Understanding alternative investments

Alternative investments, dubbed “alts” for short, is the umbrella term for essentially everything outside of the traditional category of asset classes that are popular with the majority of investors.

Traditional investments such as stocks, bonds, and cash are accessible to the general population via public markets and are characterised by high liquidity. They can be highly sensitive to market fluctuations.

On the other hand, alternative investments are typically not publicly traded, may have lower liquidity, and could potentially be less transparent than traditional investments.

Examples of alternative investments

Some examples of alternative asset classes are real estate, private equity, private debt, natural resources such as commodities and agricultural land, and infrastructure such as airports and hospitals. The alternatives universe also includes non-traditional methods of investing, such as private equity funds and hedge funds.

As they tend to be complex and are less regulated by the financial authorities, alternative assets are often held by accredited investors or high-net-worth individuals, as well as institutional investors.

That being said, there are also ways for the average individual investor to access and include alternatives in their portfolios. These include investing in a real estate fund, directly investing in a company or project (such as a property developer or an infrastructure project), or co-investing in a portfolio company of a fund.

Why should investors have some exposure to alts?

Where possible and in line with each individual's risk appetite, it can be a good idea for investors to put some money into alternatives.

This is because alts have the potential to offer portfolio diversification, downside protection, and possibly higher returns than traditional equities and bonds.

Diversification is key to your portfolio construction, as a risk mitigation strategy. Alternative assets generally have a low — and sometimes even zero – correlation to the broader market. That means they do not move in the same direction as traditional assets when market conditions change, making alts a good addition to a portfolio to reduce your overall risk exposure. They also help lower volatility and increase the resilience of your portfolio in the event of a market downturn.

Furthermore, some alternative investments employ strategies that seek returns that outperform the public markets; hedge funds and private equity are examples. 

Investors who have a longer time horizon and do not need to access their cash in the short term will thus find it attractive to get higher risk-adjusted returns from alternatives while forgoing liquidity.

The exact weight or allocation of the alternative assets within a diversified portfolio will depend on the investor’s risk tolerance, return objectives, investment horizons, liquidity constraints, and financial goals.

What are the risks?

Even though alternative investments provide diversification and could potentially enhance returns, they also come with more complexities and risks than traditional investments.

1. Lack of liquidity
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   Private equity or hedge funds have lock-up periods and redemption schedules requiring investors to commit their capital for a period of time. This makes the money inaccessible for lengthy durations. Typically, the redemption schedule is monthly or quarterly.
   
   In contrast, public equities can be liquidated at any time if you need to use the money on short notice.
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2. Regulation and valuation risks
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   Private markets, where most alternative assets reside, are characterised by their opaque nature when compared with public markets. Private companies are not obliged to reveal earnings or financial information, and are not subject to the same reporting requirements as their publicly-traded counterparts.
   
   The lack of transparency, combined with the illiquidity and product complexity, can make it difficult to price alternative assets accurately. There may also be a greater risk of fraud given that alts are not heavily regulated.
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3. Use of leverage
   
   Some alternative funds use leverage — that is, borrowed capital — to amplify returns. If successful, the investors reap larger returns. However, if the investments underperform or decline, such leveraged funds can result in bigger losses.
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Endowus has a private wealth arm that can provide access to more investment products such as alternative investments, many of which are only available to accredited investors. Contact us today for a consultation.

Next on the Endowus Fin.Lit Academy

Read the next article in the curriculum: What are family offices?

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