Alternative investments are those investments that are different from traditional investments (like equity, bonds, and cash), and some of them are their subset. For example, many hedge funds use strategies whose underlying is either equity or bond-like shorting the stock.
The first ‘alternative investments’ made in infrastructure: The Transcontinental Railroad in 1852.
The different types of alternative investments are —
- Private Equity/debt.
- Venture Capital.
- Hedge Funds.
- Real Estates.
- Commodities/Natural Resources.
- Structured products.
Who are the participants of alternative investments?
Alternative investment strategies have become more accessible to an individual or retail investors due to an increase in more liquid and tax-friendly alternative investment structures, such as REITs (real estate investment trusts) and MLPs (master limited partnerships), which can be easily accessed via ETFs (exchange-traded funds), actively-managed mutual funds or closed-end funds. Also due to advancements in technology and easy access to margins in the portfolio.
How have alternative investments have involved over the year?
The popularity of alternatives has surged in the years following the 2008 financial crisis.
The research by Preqin reveals that the alternatives industry will hold 17.16 trillion dollars by the end of 2025. Private equity and private debt will be the biggest drivers of growth, respectively increasing their assets by 16% and 11% annually. Asia-Pacific will be a key driver of global growth with assets under management increasing by 25%, but North America will still hold half of the total global alternatives
It is expected that Alternative Assets under Management will increase at the CAGR of 9.8% by Preqin.
Why there is a shift in investing in alternative investments?
- Lower Interest Rates — Before 2008, an asset allocation of 60/40 in equity and bonds was preferred. But the Global Financial Crisis (GFC) changed the allocation picture due to lower or negative yields from the bonds. To date, the yield from bonds doesn’t look good. So, people looked upon different avenues of investment to diversify and increase the return of their portfolios.
- Equities remain expensive, and forecasted future returns look less appealing. — If we see the current metrics, the stock market around the is expensive. For example, all three major stock indices are at record highs, and the S&P 500’s P/E ratio, is well above historical averages. Another popular metric known as the “Buffett Indicator,” measured as the total market cap of U.S. stocks divided by GDP, is also at an all-time high.
- Technology — Earlier only institutional investors and ultra-high net worth individuals had access to the alternative investments due to a combination of high investment thresholds, a lack of transparency, and the high degree of specialized knowledge required to understand and value investment opportunities. Now, technology-enabled platforms are giving individual investors access to the kinds of alternative investments that were previously only available to a select few.
Also, lets see the advantages of investing in alternatives that attract investors-
- They are less regulated than the other financial products like mutual funds, ETFs, public equities, or debt, which gives investors to hedge the investment from market volatility.
- It increases a portfolio’s diversification.
- Better risk-adjusted returns than traditional assets.
- It can benefit the overall portfolio risk/return profile by producing returns that may exhibit a low correlation (Correlation refers to the degree to which investments fluctuate relative to one other. Positively correlated assets move in the same direction) with traditional assets.
- Statistically speaking, alternatives often have much lower down-market capture ratios (a measure of an investment manager’s overall performance in down markets) than traditional asset classes, meaning they often produce better returns when markets are declining.
The advantages to the investment management companies —
- It gives the portfolio manager higher flexibility to use derivatives and leverage, make investments in illiquid assets, and take short positions.
- The PMs usually charge higher management and incentive fees as these funds are usually managed actively. Earlier it was 2% management fees (which should be paid by an investor irrespective of fund’s performance) and 20% incentive fees (when funds outperform), but now the industry’s average is moving towards 1.5% and 10% due to increase competition.
What should be the allocation of alternative investments in your portfolio?
Before adding alternative assets, consider what else you have in your portfolio, whether you already have enough diversification in traditional assets and whether the alternative assets you are thinking of adding will do different things to your existing holdings.
Exposure to alternative assets depends on various factors like an individual’s risk appetite, investment time horizon, age, and the purpose of the pot of money invested. If an investor wants a safe and guaranteed return then alternative assets are not for them. If you are investing to make quick money, then alternatives shouldn’t be your preference.
Points to remember before investing in alternatives —
- Always start with investing in broad funds rather than niche funds, like choose funds which have some proportion of categories of alternatives which I mentioned above.
- As alternative markets are not as efficient as equity/bond, always do a thorough analysis before investing in alternatives. It is important to understand the nature of these assets, how they work, and what are the risk and returns profile of that asset. How those assets are correlated to your other traditional assets (like alternatives include niche areas of equity markets. These are less likely to be good diversifiers to portfolios of mainstream equities as they could move in line with the broader market)
TL;DR — Alternatives bring a higher return, income, and diversification to the traditional asset portfolio, but come with higher risk so the investor should do their independent due diligence before investing.