Why Should You Choose Alternative Investments for Your Portfolio?

Alternative investments are financial assets that are different from conventional investment vehicles like cash, bonds and stocks. These include private equity, hedge funds, managed futures and infrastructure investments among many others.

Our advisors are often asked if alternatives are a good choice, and why should one invest in these asset classes. The short answer is: diversification, and low asset correlation which brings down portfolio risk. In the last couple of years, we have all seen how the markets have behaved pretty unpredictably with ongoing trade wars, and oil crashes, and a pandemic that seems to have jumped into reality from our wildest dreams. In such scenarios, bolstering your portfolio with alternative investments can help you sail through tough times with relative ease.

DID YOU KNOW:

In 2018, alternative investment industry data provider Preqin predicted that the alternative investment industry was expected to grow by 59 percent by 2023, reaching $14 trillion in assets in five years’ time.

Going beyond the 60-40 rule

If you are an investor who is looking for long-term investments, a balanced portfolio with 50:50 (or similar proportion of) allocation between stocks and bonds will not be aligned with your long-term goals. That is the main reason why alternatives are becoming so popular in the world.

Now, it’s not just the ultra high net worth but even retail clients are investing in alternatives to help mitigate volatility and diversify their portfolios. Another benefit of alternatives is that if you invest in investments that will directly affect the economy of the nation, you can also receive tax benefits, which is not the case for common stocks, mutual funds and other traditional investments. While the rate of return is not guaranteed, just like every other investment, alternatives have the potential to have higher returns than the traditional ones.

All this means that now every investor has the chance to diversify into sophisticated investments, which were previously only possible for wealthy individuals and large institutions.

How can you invest in alternatives?

Bitcoins, gold, property (real estate), and even passion or hobby-related assets like art, wine, and classic cars fall under the ambit of alternatives. However, to keep things simple, alternative investments are divided into three main categories that have their own mode of investments:

Category I

Category I includes investments that invest in new startups, small and medium enterprises, infrastructure and social ventures that benefit the economy and society. Governments typically incentivise these investments as they create jobs and promote social issues that have a positive effect on the economy of the country. These alternative investments are specifically popular in developing economies.

1. Venture capital fund – venture capital funds are funds invested in new and upcoming startup ventures that show high potential but do not have the funds to establish their business.
2. Infrastructure fund – investment funds are investments that go into the development of public infrastructure like road, railways, communication assets and more. One of the reasons why investors feel secure to invest in this sector is that the entry barriers are high and competition low.
3. Angel fund – this is similar to venture capital funds. Investors give funds to startups and help them get off the ground. Unlike venture capital investments, Angel funds include management support from the investors.
4. Social venture funds – social venture funds are invested in companies that aim to bring a social revolution or have strong social conscience.

Category II

Category II includes investments in private equities and debt security. Governments do not provide any incentive like tax benefits on these alternative investments.

1. Private equity fund – private equity funds invest in unlisted companies that cannot issue equity and stocks.
2. Debt fund – debt funds invest in growing or distressed companies with a high growth rate but also a capital crunch. They are high-risk alternative investments with high yields.
3. Fund of funds – funds of funds invest in other alternative investment portfolios instead of investing in a specific company.

Category III

Investments that aim at quick returns belong to this category. These types of funds use diverse and complex trading strategies to get short-term capital returns.

1. Hedge fund – hedge funds are straightforward. They take capital from institutions and investors and invest in domestic or international markets.
2. Private investment in public equity fund (PIPE) – This means buying publicly traded stocks that are being sold at a discounted price. This allows an investor to own a share in a company while giving it the capital it requires to grow the business.

The benefits of investing in alternatives

1. In the past the classic balanced portfolio followed the 60-40 rule, where equities and bonds offset each other. But as interest rates reached the zero boundary, the risk offset from fixed income became less than enough.
2. US treasuries, which once used to be the global panacea for risk management, are not foolproof measures anymore. Alternatives provide a good hedge against these sectors.
3. To create a risk-stabilized portfolio, one needs to look at three factors: including assets with low correlation to the stock market, hedging against long-only risk assets, and the risk-return profile of the assets chosen. With most assets (stocks, bonds, equities) the risk-return profile is pre-decided and cannot be altered by an investor. Alternatives, however, give us the option to choose assets based on our preferred risk-return profile.

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Are there any risks to investing in alternatives?

Knowing the risks of an investment is just as important as knowing it’s benefits. Here are some of the biggest risks attached with alternative investment –

1. Investing in alternatives is more complex than any traditional investment thus making access to strategies slightly difficult with higher minimum sizes. Which means that investors looking for active management strategies may have a hard time managing their funds if they are new to the world of finance.
2. Alternatives may be more volatile when compared to funds, stocks and bonds due to lower liquidity.
3. For investing in alternatives, you need to pay higher fees and need a financial advisor to guide you.
4. It is difficult to make an exit and price the alternatives regularly as they are illiquid. Therefore, selling them can be a nightmare. For example – it will be easier to sell 1000 stocks than a 100-year-old bottle of wine, as there is no set way for calculating the value of the alternative.

To make sure that you arm yourself against these risks, you need a financial expert to make the decisions for your investments when you cannot. Our financial analysts at Kristal AI along with our artificial intelligence enabled recommendations will be with you for the entire journey.

Is it the best time to invest in alternatives?

Given that volatility is here to stay, there is no time like now to diversify and invest in alternatives. If you choose your platform wisely, you can also gain exposure to alternative investments easily and without the hassle of high minimum investments. This is something we at Kristal.AI do really well.

Happy Investing!