What Are Alternative Assets?
Alternative assets represent an expansive field of investing possibilities. Basically, when you stray away from any investment that is not part of the stock, bond, or cash market you enter the world of alternative investments.
The most popular, which have private participation as well as institutional, are real estate, hedge funds, precious metals, and commodities. However, you could also add cryptocurrencies, art, cars, or even stamps.
To the above list, you could also add intangible assets such as patents, trademarks, or intellectual property. These are less common and not as easy to access for the private investor as the first list of tangible assets.
Let’s have a look at real estate and hedge funds. Both investments we are going to see are relatively easy to access.
Why Invest in Alternative Assets
There are 3 main benefits of including alternative investments in your portfolio. You can benefit from diversification of risk, a different income source, and at times protection from inflation.
Possibly the largest factor is diversification. Having all your investment capital in stocks and bonds means you are incapable of avoiding getting hurt when there is a market shock or crisis.
Diversification allows you to take on different risks while you put your money to work for you. The concept of diversifying your risk is applied to any portfolio. Even if you are only investing in stocks, rarely would a savvy investor place all their capital in one stock only.
To reduce the overall exposure to risk you would invest in various stocks. The idea is that if one company has a bad performance the others may make up for its losses. This strategy makes sense, but what happens when there is a crisis? In this scenario, it doesn’t matter how many different companies you own and to an extent not even which ones.
A way to help reduce your losses in times of market stress is to diversify by investing in uncorrelated assets. Hedge funds, precious metals, and commodities can have a completely different reaction to traditional assets in times of crisis.
How Alternative Assets Perform Within a Portfolio
When I consider investing I always like to look at how the professionals do it. One source of inspiration for me has been university endowments. These funds are run by the university to grow their funds with a long-term horizon investment.
The long-term horizon gives these endowments the advantage of being able to withstand the short-term volatility of market shocks. They also look to protect their capital and achieve relatively consistent and high returns.
Looking at how they distribute the investments of their funds you find that there is a large proportion invested in alternative assets. The chart below shows the average returns for 60/40 funds, endowment funds against their percentage of alternative assets.
You can see that the higher the percentage of funds dedicated to alternative assets the higher the annual reruns. The table below breaks it down in endowments for Harvard and Yale as well as the top 5 endowments compared to 60/40 funds.
From the table above you can see how the endowments have outperformed a traditional passive 60/40 portfolio of stocks and bonds. The endowments achieved better returns over all of the 3 periods, 10 years, 15 years, and 20 years. The Yale fund gets top marks, worthy of note, it is considered the pioneer in alternative investing.
Let’s have a look at some of the alternative assets these endowments have been and continue to invest in.
Real Estate Investing
Real estate investing can create various headaches for a private investor. Finding the right location, managing the rental contracts, and tenants. You also have a highly illiquid asset, it can take months sometimes years before you sell.
If you need to cash in on your investment the fact you might have to wait so long can cause a strain on your finances or be a cause of lost opportunity. However, various publicly quoted stocks invest in and operate real estate.
Known as REITs, these stocks give you access to the revenue streams of real estate together with the liquidity of the stock market. They also allow you to leave the buying and operating of real estate in the hands of experts.
REITs also avoid paying taxes on their income when they pay at least 90% of it in dividends. The special tax status allows investors to avoid double taxation and increases their earnings. You can get a better understanding of how REITs work in this guide to REIT investing.
Hedge Fund Investing
Hedge funds mainly invest in stocks and bonds, just like traditional mutual funds or ETFs. The difference is really in the strategy used. Mutual funds are passively managed, meaning they attempt to replicate a broader index.
A passive strategy means you should get returns and risks similar to the broader market, say the S&P 500 index. The fact that hedge funds are actively managed is what attracts investors with a high-risk appetite.
Hedge funds also have access to high levels of leverage. Leverage allows hedge funds to buy assets for multiples of the capital they manage in the fund. Typically, leverage is around five times their capital. So, you have 5 times the exposure to returns but also 5 times the risk.
Needless to say then, hedge fund investing is not for the faint of heart. These types of funds are well known for their ups and downs and sometimes devastating losses. An investor approaching this type of investment needs to do some research and get all the information necessary to make the right choices.
There are various hedge fund investing strategies, let’s go through some of the most common in terms of assets under management.
- Balanced (Stocks & Bonds)
- Emerging Markets
- Equity Long Bias
- Equity Long Only
- Fixed Income
The main goal of this strategy is to achieve growth while taking into consideration capital preservation. Hedge funds working with this strategy invest in a balanced portfolio in terms of assets. They might invest 60% in stock and 40% in bonds for example.
The big difference here to a mutual fund is that they do not spread their investments across a large number of stocks. They are not attempting to imitate an index, rather they will target companies they feel will outperform the market with a relatively short time horizon.
This is why they are much riskier than a standard mutual or index fund. The portfolio managers will attempt to identify perhaps a handful of companies to invest in. The small portfolio means they are exposed to the specific risks of each corporation and less to the overall market.
As the name of the strategy suggests they only invest in emerging markets, such as Brazil, Mexico, or Russia.
These hedge funds work in the same manner as above by targeting a group of corporations within a specific list of emerging countries. However, they can also invest in other assets such as real estate, commodities, or derivatives.
They have a higher risk level than non-emerging market funds, due to the lower levels of transparency available in most emerging markets. They can also be subject to greater price swings, but with the increase in volatility, may also come greater rewards.
Equity Long Bias
This strategy aims to maintain a higher percentage of long positions to short positions. This strategy developed in the 1990s when stock markets were booming and having a long bias in your positions was only profitable.
If markets do experience a crisis then funds with this strategy are more likely to suffer more. Their underperformance is due to the fact they always have to maintain a percentage of long positions.
Equity Long Only
Funds investing with this strategy like the name suggests only buy stocks. When they feel there may be a bumpy ride ahead for stocks in general, then they may reduce the amount they have invested in stocks and keep it in cash.
These funds typically target a specific industry or sub-sector to maintain long-only positions. The portfolio managers attempt to find the stocks that will generate higher returns than the broader market.
Although they do not benchmark their funds to a broad index, such as S&P 500, they still might use index derivatives to offset market risk.
These hedge funds analyze corporate events such as bankruptcy, mergers, acquisitions, or spinoffs. They try to establish if the event has created an opportunity for investment in as much as the market has not fully priced in the event.
Let’s take the example of the news breaking the intent of a corporation to acquire one of its competitors. Clearly, the stock price of the target corporation will increase. Usually, the price does not reach the declared acquisition price reflecting the market’s level of caution as to whether the deal will finalize.
The fund then takes on the task to establish if there is an opportunity at the current price to acquire the target company and sell once the acquisition price has been reached or goes higher.
Invest like a Pro Today
Want to learn more about alternative asset investing? To dive deeper into the attractive yet risky world of hedge funds you can continue learning more about this asset class in this helpful guide to hedge fund investing.