The world has been going through a period of slow growth since the turn of the new decade, which is why investors are leaving no stone unturned in the quest to find both lucrative and safe opportunities to invest in. This is where non-traditional or alternative investments are making their presence felt. Unfortunately, the frantic scramble to not to miss out on a good opportunity often leads to errors in judgement, fuelled by either the fear of missing out or the failure to carry out one’s due diligence. These investments also come with their own challenges, such as the eternal conundrum of which investment to choose, the size of the investment, and measuring risks and rewards effectively.
Alternative investment assets
The key thing to understand is that alternative investments are very emphatically not the same as conventional investments. This means that they are not bound by the same rules and conventions as conventional investments are, which many tend to overlook.
Alternative investments include various assets beyond the remit of the traditional cash, bonds, and stocks investments. Non-traditional investable assets range from the financial – real estates, hedge funds, exchange funds, NFTs – to collectibles – art, antiques, vintage cars, and wine. Even at first glance then, alternative investments are not for everyone. These asset classes are typically difficult to access for individuals below a certain net worth income.
‘Regular’ investors may find these assets too expensive to participate in, and their income too irregular and uncertain. Collectibles will not even yield value until they are sold.
The alternative investment assets mentioned above can also be broadly classified into four separate groups. These are commodities, real estate, hedge funds, and private equity funds. Commodities are the most widely recognised of these, being the main type of alternative investment in the market. The gold, platinum, silver markets, and crude oil are some of the better known commodities that you can invest in. These commodities can also be bought-into through exchange-traded funds and commodity futures contracts.
Real-estate is another alternative to traditional investments that can be bought into either directly or indirectly. Direct investments include buying spaces for renting purposes or providing loans for property investments. On the other hand, indirect investment methods into real estate can include buying real estate investment trusts or mortgage-backed securities.
Hedge investments are generally made accessible to retail investors through investment vehicle pools that are managed by professionals. These professionals manage several investment portfolios that can include both traditional as well as non-traditional investment avenues. Investors in hedge funds are also typically institutional, not individuals. These may invest in pension funds, sovereign wealth funds, and insurance companies, depending on their appetite for risk.
Private equity funds are also very similar to hedge funds – they are often pooled together in investment portfolios. The difference lies in the fact that private equity funds invest in companies, not wealth funds. Private equity funds act though leveraged buyout funds and venture capital to acquire companies with high potential for growth. These are then sold at a later date when investors want to realise their investment.
What sets alternative investments apart?
Cons
There are high transaction costs associated with alternative investments. Alternative investments can also prove to be expensive in other ways. For one, alternative investment vehicles are less liquid compared to the more conventional options available. This is due to reasons such as transfer restrictions either agreed on or imposed by regulatory authorities. Alternative investment vehicles also lack secondary trade markets. The value of alternative investments are therefore not easily available to their investors. In the event of a personal need for liquidity, investors would either have to liquidate at a net personal loss or seek out other expensive avenues of liquidity.
There is also a level of complexity associated with alternative investment methods. This makes the market difficult to navigate on one’s own. They therefore tend to have high professional and transaction fees associated with them. One other reason in which alternative investments may prove to be an expensive route to take is in the opportunity cost involved. Alternative investments take longer than others to ‘mature’ or to yield income. They are also difficult to estimate the market value of, so the return or the liquidating value for alternative investment vehicles may even result in a net negative, in which case the opportunity cost would have been all the other lost investment opportunities.
The lower level of transparency into the details of assets is also another aspect of alternative investments that can be hard to negotiate. The price transparency of alternative investments, for example, tend to be very low. This is because they are not traded on a public market as stocks are.
Non-traditional investments also tend to have less historical data related to their values, risk and return data due to the lack of a market platform. The high returns on alternative investments also often depend on the exploitation of mispricing due to their illiquidity.
Pros
All the expenses and risks related to alternative investment methods does not mean that there are no upsides to non-traditional investment methods. For one, they share a low correlation with the traditional investment methods such as public traded stocks and bonds. This means that they are not as sensitive to their highs and lows. While risky on their own, alternative investments therefore help lower the overall risks of an investment portfolio. Non-conventional investment avenues therefore represent an opportunity to effectively diversify an investment portfolio in a manner that mitigates market volatility.
Alternative investment instruments also represent an opportunity to access investment vehicles that were not traditionally available to lower-scale investors. While high returns are not always guaranteed, the increased risk is also related to higher potential returns. The returns on these investments can also include tax benefits that are not available for conventional investments.
There are also other characteristics of alternative investments that may work either for or against the investor’s favour. These are worth particular attention to ensure that they do not work against the investor’s favour. For example, alternative investment instruments are less regulated than traditional investments, which may work in the favour of investors, or alternatively, leave them more vulnerable. The fallout of the 2008 economic crisis also means that the lack of regulation is a situation that is being addressed by many governments.
Alternative investments were once the exclusive stomping grounds of a select few. They are however, growing increasingly popular with individual or retail investors. The market for alternative investments is expected to be a staggering 14 trillion dollar industry by the end of this year. Even as the industry grows however, the assets that are allocated to alternative investments are still small, especially in comparison with traditional investment methods. This means that as of now, alternate investments still can only take a supplementary position in any investment portfolio. The characteristics described above also still means that alternative investments may still not be for the everyday investor.
(Theruni Liyanage)