Alternative investments encompass a broad spectrum of non-traditional investment strategies that include both hedge funds and private equity.

HEDGE FUNDS
Hedge funds' edge over traditional retail investments and mutual funds stems from their opportunistic nature. Hedge fund managers can use leverage, sell securities short, take large positions, invest across asset classes and security types, and generally work in areas not populated by the herd. Many managers employ strategies whose returns are largely insulated from the vagaries of market movements. Historically, returns from alternative investments have had little correlation with traditional investment strategies or markets.

In formulating an asset allocation strategy the private investor must first determine the role alternative investments should play in the overall investment program. Defining the investor's objectives in terms of return requirements and risk tolerance is critical. By evaluating the investor's personal situation with regard to these factors, one can customize the investment program to meet the specific needs of that investor. While some families allocate all of their "marketable securities" investments to hedge funds, it is more common for alternative investments to comprise, at a minimum, 10-20 percent of one's asset allocation.

The limited partnership structure of most hedge funds provides investment flexibility, but also poses significant challenges to the due diligence process. It is crucial for family office professionals to develop the tools necessary for evaluating funds based upon their investment strategies, personnel, and general business plans. If the family office chooses not to develop the expertise in-house, engaging an alternative investment professional should be considered the price of entry of these investments.

Sophisticated computer programs are frequently used in the manager evaluation process. Analysis of the returns provides data that are used to compare various strategies and managers based on risk/return measures. However, it is not advisable to use quantitative analysis as a crutch in place of sound qualitative analysis. The simplicity of transforming art into science provides investors with a false sense of security. Further, the utility of statistical analysis is completely dependent upon the extrapolation of trends. Relying solely on this type of analysis is not prudent. Understanding the strategy and the people employing it are of far greater value when assessing the investment risk involved.

Operating one's own investment pool of alternative managers can be problematic as most families lack sufficient resources, expertise, and/or stamina to stay the course. For many investors, once the decision to hire the managers is made, little attention is paid to ongoing due diligence. Simply tracking the manager's performance is not sufficient. The importance of maintaining regular contact with the managers, as well as their peers, competitors, service providers, brokers and other investors should not be underestimated. A commitment to information gathering will better position the family office to monitor managers' exposures, leverage, and diversification.

Unlike traditional investments, Hedge Funds require a distinct due diligence process that must be undertaken by market professionals. It is the combination of these elements that should enable families to articulate their investment directives into a successful alternative investment program. Only through keen product differentiation are families able to establish realistic investment expectations.

PRIVATE EQUITY
The importance of private equity as a source of funds for companies that either cannot or do not wish to raise capital in the public market has increased steadily in recent years. The explosive growth of the private equity market translates into increased opportunities for investors and greater access to capital for companies.

Despite its growth, private equity has received relatively little attention from press and academic circles. The availability of information regarding private equity is still limited. However, investors can benefit from arbitrage opportunities between private and public markets. Private equity has historically been a venue for higher rates of return than other asset classes.

The highest returns came to those partnerships formed during periods when little capital was raised. This relationship is intuitively correct under the principles of supply and demand. When little capital is available, funds become more expensive. Companies are forced to give up higher ownership percentages. At the same time limited partnerships can be more selective in choosing portfolio companies, thereby making better investments.

Higher levels of commitments are triggered by favorable exit conditions. Hot IPO market and copious mergers/acquisitions provide high valuation and liquidity to private equity investors. The hot IPO markets of 1991-93 produced high returns on private equity investments. This, in turn, sparked a record number of commitments in 1994. This high level of commitments introduces new uncertainties to the private equity market. The U.S. private equity market has recently been deluged with investor capital; effectively there are more players with more capital chasing a fixed number of deals. As the U.S. becomes saturated with capital, investors seeking superior rates of return and the diversification benefits of private equity must look to international and emerging markets.

The supply of capital in Europe remains limited. Since European public stock markets are still underdeveloped, most companies must turn to private equity. Opportunities for high rates of return are especially abundant in formerly communist countries since the living standards and wage levels remain relatively low. This allows companies to begin operations at lower costs. Investments in these areas may be better served than investments in high-wage countries such as Germany and Switzerland. Potential rewards are, however, always associated with risks. Many governments are struggling to entice foreign investment and offer attractive incentives, but investors must be wary.

The economies of emerging markets are generating significant interest as growth rates uniformly outpace Western countries. Latin Americans and Asians are demanding more consumer goods as living standards improve. The benefits of Latin America's comprehensive economic and political reforms can now be reaped. The continent offers many of the same opportunities as Europe with continually improving fundamentals, falling inflation rates, and rising foreign investment. Infrastructures have been modernized while wages remain low. Africa is currently steering away from command economies and toward capitalism. This shift will open new doors for foreign investment. Private equity allows investors to purchase securities at low price/earnings ratios; typically 2 to 5 percent. Privately negotiated deals offer the most compelling opportunities to access the emerging parts of the world.

The same factors that influence private equity returns in the U.S., do so globally. Investors should, therefore, focus on markets with a capital deficit. Today, Europe is the obvious choice for international private equity investments. The continent lacks capital, much as the U.S. did in the 70s. The European private equity market could, therefore, parallel the development of its U.S. counterpart. With proper due diligence by industry experts, private equity investors in Europe can expect to see the spectacular returns associated with lacking capital and hot IPOs. Best of all, these returns have a low correlation to traditional assets. Private equity, namely international private equity, is an important addition to a global, diversified portfolio.

James Hedges is managing director of LJH Global Investments, Inc., an alternative investment consulting firm based in Naples, Florida, advising $1.2 billion of non-traditional investments for high net worth investors and families.