Alternative investments: do they belong in your portfolio?
By A.G.
08:58, 13 May 2020
What is an alternative investment?
Alternative investments, or simply alternatives, are financial instruments that fall outside of the mainstream asset classes like public equities (stocks), fixed income (bonds) and cash equivalent.
Many types of alternative investments have been around for some time and are well known to investors. Venture capital, in its current form, has been around since the 1950s. Private equity industry, historically tied to leveraged buyouts, has been showcased in many films, including Wall Street (1987).
Other assets, however, are relatively new, with alternative investment opportunities continuing to expand in line with the rising demand. Just last year, the Association of Investment Companies in the UK added music royalties to its alternative investments category.
Some of the prominent alternative investments examples include cryptocurrencies, commodities, real estate, art, wine, cars, diamonds and peer-to-peer lending.
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Why alternative investments are favoured by modern investors
Most investment portfolios are constructed to maximise future returns while minimising risk. This can be achieved by combining various asset classes, ideally with little or negative correlation to each other. Diversification is a key investment concept meant to reduce overall portfolio risk.
The key benefit of adding alternative assets to a portfolio is their low correlation to traditional assets. Investors also expect to generate higher returns in alternatives as these assets are fairly illiquid and unregulated. Some alternatives might benefit from an economic downturn, a rising dollar, or inflation. Gold, for instance, ticks all of those boxes and is commonly viewed as a “safe haven” asset by many investors. Depending on your circumstances, an alternative investment portfolio might also offer some tax benefits.
Historically, alternatives have been available primarily to institutional and high net worth (HNW) investors. A report by a global investment firm, KKR, shows that a typical global pension plan and a typical HNW account have a 24 per cent and a 22 per cent allocation to alternatives, respectively.
One of the recent alternative investment trends, however, has been the emergence of new alternative assets as well as liquid alternatives, ETFs and mutual funds. These financial products have opened the asset class to many retail investors.
What are the pros and cons of alternative investments?
Let’s quickly recap some of the advantages and risks associated with alternative investments.
What are the most popular types of alternative investments?
So, what are the alternative assets that get the most attention today?
In the world of high net worth investors, pension funds and large institutional investors, the most popular alternatives are hedge funds, private equity funds and real assets.
Hedge funds and private equity funds are structures that pool together funds from many different investors to exploit market opportunities. Hedge funds often employ complex quantitative strategies and are known for their extensive use of algorithms and high-frequency trading. At the end of 2019, hedge funds managed approximately $3.2 trillion for investors.
Private equity funds invest in private businesses to restructure underperforming companies or take a company public through an IPO. Venture capital, for example, is a subset of private equity associated with early-stage investments in start-ups.
Real assets are quite different from either hedge funds or private equity. These are physical assets like real estate, infrastructure (airports, toll roads, electricity grids, etc.), physical commodities or natural resources. Real assets, especially infrastructure, have seen significant growth over the last several years driven by low-interest rates and often stable, predictable cash flows.
While popular with sophisticated investors, the above assets are often difficult to access for an average investor. Recent growth in liquid alternatives made them more accessible but their track record is inconsistent. Potential investors should do their research before jumping in.
Some other types of alternative investments that are gaining popularity
Peer-to-peer lending
Peer-to-peer (P2P) lending is developed, in a way, to facilitate lending to individuals and small businesses that were not able to secure loans from traditional banks. P2P platforms bring together lenders and borrowers, using algorithms to assess borrowers’ credit and set conditions for a loan.
As an investor, small business loans as well as consumer loans, are generally low-risk investments.
Real estate crowdfunding
Real estate investments, whether commercial or residential, typically have stable cash flows and less exposure to the real economy. Even in an economic downturn, most people will continue paying their rent. Crowdfunding platforms pool funds from many small investors to buy a residential or commercial property. The platform then manages that property, generating rental income that is distributed to individual investors. Crowdfunding platforms often have low minimum investment requirements.
Art, wine and cars
Investing in art, wine or cars no doubt requires some subject matter expertise. One thing these alternative investments have in common is that their performance is not correlated with any major asset class.
Cryptocurrencies
Cryptocurrencies are an exciting industry that has been emerging at a rapid pace over the past decade. In April 2020, there were around 5,430 digital coins and tokens available. However, it is important to note that not all of them will survive and shine like the industry's most prominent names Bitcoin (BTC), Ethereum (ETH) and Ripple (XRP).
The promise of a decentralised world currency is what makes cryptocurrencies rather thrilling. At the moment, however, the regulatory landscape for digital money is still quite challenging. For that, while they present high reward investment opportunities, they come with a high risk.
Forex
Also known as the foreign exchange market, forex is a global decentralised or over-the-counter market dedicated to currency trading. In fact, it is the largest, most liquid market in the world with an average daily trading volume exceeding $5 trillion.
Currency traders include governments and central banks, commercial banks, other financial institutions and institutional investors, commercial corporations, currency speculators and individuals. Trades between these market participants can be extremely large, involving hundreds of millions of dollars.
Retail investors engaged in the forex market are buying and selling different currency pairs in order to profit from their price fluctuations. Some of the most traded forex pairs include EUR/USD, USD/JPY, GBP/USD and USD/CHF.
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Are alternative investments good for you?
In the world of finance, there is no such thing as a “100% safe investment”. However, overall, alternative investments are usually considered a sound addition to any investment portfolio. As always, we highly recommend you to do extensive research and arm yourself with as much knowledge as possible before investing your hard-earned cash.
How to trade alternative assets
Luckily, technologies have opened up alternative investment opportunities, previously reserved for HNW individuals and institutions, to all investors. Today, one of the easiest ways to start trading some of the most popular alternative assets, like forex, crypto, commodities and ETFs, is through contracts for difference, or CFDs.
A contract for difference is a financial instrument between a broker and a trader, in which one party agrees to pay the other the difference in the value of the security between the start and end of the trade. When you trade shares using CFDs, you speculate on the direction of the underlying asset without actually owning it.
You can either take a long or short position, depending on whether you expect the price of an asset to rise or fall. Therefore, it gives you an opportunity to profit from both negative and positive price fluctuations.
CFDs allow trading on margin, providing you with greater liquidity and easier execution.
However, note that CFDs are a leveraged product. Therefore, profits, as well as losses, are magnified.
You can learn more about CFD trading with free online courses and stay on top of the latest market news and trends with Capital.com.
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