Alternative investments are asset classes that aren’t stocks, bonds or cash. The term “alternative” in this context simply refers to the fact of the investment being an alternative or different option to traditional investments. They are most often also referred to as private market or unlisted assets although some may be derived from listed markets.
Until recent years alternative investments have only been accessible to stockbrokers, family offices and institutional investors such as superannuation funds and endowment funds such as the Harvard Endowment Fund and Australia’s Future Fund. This has been due largely to their complexity, degree of risk and the high minimum investment required (generally $1m+). In Australia some alternative investments are only available to accredited individual investors that meet the definition of a wholesale investor.
Examples of alternative asset classes include private equity, venture capital, hedge funds, alternative credit, property, commodities, infrastructure and agriculture. Many people are already be invested in alternatives through their superannuation fund or if they hold an investment property. Here we explore the pros and cons of alternative investments which are an important and growing component of a well-structured investment portfolio.
Why have alternatives in a portfolio?
Alternative investments have a number of benefits and offer investors the ability to diversify away from traditional assets such as stocks, bonds and cash. By including alternatives in their portfolio investors get access to a broader range of opportunities which can reduce volatility and ultimately produce more stable returns overall.
Diversification is important as it lowers investment risks by smoothing out the bumps in investment markets, as different types of investments react differently to the same market conditions. At times when public markets are down, alternatives can play a significant role in mitigating downside risk and improving returns. Market neutral or hedge fund strategies can generate positive returns even when the economy is in a downturn or recession.
Typically illiquid, alternative investments can have investment horizons spanning from one year all the way to ten years and beyond. However, investors are generally well compensated for the risk and illiquid nature, as returns tend to be superior on a risk-adjusted basis.
When compared to traditional investments, alternatives can offer the following pros and cons:
Pros:
- Risk reduction through diversification
- Reduce the impact of market volatility
- Often provide higher return potential
- Offer protection against inflation
- Provide greater scope of investment options
- Flexibility to select investments around preferences, risk appetite and goals
- Typically lower transaction fees
- Additional return potential from active development and operational improvement of assets
Cons:
- Higher minimum initial investment requirements
- Suited to high-net-worth investors
- Often illiquid with lock-up periods
- Less regulated requiring greater investor due diligence
- Investors may be required to pass an eligibility test
- More complex than traditional investments
- Typically higher upfront fees
- Harder to access consistently better performing strategies
- Wide dispersion of returns and lack of transparency makes selection more difficult
How can individual investors access alternative markets?
Until recently the high barrier to entry has put alternative investment opportunities out of reach for most individual investors, leaving this space to family offices and institutional investors.
In recent years accessibility to this market has grown via investment vehicles that pool individual capital commitments and then invest the capital into a master fund. This model reduces the individual investor capital commitment down to as low as $100,000 making it possible for eligible high-net-worth investors to explore alternative investment opportunities. However, access by itself is not enough as informed selection is important to increase the likelihood of better future returns.
How should investors go about adding alternatives to their portfolio?
In Australia, many alternative investments are only available to individual investors that meet the definition of a wholesale investor. In order to qualify an investor must meet at least one of the following criteria:
- Net assets of at least $2.5 million, or
- Gross annual income of at least $250,000 for each of the last 2 financial years.
There are a number of other things to consider before investing:
Your personal goals: What do you want to achieve from the investment? Are you likely to need cash available quickly or can you afford to have it ‘locked-up’ for a period of time? Are you looking for income from your investments or capital growth?
Your personal risk profile: Alternative investments tend to be higher risk than traditional investments making due-diligence processes very important. Look for a fund manager with robust compliance processes and a proven track record.
Ultimately investment choices will come down to personal preferences and risk tolerance and are best determined in consultation with your advisor.