplanes, computers, and rock-etships.

We provide a brief digression to consider where real estate belongs in our classification scheme. Real estate is a distinct asset class, but is it an alternative one? For purposes of this book, we do not consider real estate to be an alternative asset class. The reasons are several.

First, real estate was an asset class long before stocks and bonds became the investment of choice. In fact, in times past, land was the single most important asset class. Kings, queens, lords, and nobles measured their wealth by the amount of property that they owned. "Land barons" were aptly named. Ownership of land was reserved only for the most wealthy of society.

However, over the past 200 years, our economic society changed from one based on the ownership of property to the ownership of legal entities. This transformation occurred as society moved from the agricultural age to the industrial age. Production of goods and services became the new source of wealth and power.

Stocks and bonds were born to support the financing needs of new enterprises that manufactured material goods and services. In fact, stocks and bonds became the "alternatives" to real estate instead of vice versa. With the advent of stock-and-bond exchanges, and the general acceptance of owning equity or debt stakes in companies, it is sometimes forgotten that real estate was the original and primary asset class of society.

In fact, it was only 25 years ago in the United States that real estate was the major asset class of most individual investors. This exposure was the result of owning a primary residence. It was not until the long bull market started in 1983 that investors began to diversify their wealth into the "alternative" assets of stocks and bonds.

Second, given the long-term presence of real estate as an asset class, several treatises have been written concerning its valuation. Finally, we do not consider real estate to be an alternative asset class as much as we consider it to be an additional asset class. Real estate is not an alternative to stocks and bonds—it is a fundamental asset class that should be included within every diversified portfolio. The alternative assets that we consider in this book are meant to diversify the stock-and-bond holdings within a portfolio context.

Initially, asset allocation involved four asset classes: equity, fixed income, cash, and real estate. Within each class, the assets could be further divided into subclasses. For example, stocks can be divided into large capitalized stocks, small-capitalized stocks, and foreign stocks. Similarly, fixed income can be broken down into U.S. Treasury notes and bonds, investment-grade bonds, high-yield bonds, and sovereign bonds.

The expansion of newly defined "alternative assets" may cause investors to become confused about their diversification properties and how they fit into an overall diversified portfolio. Investors need to understand the background of asset allocation as a concept for improving return while reducing risk.

For example, in the 1980s the biggest private equity game was taking public companies private. Does the fact that a corporation that once had publicly traded stock but now has privately traded stock mean that it has jumped into a new asset class? Furthermore, public offerings are the primary exit strategy for private equity; public ownership begins where private equity ends (see Horvitz, 2000). Therefore, it might be argued that private equity is just an extension of the equity markets where the dividing boundary is based on liquidity.

Similarly, credit derivatives expand the fixed income asset class, rather than hedge it. Hedge funds also invest in the stock-and-bond markets but pursue trading strategies very different from a traditional buy-and-hold strategy. Commodities fall into a different class of assets than equity, fixed income, or cash, and will be treated separately in this book.

Finally, corporate governance is a strategy for investing in public companies. It seems the least likely to be an alternative investment strategy. However, it can be demonstrated that a corporate governance program bears many of the same characteristics as other alternative investment strategies (see Anson, 2006).

Alternative assets should be used in a tactical rather than strategic allocation. Strategic allocation of resources is applied to fundamental asset classes such as equity, fixed income, cash, and real estate. These are the basic asset classes that must be held within a diversified portfolio.

Strategic asset allocation is concerned with the long-term asset mix. The strategic mix of assets is designed to accomplish a long-term goal such as funding pension benefits or matching long-term liabilities. Risk aversion is considered when deciding the strategic asset allocation, but current market conditions are not. In general, policy targets are set for strategic asset classes, with allowable ranges around those targets. Allowable ranges are established to allow flexibility in the management of the investment portfolio.

Tactical asset allocation is short term in nature. This strategy is used to take advantage of current market conditions that may be more favorable to one asset class over another. The goal of funding long-term liabilities has been satisfied by the target ranges established by the strategic asset allocation. The goal of tactical asset allocation is to maximize return.

Tactical allocation of resources depends on the ability to diversify within an asset class. This is where alternative assets have the greatest ability to add value. Their purpose is not to hedge the fundamental asset classes, but rather to expand them. Consequently alternative assets should be considered as part of a broader asset class.

An example is credit derivatives. These are investments that expand the frontier of credit risk investing. 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 does not have a credit rating on par with the U.S. government. Consequently, spread products trade at a credit spread relative to U.S. Treasury securities that reflects their risk of default.

Credit derivatives are a way to diversify and expand the universe for investing in spread products. Traditionally, 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 the exact credit profile to match the risk profile of the investor. Credit derivatives can help to plug the gaps in a fixed income portfolio, and expand the fixed income universe by accessing credit exposure in more efficient formats.

Another way to distinguish alternative asset classes is based on the efficiency of the market place. The U.S. public stock-and-bond markets are generally considered to be the most efficient marketplaces in the world. Often, these markets are referred to as "semi-strong efficient." This means that all publicly available information regarding a publicly traded corporation, both past information and present, is fully digested in that company's traded securities.

