Alternatives 101 – Part 2

TYPES OF ALTERNATIVE INVESTMENTS

There tends to be a wide disparity in availability across different alternative investments. Some alternatives are exclusive to high net worth individuals and institutional investors, such as hedge funds and private equity funds, while others are more widely available to retail investors such as real estate, gold, and cryptocurrencies. Other alternative investments are somewhat esoteric, including fine art and derivative contracts.

While there is an endless list of alternative investment options, we will discuss 4 of the more common options in more detail.

PRIVATE EQUITY

A private equity investment is a type of Alternative Investment whereby Individuals own a portion of a company that is not publicly owned, quoted, or traded on a stock exchange. Private equity investment strategies range from venture capital investments to leveraged buy-outs.

By its very nature, private equity possesses distinct characteristics that set it apart from public equity.

ADVANTAGES

Diversification

The factors that drive returns in public equity markets have little impact on private equity, enhancing private equity’s diversification potential.

Long-Term Focus

Private ownership enables long-term strategic focus as opposed to the public market’s obsession with quarterly earnings. This “patient” perspective has the potential to generate significant returns for private equity investors.

The availability of private capital and the burden of regulation within public markets has resulted in billion-dollar private companies staying private for longer.

The number of publicly listed U.S. companies has been cut in half from a peak of over 8,000 in 1996. This trend has resulted in a larger portion of the growth phase of a company taking place prior to going public, which has functioned to increase demand and interest within the private equity sector over time.

Attractive Returns

Private equity has exhibited attractive performance on both a risk-adjusted and an absolute basis.

The illiquidity premium in private equity has produced an additional 4%-6% per year over public equity markets.

DISADVANTAGES

Despite the recent growth within the Private Equity space. This asset class will not be suitable for everyone.

Initial Negative Cashflow

Private Equity can offer tremendous capital appreciation long-term but typically offers little to no cash flow for the first 2-7 years given the initial capital-intensive growth phase of many of these private companies.

Private Equity Fund – Cash Flow Model

Illiquidity

Many Private equity investments can have a lock-up period of 6-8 years. Investors are not allowed to redeem or sell shares during this time. Once this lock-up period has passed, the redemption windows will typically be quarterly compared to the daily liquidity in public markets.

No Direct Investments for Retail Investors

Direct investments into these private companies are typically exclusive to Institutional investors or high net worth individuals. A retail investor looking to invest in private equity can invest through a private equity firm. These firms will raise investor capital and invest on their behalf in private companies that show great promise and potential.

As access to private funding increases, companies will continue to pursue their business objectives without the costs and distractions associated with operating in the public spotlight. More than ever before, the rapid growth companies experience, and the value created by that growth is occurring before IPO, creating ample opportunity within the private equity space.

REAL ESTATE

We all know what real estate is! It’s a house, an apartment building, an undeveloped acre of land.

Real estate investing is purchasing property to generate income rather than using a property as a place of residence. There are several types of real estate investments, but most fall into two categories: Direct investments where you physically own the property or indirect investments such as REITs where physical ownership of the property is not required.

Direct Ownership

You can achieve this by investing directly into a property to earn rental income. The tangible and familiar nature of direct real estate investing has made it a popular choice amongst investors over the years, with the leveraged aspect of real estate investing driving superior returns. Unlike investing in stocks, you can use significant amounts of financing when investing in real estate without adding a ton of risk, with the majority of the investment financed by the underlying mortgage.

Traditional physical ownership of real estate can offer a high return and substantial income stream, but it also requires more money upfront, active management, and high ongoing costs.

REITs

Late-night calls to fix leaky toilets aren’t for everyone. For those less enamored by the prospect of actively managing tenants, investing in real estate investment trusts, or REITs offers a more passive approach.

A REIT is a trust company that buys, develops, manages, and sells real estate. You can invest in shares of these companies on a stock exchange. By investing in REITs, you are investing in the real estate these companies own. This approach represents a more passive and less capital-intensive approach to real estate investing vs. direct property investments.

REITs are required to return at least 90% of their taxable income to shareholders every year. This means investors can receive attractive dividends in addition to diversifying their portfolios with real estate. Listed REITs also offer greater liquidity as their shares are traded on a stock exchange.

Hedge Funds

With over $3.6 trillion invested in the hedge fund industry, hedge funds are notoriously big business. Synonymous with lavish Wall Street antics for several decades, hedge funds have long been the most misunderstood asset class in finance. The name is typically the source of most confusion here. While some hedge funds implement sophisticated strategies to help hedge the market, most of these so-called ‘hedge funds’ are not based around a specific hedging strategy.

Simply put, hedge funds are pooled funds, aiming to make money irrespective of the prevailing market conditions by pursuing investments that are outside the traditional long-only portfolios of equities and fixed income.

Hedge fund managers have discretion to use more aggressive trading strategies, investing in any or all of stocks, bonds, derivatives, options, commodities, or even other hedge funds. They may invest long, short (benefits as prices fall), or a combination of both.

Many of these strategies have low correlations to traditional stock and bond asset classes, which can help improve overall portfolio return potential compared with traditional-only portfolios.

Advantages 

Flexibility 

Unlike mutual funds, the unconstrained investment approach offers hedge funds managers the opportunity to generate positive returns in both rising and falling financial markets.

Diversification

As mentioned previously, diversification is a crucial aspect of portfolio construction. Hedge funds can produce a return stream that has a low level of correlation with traditional assets, thus lowering the portfolio’s exposure to general market movements.

