Investors are increasingly investing in alternative investments for portfolio diversification. With characteristics different from traditional stocks and bonds, here are four things you should know before investing in alternative investments.
1. Definition and Industry Trends
Alternative investments comprise of assets other than traditional stocks, bonds, or cash. These include investments in financial assets and pooled funds such as venture capital, private equity, hedge funds, REIT’s, and commodities. Real assets like precious metals, rare coins, wine, and art fall within this category as well. Alternatives often feature low correlation to stocks and bonds, may be difficult to value, and are generally more illiquid than traditional investments.
Liquid alternatives are an asset class that has developed in the last few years. ETF’s and mutual funds act as liquid alternatives that are traded publicly and managed to mimic the performance of an alternative asset class. Strategies that require leverage and that are inherently illiquid in investment focus are not appropriate for liquid strategies. However, some strategies that utilize long/short and managed futures can be appropriately structured within a mutual fund, offering daily redemptions and Net Asset Value (NAV) pricing.
The industry is transforming from a relatively opaque and fragmented space to a more transparent and data-centric market. With favorable regulatory changes and the addition of liquid alts, more investors are participating in this asset class. This growth is bringing to the fray more niche and emerging managers that are increasingly competing with big money managers for investor capital. New competition is disrupting the market as globalization is shrinking the world and affecting the alternative industry by linking economies. Managers are tapping into developing economies and extending their reach in emerging markets with the goal of seeking high growth opportunities.
2. Who Invests in Alternatives
Increasingly, individuals and institutions are allocating to alternative investments as they look for uncorrelated returns with longer time horizons. According to a recent E&Y PE report, 2013 marked the best year for PE fundraising since the financial crises. Assets under management reached $401Bn and pension funds are increasingly allocating to PE at an 8.5% target. Generally only accredited investors are able to invest directly in alternatives like hedge funds and private equity. This is the case because many fund managers rely on private placement registration exemptions that limit their investor base to only accredited investors but allow them to operate in a less regulated fashion.
The alternative marketplace is getting more transparent as technology and growing emerging markets create greater opportunities for investor participation. Emerging markets fundraising accounted for 20% in total global allocation in 2012. Digital distribution of alternative investments is another trend that opens up investment opportunities to new audiences.
3. Return Characteristics and Correlation
Investors have a general idea of what constitutes a normal market. The stock market is supposed to return a consistent 7-9% year over year, with market cycles of recessionary periods followed by a normalization into boom years, and then another correction. Investors learned all too much in 2007-2008 that the market can be an extremely rocky ride. Extreme volatility in the market presents itself every few years, reflecting the economic conditions and industry bubbles like the dot-com bubble in the early 2000’s and the real estate bubble leading up to the mortgage crises in 2007-2008. A volatile ride, even with huge gains, is still not as attractive as a smoother ride featuring more modest gains. The reason for this is that investments are compounded. A 6% gain every year for 3 years is a cumulative return of 19.1%. A 6% average gain for three years, with a 30% gain the first year, 20% loss the second year, and an 8% gain the third year creates a cumulative gain of 12.3% over three years. Smoother rides are beneficial for long term gains and this is gained through diversification; constructing a portfolio of assets that will behave differently through different economic cycles can help stabilize returns.
Many alternative strategies and asset classes have a low correlation to the market and different risk profiles, providing this diversifying effect. Correlation is measured through historical performance with a correlation of 1 meaning that the assets move in lock step, 0 meaning that the assets have no relationship, and -1 meaning that the assets move in equal opposite directions. In certain hedge fund strategies for example, assets are coupled with negatively correlated assets where the poor performance of one asset will be hedged with strong performance of another asset in the portfolio.
4. Risk Profile and Debt Structures
Understanding the risk profiles of alternative investments is key to deciding what to include within a portfolio. Investing in a venture capital fund provides diversification through the manager’s portfolio picks, whereas investing in a single company directly, while potentially lucrative, is obviously more risky. Commodities historically feature low correlation to stocks and bonds but can be very volatile and risky.
If investing in a fund, the strategy or focus will define the risk profile. For example, a venture capital fund investing in early stage technology companies in South Korea carries the risk profile and inherent economic risks with South Korea’s economy. The fund limits its sector focus to technology, which carries risks associated with investing in only one sector of the market. And finally, investing in only early stage companies brings risk associated with the reality that only a small percentage of early stage firms can climb to the next level and reach critical mass.
If you invest in a distressed debt fund do you understand the method and priority of payments that will determine the profitability of the fund? Managers of distressed debt invest in companies under financial stress that might exhibit hidden promise. Debt or equity is purchased at a discount and investments can be realized upon a bankruptcy or liquidation of the company. Senior debt is returned before subordinate debt, and equity is generally only returned to investors after creditor obligations are met. A key consideration in this investment would be to understand the recovery value of the asset. How much would the investment be worth, taking into account default probability and priority of payment?
There are obviously many things to consider when investing in alternative investments. The first step would be to understand what asset class interests you to determine if you are qualified to invest. Then an investor should do a deep dive into the return characteristics and structure of the investment to determine if it matches the risk-profile of your eventual goal – to achieve diversification and enhanced alpha by allocating to alternative investments.
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