Are alternative investments for you?
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Are alternative investments for you?

Updated
1
Aug 2023
published
4
Jul 2023
Alternative investments are all the rage -- are they suitable for your portfolio?

Retail investors are getting more access to alternatives, such as private equity and hedge funds. You may consider alternative investments to improve returns, lower volatility and correlation, and get access to greater diversification.

When invested in the right way through diversification and the appropriate amount of risk, alternative assets can be a source of alpha.

The original version of this article first appeared in The Business Times.

Alternatives are all the rage — this is normal as they traditionally outperform when market returns are negative. They give retail investors (and especially accredited investors in Singapore) an increasing number of opportunities to access and invest in an asset class traditionally reserved for institutions such as sovereign wealth funds.

Alternative investments do not fall into the conventional category of publicly traded stocks, bonds, and cash. They typically include private equity, private real estate, private credit and hedge funds.

Private equity (PE) is the largest and most popular, and can be divided into sub-asset classes depending on the stage of the company’s growth and profitability — such as venture capital, growth capital, buyout, and distressed, among others.

Private equity firms generally take a meaningful ownership share of a company and help add value to the management team, or even directly operate the company to grow its business. This is with a view to exiting after a multi-year investment period that is typically much longer than public-market investing.

Private credit is a fast-growing segment of alternatives that includes direct lending, distressed debt, and mezzanine debt. It has been growing as an alternative asset class as companies stay private for longer, and as banks pull back loans to private borrowers after the 2008 financial crisis, and investors look for less volatile income. Typically, private credit allows for higher yield due to the longer-term nature of the underlying debt.

The size of the private assets market is about US$13 trillion globally. While this is still a fraction of the public securities market, it has been rapidly growing with an ever-increasing allocation by traditional institutional investors.

A new growth spurt is also driven by individual investors as the market gets disintermediated by both traditional banks such as private banks, and new players such as Endowus.

A recent Goldman Sachs survey on family offices shows that family offices have allocated 26% of their assets to private equity.

Hedge funds are around US$4 trillion in asset size. Hedge fund strategies are broken down into long-short equities, quant, macro, credit relative value, and arbitrage, among others. The hedge funds that have seen the most demand recently are the multi-strategy, multi-manager platform hedge funds which have been able to generate solid and consistent returns uncorrelated to global equity or bond markets.

Why include alternative investments for your wealth management needs?

Depending on the individual’s specific needs and circumstances, the three main reasons investors might consider investing in alternatives are: to improve returns; lower volatility and correlation; and further diversification.

Chart: Adding alternative investments to your portfolio can help improve risk and return. Source: Endowus Research

Improving returns

The global public equities market has returned an average 7% per annum over a multi-decade period. There are only a few ways to improve returns above the public equity beta over a longer-term period. These include alpha, illiquidity premium, and leverage.

Alternative investments have a higher chance of alpha generation in private opportunities that are available only for a small group of investors. There may also be greater flexibility to achieve alpha with the absence of benchmarks and the use of shorts and derivatives.

It also has an illiquidity premium as long-term capital that does not need to be withdrawn can demand higher returns from companies that need funding.

Lastly, leverage. Many private equity funds and hedge funds use leverage to enhance returns if the underlying asset has strong fundamentals and/or has relatively little risk.

Lower volatility and correlation

Alternative investments tend to have lower volatility compared with the public markets, as private equity firms would value their funds (mark to market) on a less frequent basis, often based on “events” such as the pricing of the latest fundraising round. Thus, they are not subject to the daily volatility of public markets.

Hedge funds 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. They would at least partially hedge market risk (or public equity beta), and thus lower its volatility and correlation.

Broader diversification

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

Alternatives would also likely have more flexibility to include segments that are harder to access. These include aircraft leasing, ownership of sports franchises, senior housing, and music intellectual property (IP).

Hurdles and risks for alternative investments

In the past, alternatives were not widely available for the general public due to lack of access, large minimum investment hurdles, and high costs. Moreover, most private market funds have a "J curve", as shown in the chart below, which makes it difficult for individual investors to manage their cash flow as capital calls are typically made over time.

Chart: Private equity funds - J curve. Unlike in public markets, capital in the private markets is not invested or distributed immediately. Source: Goldman Sachs Asset Management

Many new digital players have been expanding access to alternatives offerings. Some factors help to facilitate access for individual investors. One is a lower minimum investment amount; second, a better liquidity hurdle to reduce angst that comes from investing in illiquid assets; and third, an open-ended structure with the investors’ money fully invested as managing capital calls is difficult and adds further risk for individuals.

While alternatives as an asset class have provided meaningful benefits to long-term investors, it is also important to understand the risks.

Liquidity is a key risk because of the long fund life, notice periods, gates and lock-ups that make it hard to access your capital. This is due to the potential mismatch of the liquidity of underlying investments and the liquidity needs of investors.

Moreover, liquidity in investments that are not diversified by region, vintage or asset class may be at risk in times of crisis. Hence, it is important to be invested in alternatives that are as diversified as possible.

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

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

Alternative investments such as hedge funds are not as regulated as fund vehicles such as unit trusts. This means the disclosures may not be as standardised as other retail products, and information may be less accessible. While there is a place for alternatives in your portfolio, a proper understanding of the benefits and risks would determine the right allocation for you.

Improving access to private and illiquid assets for individual investors is an important part of democratising wealth management.

However, it is also important that alternatives are approached in the right way for the right reasons. Otherwise, they may struggle to generate returns comparable to investing in a passive equities index or a 60:40 balanced portfolio.

The evidence is clear that when invested in the right way through diversification and the appropriate amount of risk, alternatives are a great source of alpha. It is important to have a trusted, independent, and professional adviser to guide you and help to achieve good outcomes.

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Start your alternative investing and wealth management journey 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, clients looking to invest a minimum of S$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.

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

The information herein pertaining to Endowus Singapore Pte. Ltd. (“Endowus”) and the Endowus investment platform is for general information only and does not constitute a recommendation, an offer to sell, or a solicitation to invest in any securities, options, or other derivatives in any jurisdiction and its content is not prescribed by securities laws.  This information herein is not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject Endowus or the relevant asset manager to any registration or licensing requirement in such jurisdiction or country.

Investment involves risk. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. Past performance is not an indicator nor a guarantee of future performance. Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund. 

Any forward-looking statements, prediction, projection or forecast on the economy, stock market, bond market or economic trends of the markets contained in this material are subject to market influences and contingent upon matters outside the control of Endowus and therefore may not be realised in the future. Further, any opinion or estimate is made on a general basis and subject to change without notice. 

In presenting the information above, none of Endowus, its affiliates, directors, employees, representatives or agents have given any consideration to, nor have made any investigation of the objective, financial situation, investment eligibility or particular need of any user, reader, any specific person, group of persons. For example, it does not take into account your eligibility to invest in specific classes or types of products. Therefore, no representation is made as to the completeness and adequacy of the information to make an informed decision. You should carefully consider (i) whether any investment views and products/ services are appropriate in view of your investment experience, objectives, financial resources, eligibility and relevant circumstances. You may also wish to seek financial advice through a financial advisor or the Endowus platform and independent legal, accounting, regulatory or tax advice, as appropriate.

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Alternative investments are all the rage -- are they suitable for your portfolio?

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