Alternative Outlook

What are Alternative Investments?
As there is no official definition of alternative investments, it’s a term that can be open to widely different interpretations that can encompass everything from Hedge Funds to Stamp Collections. With this in mind, perhaps the most sensible starting point is to define alternative investments by what they are not. Alternative investments are not the more commonly held assets that we have been familiar with over the years such as stocks, shares, cash, property funds, bonds or fixed income products.

For many, this definition of alternative investments is good enough. However, we can tighten up our definition by adding a few more criteria:

1.       Firstly and most importantly, alternative investments should be uncorrelated with the more commonly held investments and the wider financial markets. What this means is that there is no direct link between the performance of these markets and the performance of alternatives. In fact, when more commonly held assets perform badly, alternatives perform well. This makes them a very powerful diversification tool or something similar to an insurance policy – in a market downturn or a crisis they will perform well and earn you returns when you need them most – when your other investments perform poorly. Diversifying in this way helps to smooth out the total return of your portfolio over time.  This is the key reason why you should consider allocating some of your portfolio to alternatives.

2.    Secondly, alternative investments should be directly held, tangible assets. This removes counter-party risk: if the product provider ceases trading you still have the security of owning a concrete asset. When you think about it, this is key to the proposition of alternatives as an insurance policy. The proposition doesn’t stand up if you can’t realize the value of the asset in a crisis because the product provider has gone bankrupt or it was all just paper money to begin with.

3.    Alternative investments often have a compelling story or an interesting concept behind the rationale for investing. For example, the rising global demand for food supports the case for farmland; the need for clean, sustainable energy supports the case for green oil plantations; market uncertainty and economic concerns support the case for gold.

4.       Similarly, alternative investments often have a strong appeal to personal interest – you might enjoy collecting rare coins or developing your knowledge of wine or art, and can combine business with pleasure.

The Benefits of Alternatives

Actually, alternative investments are nothing new and both institutional investors and high net worth individuals have long had access to alternative markets. In fact a recent report by Cap Gemini and Ernst and Young estimates that the rich put 10% of their wealth into alternatives. There are two reasons why they do this: diversification and performance.

Diversification

Diversification is the strategy of spreading your wealth across a range of assets to reduce the risk of being over exposed in one area. If the majority of your wealth is in the property market or the stock market and these markets do badly, it will have a big impact on your financial wellbeing.  If your wealth is spread across several asset classes, a downturn in one area can be offset by strong performance in another. A more common way of thinking about diversification is “don’t put all your eggs in one basket”.

What many investors came to realise after the market turmoil in 2008 and subsequent recession was that a lot of the assets they held were correlated – when one market performed badly, they all did. For example, many people’s wealth and assets are allocated like this:

• Shares and bonds (most pensions are invested this way)
• Property (home ownership)
• Cash (savings in bank accounts and ISAs, fixed income products from banks and building societies)

In the crash of 2008, all of these investments performed poorly at the same time. It’s clear that for many people, further diversification is needed and alternatives are the perfect tool. The following charts compare how a portfolio of commonly held assets would have performed through the crisis with and without an allocation to alternatives.

Conventional thinking was really challenged by the events in 2008 and people have been forced to question their assumptions. Nobody expected or predicted that:

• There would be a run on a UK bank as we had with Northern Rock
• That major UK institutions would be part nationalized as we had with RBS
• That giants of the markets like Lehman Brothers could fail.

Governments have done much to stabilize the markets and global economy since 2008, but many investors still feel uncertain about the economy and the markets. A sensible conclusion is to have an allocation to alternatives at all times.

Performance

As well as the benefits of diversification alternatives provide the opportunity to earn good returns in their own right.  The table below shows the average ten year returns of some popular alternative products

Social and Ethical Investing

Increasingly alternatives can also provide an opportunity to invest in social, ethical or environmentally friendly projects. Examples include:

• Green Oil plantations, which plan to grow crops that provide a sustainable source of carbon neutral bio-oil.
• Farmland and Agricultural investments that bring previously marginal land into use to address the growing demand for food.
• Sustainable bamboo and forestry plantations that provide alternative sources of timber and hardwood that do not rely on deforestation.
• Projects in developing countries that provide jobs, investment and infrastructure to local communities.

Personal Interest

The great thing about many alternative investments is that as well being sound investments; they can also be great hobbies. The obvious candidates are fine wines, art and other collectibles such as classic cars, memorabilia or rare coins. There are two great advantages to this; firstly, by following an interest an investor can develop a deep and profitable knowledge of a particular market. Secondly, even if the asset does not perform well, it still retains its intrinsic worth as something that the owner takes pleasure from regardless of the valuation the outside world put on it!

The disadvantages of alternatives

By their very nature as uncorrelated, less widespread investments, alternatives can have different characteristics to more commonly held assets.

• Some alternatives can be less liquid then cash and mainstream stocks and shares.
• It can be harder to determine their true market value and an independent valuation might be needed: for example with fine art or a stamp collection.
• When it comes to entering an investment, there may only be limited historical data available to help assess them: for example with a young, developing industry such as green oil or wind-farms.
• There can be high transaction costs, as well as on-going costs to consider such as storage for gold or operating costs for farmland.
• The exit from the investment can be vague or undefined: how do you exit an investment in stamps?

Key Conclusions

1.       Alternative investments are increasingly available to a wider range of investors and are no longer the sole preserve of the rich of mysterious hedge funds.

2.       Many types of assets can be considered to be alternatives, but investors should look for assets that are not correlated to the wider financial markets in order to diversify their portfolios and reduce the risks they are exposed to.

3.       Alternatives are an opportunity to earn strong returns.

4.       Direct, tangible ownership of alternatives provides another level of security by reducing counterparty risk.