Time to Invest in Alternatives - Holdun

Time to Invest in Alternatives

Breaking News: Stocks And Bonds Are Not The Only Investment Vehicles Out There!

The recent volatility in equity markets and the historically low interest rate environment has highlighted the shortcomings of traditional assets such as stocks and bonds alone when building a well-diversified investment portfolio.

More and more investors are now exploring alternative investments such as private equity, real estate, and commodities to generate acceptable returns while diversifying their portfolio.

From fine wine to art, wind farms to venture capital, alternative investments have become less “alternative” over the years. In particular, the demand for private assets has increased substantially as investors strive to boost returns, generate incremental income, and provide diversification. From 2007 to 2020, the alternatives market has more than tripled, increasing from $2.5 Trillion to over $10 trillion and is expected to reach $14 Trillion by 2023.

Once a domain exclusive to institutional and ultra-high net worth investors, alternative investments are now being explored by retail investors looking to increase their portfolio’s risk-adjusted returns.

Before adding any investments from this growing asset class to your portfolio, you must first understand;

  1. What are alternative investments?
  2. What are their potential pitfalls?
  3. Where do the opportunities lie?

What Is An Alternative Investment?

Before going any further, it is essential that you have a broad understanding of the concepts of an asset class.

An asset class is a type of asset that has a specific set of similar characteristics. Different types of investment assets – such as stocks or bonds, are grouped together based on a similar financial structure, and these groups are referred to as asset classes.

Historically speaking, an individual’s investment portfolio would be made up of three main traditional asset classes.

With all this in mind, an alternative investment is simply any type of asset that does not fall into one of these three traditional asset classes.

Traditional assets are primarily made up of publicly listed stocks and bonds, characterized as:

  • Highly liquid
  • Publicly traded
  • High correlation to markets

Alternative assets are assets that sit outside the scope of the three main asset classes of stocks, bonds and cash. These investments look to exploit the inefficiencies in markets by focusing on less publicly traded markets.

  • Typically, less liquid
  • Assets often held in private markets
  • Low correlation to markets
  • Focused on inefficient markets

Benefits And Drawbacks

By their very nature, alternative assets tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies. Although higher potential returns and greater diversification is on offer, alternatives are not without risk. They will often have higher fees, exhibit more complex structures with less transparency, and are often illiquid relative to traditional asset classes.

Benefits

Potential for Higher Returns

Less efficient markets present opportunities for managers to outperform and take advantage of arbitrage opportunities as they arise.

Diversification Benefits

One of the most important tenets of intelligent investing is “don’t put all your eggs in one basket”. Diversification focuses on mitigating risk and enhancing return. During those inevitable periods when some of your investments are performing poorly, you’ll want other investments that are uncorrelated or negatively correlated to these assets to balance off the losses in your portfolio, ultimately creating a more consistent rate of return over time.

Potential Hedge Against Inflation

Some of these investments, typically hard assets such as gold or real estate, can hedge against inflation. Inflation is inevitable in most situations and will function to reduce the purchasing power of your cash over time. Asset classes, such as fixed-rate bonds, are especially exposed to inflation. With this in mind, it is important to invest in areas that are not as vulnerable to inflation, thereby diluting your exposure to future inflation.

Drawbacks

Illiquid Markets

The private nature of these investments can make them tougher to trade, given the smaller pool of buyers and sellers vs. traditional public markets.

Overall Complexity

Alternative investment assets are generally more complex than conventional investment assets. The complexity of these investments can often lead to a lack of transparency and a lack of available data on the investment.

Higher Fees

Management fees are often higher for many alternative investments given the specialization required and actively managed nature of the funds.

The Growth Of Alternatives

As mentioned earlier, the alternative investments market is expected to grow substantially over the coming years with assets under management of over $14 trillion by 2023, up 59% vs. 2017.

There are a variety of factors fueling the popularity of alternative investments in recent years.

  • Alternatives’ track record and enduring ability become more appealing as volatility spreads in traditional financial markets, and uncertainty surrounding the Federal reserve’s interest rate policy persists.
  • Investors’ search for yield becomes more difficult given the efficiency of public markets, leading to widespread increases in allocations to alternatives.
  • The steady decline in the number of publicly listed stocks, as private capital is increasingly able to fund businesses through more of their lifecycle. Success stories such as Airbnb have gathered valuations of $100 billion upon entry into public markets, making it bigger than any public company in existence 25 years ago. This results in public market investors missing out on an increasingly significant portion of a companies growth phase.
  • The growing opportunities in private debt as traditional lenders decline.
  • Opportunity in emerging markets. As the world undergoes an economic and political shift globally, the opportunities within emerging markets intensify. By the end of 2020, emerging economies will likely make up over 60% of the world’s GDP. Inefficiencies within these markets continue to represent opportunities for investors, with Asian markets leading the way. Fund managers predict that by 2023, the level of alternative assets capital coming from emerging Asia will have increased by 23%.
  • Pension funds’ persistent need to narrow their liability gap. Pension Funds continue to display chronic underfunding problems, with Citibank estimating the total value of unfunded or underfunded government pension liabilities for OECD countries exceeds $78 Trillion. This shortfall will intensify the search for risk-adjusted returns over the coming years, with private markets representing one of the few tools available to help close these funding gaps.
The ability to take advantage of private market inefficiencies has seen institutions with longer time horizons leverage their illiquidity premium, creating the potential for greater returns in the process.

Institutional investors have generally allocated 8-12% of their portfolio to real estate alone, with an overall allocation of over 30% across the alternatives space.

Individual retail investors are not quite as vested in the space, with the typical individual investor in the U.S. holding less than a 3% exposure to alternatives.

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. 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 over the coming weeks.

Should You Add Alternative Investments To Your Portfolio?

Now more than ever, alternative assets play a vital role within the investment portfolios of institutional and retail investors alike.

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

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 for new investors.

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.

Alternative asset classes can provide diversification, offer returns with low correlation to other asset classes, reduce volatility, generate reliable income, offer high absolute returns, and an inflation hedge.

Next Article

Next up, we explore private equity, the biggest player in the alternatives world.