Return Potential

There are not as many regulations on hedge funds when compared to other investment opportunities, such as mutual funds; this provides hedge fund managers with more investment options. As a result, hedge funds have the freedom to implement more aggressive investment options across a broad spectrum of products to capitalize on opportunities as they arise.

Disadvantages

Higher Fees

Higher fees are the most often cited downside to hedge funds. Most hedge funds have a “2 and 20” fee structure. In this structure, investors pay a 2% management fee for operations of the fund and a 20% performance fee for any profit above a pre-agreed hurdle rate.

Less Liquidity

Hedge funds sometimes invest in illiquid assets. To account for this, they often have lock-up periods or longer redemption notice periods relative to more traditional public securities.

Less Transparency

Most hedge funds are not subject to the same disclosure requirements that apply to mutual funds as they do not advertise publicly. This lack of transparency can make it more difficult for investors to see exactly how their money is being invested.

The Future for Hedge Funds

A decade of central bank support has resulted in record-low interest rates and the longest bull market in history. This low volatility, utopian environment has favoured cheap index-tracking funds and made life difficult for those pursuing more complex, expensive strategies.  

Hedge funds have lost ground to passive
balanced investments over the past decade

For years hedge funds managers have longed for an uptick in market volatility, promising outperformance and downside protection once markets eventually falter. With volatility and uncertainty now at the forefront of the investment landscape once more, is a comeback on the cards for hedge funds?

Interest certainly seems to be picking up. 44% of hedge fund investors surveyed by Preqin in June 2020 said they intended to increase their commitments to hedge funds over the next year, nearly double the proportion from a year ago.

No doubt, this increase in market interest is reassuring, and several hedge funds have seen performance soar due to the pandemic-induced volatility. However, other strategies have suffered the opposite fate. The challenge for all investors is, and always has been, separating the hedge fund managers that excel over time from those that don’t.

Generally, hedge funds are run by some of the best and brightest investment managers in the business. While the fees can often seem high, the recent market volatility may well coincide with the re-emergence of higher returns for the best performing hedge fund managers.

Commodities

Commodities are raw materials that are either consumed or used to build other products. As you can probably imagine, there is an endless list of these resources, but all commodities exist within the three categories mentioned below.

Agriculture

Commonly traded agricultural products such as wheat and coffee as well as livestock.

Metals

Metals are divided into traded metals such as copper and steel and precious metals such as gold and silver.

Energy

This includes commodities such as crude oil and natural gas. The oil market alone is larger than all metal markets combined with crude oil being the most traded commodity in the world.

How to Invest in Commodities

The commodities market has grown significantly since the day’s farmers and miners traded products in the local marketplace. In today’s innovative markets, commodities are either acquired directly, using commodity futures contracts, or through investments into commodity ETF’s.

Direct Investments 

While there is nothing theoretically stopping you from directly purchasing barrels of oil or bushels of corn, the impracticality of actual delivery and inevitable storage issues has ensured that this logistical nightmare is seldom the investment method of choice for private investors.

Commodity Futures Contracts

Commodities trading typically uses a brokerage to buy futures contracts, which are obligations to buy or sell commodities at a future date, at a price agreed today. Commodity prices can be extremely volatile due to their sensitivity to country, economic and operational risks. As a result, futures contracts are agreed between buyers and sellers to hedge this volatility risk. Generally speaking, when someone is investing in commodities futures, they’ll never physically take possession of the commodity; it is simply used as a speculative or hedging mechanism.

For example, a producer such as a farmer can sell futures contracts to lock in a price for their output. Conversely, a consumer can buy futures contracts to lock in a price for their requirements.

Purchasing an ETF

The cheapest and easiest way to invest in commodities for most private investors is to find an ETF that invests in one, some, or even the entire commodities market, or ETFs investing in companies that are dependent on specific commodities.

Why invest in Commodities

While the volatility of commodities markets may present opportunities, this short-term trading approach is best left to the professional commodities traders given the speculative nature of the investments.

Despite this volatility, the low correlation to the broader markets provides diversification benefits.

Commodities can also act as an effective inflation hedge. Commodities sit at the epicenter of the global supply chain, ensuring that commodity prices should also increase as prices rise.

Some precious metals function as a store-of-value play with investors turning to the likes of gold when there is fear in the market, with gold demand spiking as equity markets turn negative.

In summary, commodity investing is cyclical and distinct, with huge disparity between the performance of different commodities depending on the commodity in question and the time frame selected. Although Gold offers a tried and tested currency hedging play and the return opportunities on offer across some of the more volatile commodities is undeniable, I would advise investors to proceed with caution.

If you do decide to take an exposure to a specific commodity, be mindful of the risks involved. Without a detailed understanding of the commodity in question, future price volatility may become all too much to bear. Those who are not well versed in any particular commodity may be best served investing in a broad-based commodity fund.

Should you add alternative investments to your portfolio?

A growing consensus among market analysts is that public equity returns may be constrained by a combination of slowing economic growth and relatively high equity valuations over the next several years.

The recent monetary stimulus has created a challenging landscape for fixed income. Once the traditional counter to equity headwinds, the appeal of safe-haven bonds has been eroded as central bank purchasing schemes push bond valuations to all times highs, all but eliminating their future upside potential.

This growing volatility and muted upside potential has highlighted the need for more than just traditional stocks and bonds when creating a well-diversified portfolio.

These alternative asset classes can provide diversification, offering returns with low correlation to other asset classes, reduce volatility, generate reliable income, offer high absolute returns, and an inflation hedge. Now more than ever, alternative assets play a vital role within the investment portfolios of institutional and retail investors alike.