Yet inefficiencies exist in all markets, both public and private. If there were no informational inefficiencies in the public equity market, there would be no case for active management. Nonetheless, whatever inefficiencies do exist, they are small and fleeting. The reason is that information is easy to acquire and disseminate in the publicly traded securities markets. Top-quartile active managers in the public equity market earn excess returns (over their benchmarks) of approximately 1 % a year.

In contrast, with respect to alternative assets, information is very difficult to acquire. Most alternative assets (with the exception of commodities) are privately traded. This includes private equity, hedge funds, and credit derivatives. The difference between top-quartile and bottom-quartile performance in private equity can be as much as 25%.

Consider venture capital, one subset of the private equity market. Investments in start-up companies require intense research into the product niche the company intends to fulfill, the background of the management of the company, projections about future cash flows, exit strategies, potential competition, beta testing schedules, and so forth. This information is not readily available to the investing public. It is time consuming and expensive to accumulate. Furthermore, most investors do not have the time or the talent to acquire and filter through the rough data regarding a private company. One reason why alternative asset managers charge large management and incentive fees is to recoup the cost of information collection.

This leads to another distinguishing factor between alternative investments and the traditional asset classes: the investment intermediary. Continuing with our venture capital example, most investments in venture capital are made through limited partnerships, limited liability companies, or special-purpose vehicles. It is estimated that 80% of all private equity investments in the United States are funneled through a financial intermediary.

Investments in alternative assets are less liquid than their public market counterparts. Investments are closely held and liquidity is minimal. Furthermore, without a publicly traded security, the value of private securities cannot be determined by market trading. The value of the private securities must be estimated by book value or appraisal, or determined by a cash flow model.

During the great bull market from 1981 to 2000 the asset management industry only had to invest in the stock market to enjoy consistent, high, double-digit returns. During this heyday, investment management shops and institutional investors divided their assets between the traditional asset classes of stocks and bonds. As the markets turned sour at the beginning of the new millennium, asset management firms and institutional investors found themselves "boxed in" by these traditional asset class distinctions. They found that their investment teams were organized along traditional asset class lines, and their investment portfolios were constrained by efficient benchmarks that reflected this "asset box" approach.

Consequently, traditional asset management shops have been slow to reorganize their investment structures. This has allowed hedge funds and other alternative investment vehicles to flourish because they are not bounded by traditional asset class lines—they can invest outside the benchmark. These alternative assets are free to exploit the investment opportunities that fall in between the traditional benchmark boxes. The lack of constraints allows alternative asset managers a degree of freedom that is not allowed the traditional asset class shops. Furthermore, traditional asset management shops remain caught up in an organizational structure that is bounded by traditional asset class lines. This provides another constraint because it inhibits the flow of information and investment ideas across the organization.

One of the first and best papers on hedge funds by Fung and Hsieh (1997) shows a distinct difference in how mutual funds and hedge funds operate. They show that the economic exposure associated with mutual funds is defined primarily by where the mutual fund invests. In other words, mutual funds gain their primary economic and risk exposures by the location of the asset classes in which they invest. Thus, we get large-cap active equity funds, small-cap growth funds, Treasury bond funds, and the like.

Conversely, Fung and Hsieh show that hedge funds' economic exposures are defined more by how they trade. That is, a hedge fund's risk and return exposure is defined more by a trading strategy within an asset class than it is defined by the location of the asset class. As a result, hedge fund managers tend to have much greater turnover in their portfolios than mutual funds.

Strategic asset allocation (SAA) revolves around the most efficient combination of stocks, bonds, and other asset classes to achieve the best return and risk trade-off. This is the concept behind charting the efficient frontier—the most efficient trade-off between risk and return given a mix of asset classes. In this sense, SAA is all about capturing the systematic risk premiums that exist for investing in different asset classes. However, if additional asset classes can be added to the mix, the efficient frontier can be "pushed out" to provide a greater range of risk and return opportunities for an investor.

This is another way to consider alternative assets—as an alternative source of beta that is different from the traditional mixture of stocks and bonds. Access to alternative assets can provide new systematic risk premiums that are distinctly different than that obtained from stocks and bonds. Commodities are a good example—they provide a different risk exposure than the stocks or bonds. Consequently, the risk premium associated with commodities is less than perfectly correlated with the traditional financial markets. This is a form of "alternative beta." Investing in alternative assets does not have to focus exclusively on the quest for excess returns; it can also look at the diversification properties of alternative assets when blended with a traditional portfolio of stocks and bonds. Alternative beta can be a form of added value through diversification properties instead of a desire for excess return.

Related to the idea of trading strategy versus investment location is the notion of risk premiums. You cannot earn a return without incurring risk. Traditional investment managers earn risk premiums for investing in the large-cap value equity market, small-cap growth equity market, high-yield bond market—in other words, based on the location of the asset markets in which they invest.

Conversely, alternative asset managers also earn returns for taking risk, but the risk is defined more by a trading strategy than it is an economic exposure associated with the systematic risk contained within broad financial classes. For example, hedge fund strategies such as convertible arbitrage, statistical arbitrage, and equity market neutral can earn a "complexity" risk premium (see Jaeger, 2002).

These strategies buy and sell similar securities expecting the securities to converge in value overtime. The complexity of implementing these strategies results in inefficient pricing in the market. Additionally, many investors are constrained by the long-only constraint—their inability to short securities. This perpetuates inefficient pricing in the marketplace which enables hedge funds to earn a return.