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What You Need To Know About Alternative Investments – Forbes Advisor UK

Ask most retail investors about what makes up the bulk of their investment portfolio and the chances are that ‘stocks and shares’, ‘bonds’ and ‘cash’ will figure in their replies.

You’re less likely, however, to hear many references to ‘alternative’ investments.

Despite having a relatively low profile among mainstream investors, the market for ‘alternatives’ has grown significantly over the past 10 years.

So, what are alternatives, and could they play a role in your investment portfolio? 

What are alternative investments?

Alternatives occupy the space beyond the conventional and traditional core asset classes of shares, bonds and cash.

Bill Blain, head of alternative assets at Shard Capital, says: “The business of alternative investing is simple. It’s to do with seeking returns from the real economy, rather than trying to second guess traditional financial markets.”

Blain says alternatives cover a wide spectrum of assets: “Anything that provides a real return is potentially an alternative, from the stream of leasing payments on an aeroplane, for example, to commercial rents on warehouses, or power contracts from a wind farm.”

Popular types of alternatives include:

  • Private equity Investing in companies not publicly traded on an exchange
  • Commercial property Investing directly or indirectly in offices, shopping centres, leisure outlets, industrial units and warehouses.
  • Infrastructure Investing in projects aimed at delivering services which keep society functioning, such as roads, schools, water and clean energy.
  • Venture capital Investing in newer companies with the potential for substantial growth.
  • Hedge funds Investment funds designed to produce positive returns regardless of how the stock market is performing.
  • Natural resources Investing in commodities such as precious metals and forests.
  • Collectables Investing in luxury items, anything from antiques, art and classic cars to jewellery, fashion items and fine wine.

How big is the alternatives market?

It may not be the first port of call for retail investors, but the alternatives market is substantial and getting larger year-on-year. 

Data provider Preqin omits collectables from its calculations but says there was about £12.2 trillion ($14.7 trillion) invested via alternatives worldwide at the end of 2021.

According to Preqin, the 2021 total broke down as follows: 

  • £5.8 trillion ($6.9 trillion) invested in private equity 
  • £3.6 trillion ($4.3 trillion) in hedge funds
  • £1.1 trillion ($1.3 trillion) in real estate 
  • £790 million ($950 million) in infrastructure
  • £1 trillion ($1.2 trillion) in private debt
  • £175 billion ($210 billion) in natural resources.

Last year’s total was a substantial increase compared with the approximately £4.5 trillion ($5.3 trillion) managed in alternatives just a decade earlier. Preqin forecasts that the figure for alternatives could reach as much as £20 trillion ($24 trillion) by 2026.

Why invest in alternatives?

There are several reasons why alternatives should be considered for inclusion within a portfolio.

Joe Smith, investment analyst at Equilibrium Financial Planning, says: “In the present economic conditions, investors should be looking to alternative investments to diversify portfolios and hedge against inflation.”

“For example, infrastructure such as renewable energy, often provides a natural inflation hedge. Similarly, property tends to benefit from inflation-linked rent.”

Leslie Uzan, head of private equity and debt at St James’s Place, says alternatives provide investors with extra choices: “Investing in private assets allows us to access a vast opportunity set. If we only focus on the public markets, we are missing out on a very large number of high-potential opportunities.”

As an example, she points to the US where there are over 17,000 private companies with annual revenues over $100 million vs. approximately 2,600 public companies with the same annual revenues.

Another advantage of investing in alternatives is that they tend to behave differently from traditional asset classes. This is known as having low (or, even, no) correlation and can be useful when it comes to managing investment risk and generating returns within a portfolio of different assets.

Brian Byrnes, head of personal finance at Moneybox, says: “Some alternatives can be a good diversifier and protect portfolios in times of market stress. They can also provide additional value and enjoyment outside of investment returns, for example, wine or classic cars.”

Potential drawbacks

Each of these are valid reasons for investors to think about getting involved in alternatives. But investing rarely offers a free lunch and, for would-be participants in alternatives, there are trade-offs to bear in mind. 

For example, Mr Byrnes says accessing alternatives can be harder and the investing environment tends to be more opaque when compared with mainstream investments: “It can be difficult to assess the merits, security and fees of an investment in advance,” he says.

The UK’s financial watchdog, the Financial Conduct Authority, recently announced it would be probing investing firms over how they are managing the risk of mis-selling alternatives.

In a ‘Dear CEO’ letter to investment firms operating in this space, the regulator said it would begin questioning their business models, products, investor categories and controls.

The letter said those unable to show they have taken ‘reasonable steps’ to ensure clients are taking appropriate risks would receive further scrutiny.

The regulator said: “During the last two years, we have conducted assessments of alternatives firms’ risk controls and will continue to do so where market footprints imply a higher inherent risk of contagion or harm.”

Shard’s Mr Blain agrees: “Alternative assets require much more work than traditional financial assets. Information is not as available or as public. It’s a matter of doing more analysis to understand returns.”

Mr Byrnes accepts alternative investments have attracted attention so far in 2022, because some niche asset classes have produced positive returns in an environment where more mainstream investments, such as equities and bonds, have been significantly negative.

He says: “It’s very difficult, if not impossible, to tell in advance which alternative asset classes are going to perform well in different market conditions. In addition, investing in alternatives is typically a more expensive way of investing compared to equity or bond tracker funds.”

According to Santander Asset Management: “Alternatives can potentially expose you to higher or more complex types of risk compared with shares, bonds or cash, and you need to understand these to use them effectively”.

Santander says this is one of the reasons why alternatives have traditionally tended to be more popular with institutional investors – professionals who invest money on our behalf through pension and investment funds – and also high-net worth individuals compared with, say, the broader  retail investment community.

