How alternative investments can fit into one’s portfolio

What are alternative investments?

An alternative investment is a financial asset that does not fall into the conventional category of publicly traded stocks, bonds, and cash. It typically includes private equity, private credit, and hedge funds.

The size of the private equity market is about US$12 trillion, private credit is over US$1 trillion, and the hedge fund segment is about US$4 trillion. 

While this is still a fraction of the public securities market, it has been rapidly growing as a real allocation to portfolios not only for institutional investors but also for individual investors. A recent Goldman Sachs survey on family offices shows that family offices have allocated 26% of their assets into private equity.

While alternatives are still not widely available for individual investors due to lack of access, large minimum investment hurdles, and high cost, Endowus has been expanding its alternatives offering to offer high-quality products in each sub-segment for professional investors in Hong Kong.

Why include alternative investments for your wealth management needs?

Depending on the investors’ specific needs and circumstances, the three main reasons investors might consider investing in alternatives are to a) potential to improve returns, b) lower volatility and correlation, and c) get access to further diversification.

a) Potential to improve returns

The global public equities market has returned an average 7% per annum over a multi-decade period. We will call this average 7% return the “public equity beta”. There are only a few ways to improve returns above the public equity beta over a longer term period. This includes i) alpha, ii) illiquidity premium, and iii) leverage. 

Alternative investments can potentially improve investors’ portfolio returns because of access to alpha generation investment opportunities in the private markets that are available only to a smaller group of investors (vs for all investors in public markets), or due to stronger flexibility of investments with the absence of benchmarks and the ability to leverage the use of shorts and derivatives.

Alternative investments also give portfolios a chance to potentially generate higher returns through illiquidity premiums. Long-term capital that does not need to be withdrawn can demand higher returns from companies that need funding.

Lastly, alternative investments can potentially generate higher returns through the use of leverage. Many private equity funds and hedge funds use leverage as a means to improve returns if the underlying asset has strong fundamentals and/or has relatively little risk.

b) Lowering volatility and correlation

Alternative investments tend to have lower volatility as compared with public markets as they mark-to-market much less frequently. Private equity firms would value their funds on a quarterly basis and the marks would typically tend to be based on “events” such as the pricing of the latest fundraising round of the company. As such, it would not have to go through the daily volatility that public markets go through. 

Hedge funds would tend to have lower volatility and correlation because of their use of shorts and derivatives. The idea of a hedge fund is to “hedge” the risks where it doesn’t have a view and typically a hedge fund would at least partially hedge market risk (or public equity beta), and thus lower its volatility and correlation.

c) Providing broader diversification

Alternatives can provide broader diversification to a portfolio as it gives access to private companies that are otherwise not available for investments in the public markets. The universe of private companies is getting larger as private companies stay private for longer.

Alternatives would also likely have more flexibility to include segments that are otherwise not available in public markets such as aircraft leasing, ownership to sports franchises, senior housing, and music IPs, among others.

Hurdles for individuals to access alternatives 

The main hurdle for individual investors would be a) lack of access, b) large minimum investments, c) liquidity constraints, and d) complexity of the investment. 

At Endowus, we are working to overcome these hurdles as we provide access to multiple high quality alternative investments for professional investors in Hong Kong. 

Our alternatives have a minimum of US$50,000 - US$100,000 compared with typical minimum investment sizes of at least US$1 million for direct investments, and US$250,000 minimums at private banks. An individual who wants to qualify to be a private bank client will also have to satisfy high minimum requirements to begin with.

The liquidity profiles of products available on Endowus’ platform are generally better than going direct, by offering  a pooled capital structure that allows for lower investment minimums, it enables investors to better overcome fund gates. Also, our focus on open-ended private funds can generally provide investors with quarterly liquidity without the usual onerous lock-ups associated with alternative investments..

As for breaking down the barrier of complexity, Endowus strives to  provide our investors with the knowledge and education through webinars and in-person events, with access to fund managers to explain the asset class and product thoroughly before our clients commit to their investments. 

Risks associated with alternative investments

As discussed earlier, alternatives can provide many benefits to complement an existing public portfolio. Moreover, Endowus has made it much easier for individual investors to access alternatives by lowering the hurdles. With all of that said, it is also important to understand the risks of alternative investments such as a) liquidity, b) leverage, c) cost, and d) transparency.

a) Liquidity

Liquidity is a key risk for alternatives not only because of the long fund life, notice periods, gates and lock-ups that make it hard to access your capital because of the potential mismatch of the liquidity of underlying investments and the liquidity of investors. Moreover, liquidity in investments that are not diversified by region, vintage, or asset class, maybe at risk in times of crisis. As such, it is important to be invested in alternatives that are as diversified as possible.

b) Leverage

Leverage is another key risk for alternatives. Leverage is a double-edged sword that can be powerful when used properly, but dangerous when it is abused.

c) Cost

Cost is also a risk that can dilute the performance of your portfolio over the long run. Cost can include anything from high management fee and performance fee — known as carry — or the overuse of beta hedging that dilutes market performance. 

We believe there is a place for alternatives in your portfolio but a proper understanding of the benefits and risks would determine the right allocation of alternatives for you.

d) Transparency

Alternative investments such as hedge funds are not as regulated by regulators as compared with fund vehicles such as unit trusts, which means the disclosure may not be as standardised as other retail products. Information on alts products may also be less easily assessed by investors. 

Accessing alternative investments with Endowus Private Wealth

Endowus has a private wealth arm that provides access to more investment products such as alternative investments. With Endowus Private Wealth (EPW), clients looking to invest a minimum of US$1 million in assets across our services can gain exclusive access to more personalised solutions and products.

Let us introduce you to a better way to manage your wealth. For more information, please contact us for a consultation.

Read more:

• Why become a professional investor in Hong Kong
• Understanding private credit investing
• An introduction to private equity
• Why invest in hedge funds

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Endowus Alternatives and Endowus Private Wealth are intended for professional investors only.

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