Alternatives for all?

Equilibrium’s Joe Smith says it’s still possible for investors to get a piece of the alternatives action, even with just a few thousand pounds to invest, because various collective funds specialise in this sphere: “There are numerous investment trusts and pooled funds on fund platforms that retail investors can access for modest amounts.

“Investors may not have access to the more sophisticated products, but real estate investment trusts (REITs), private equity investment trusts, long/short funds and infrastructure funds will all be available to them. In addition, they provide more by way of diversification than, say, a simple 60/40 investing strategy that’s just split between equities and bonds.”

Vanessa Gibson, CEO of illio, says: “Thanks to a growing number of recently established platforms, I believe alternative investments are certainly becoming more viable for retail investors.

“For example, there are platforms which can now allow investors to buy private equity or hedge funds in much smaller amounts than a fund would typically charge. Fundfront for example, can allow investors to buy certain hedge funds with as little as £10,000.”

Ms Gibson adds that more recently, fractionalisation – essentially the splitting-up of ownership of a specific asset – is giving even further access to alternatives for retail investors: “This trend is seeing investors now able to buy fractions of alternatives on platforms that may have previously been unobtainable – such as luxury cars, art or even collectibles like wine or whisky.”

Types of alternative investment

Private equity funds

Private equity funds are pooled investment vehicles that aim to acquire controlling stakes in private and public companies. They take an active role in managing their portfolio companies, providing intellectual and financial capital.

When a private equity fund acquires a stake in a company, the goal is usually to restructure the firm and provide capital to accelerate growth. The fund turns a profit when it liquidates its stake, either by taking a portfolio company public in an initial public offering (IPO) or by selling it off to another company.

Leslie Uzan, head of private equity and debt at St James’s Place says: “Private equity, now more than ever, could represent an attractive opportunity for investors, by tapping into a differentiated investment universe and by giving investors a differentiated source of return thus providing diversification in portfolios.

“Furthermore, private equity historical returns show that this asset class has been resilient across many market cycles, especially when compared to public market indices.”

Property

Property is one of the most accessible forms of alternative investment when you remember that many Brits already own their own home. Property investing means buying actual property or gaining exposure to property or real estate funds that specialise in the area of bricks and mortar.

Property investors anticipate appreciation in value over time, while real estate assets such as office blocks or shopping centres generate steady rental income.

Equilibrium Financial Planning’s Joe Smith says: “When it comes to investing in property, we usually favour REITs as these provide a liquid vehicle to hold an illiquid asset.” 

Liquidity is a measure of how easy it is to convert the holdings to cash of a particular asset class.

Hedge funds

Hedge funds are private, pooled investment funds that seek high returns through varied and sometimes risky investing strategies. They are allowed to invest participants’ money in just about anything, from publicly traded securities and start-ups, to currencies and derivatives (sophisticated financial investments).

Unlike traditional ‘long only’ funds that seek to make money from rising asset prices, hedge funds often make use of less traditional investment strategies including leverage (borrowing to invest) and short-selling (looking to profit from falling share prices).

Mr Byrnes says: “Alternative investments such as hedge funds or collectibles tend to suit more experienced investors with a longer time horizon. Given the extra effort and due diligence required to find and assess such investment opportunities they would typically not be suitable for new investors or vulnerable clients.”

“Many alternative asset classes can also be illiquid in nature and require your funds to be committed for long periods of time, five to 10 years, for example. This would only suit investors who do not need access to their funds over that type of time period and have a relatively high capacity for loss.” 

Alternatives also tend to have higher costs associated with them compared to more mainstream investments. Hedge funds for example have typically had a ‘2 and 20’ fee structure, where the investor pays 2% per annum and also 20% of the profit above a pre-agreed benchmark is kept by the fund manager.

Venture capital funds

Venture capital (VC) funds provide financial backing to promising start-up companies in exchange for an equity stake. In a similar vein to private equity firms, VC providers may take an active role in management and lend necessary expertise.

VC investors may stay invested in a particular firm longer than a private equity fund. They also work with the portfolio company concerned and monitor progress, releasing extra rounds of funding as certain benchmarks are met. VCs exit the investment following a merger, acquisition or IPO.

Infrastructure

Traditionally provided by governments, the idea behind infrastructure has evolved in recent decades often into combined public-private partnerships with investment firms and major institutions such as pension funds playing a role.

Victoria Hasler, head of research at EQ Investors, says: “One alternative asset class which we have liked for some time, and which has provided a good degree of ballast to portfolios so far this year, is infrastructure. In particular, the kind of infrastructure which will help in the transition to net zero.

“An example of a fund which we think will benefit from the transition is the Harmony Energy Income Trust. We bought this fund at IPO and have been rewarded with positive returns in a falling market. The fund develops and operates battery storage facilities, buying energy from the National Grid when demand and prices are (relatively) low and selling it back at times of high demand when prices rise.”

Natural resources

According to data provider Preqin, natural resources are materials or substances that occur naturally on Earth that can be mined, farmed or collected in raw form. Raw materials are often engineered into more complex man-made materials and extracted, processed or refined for the realisation of their economic value.

Jai Bifulco, chief commercial officer, at Kinesis Money says that when recession clouds are gathering, one of the most obvious alternative investments and stores of wealth is gold: “In times of economic turmoil, precious metals, gold in particular, have outperformed other traditional asset classes,” he says.

“It has always been considered prudent to hold a portion of an investment portfolio in precious metals. But precious metals are especially attractive at the moment considering they can protect against the threat of inflation damaging the value of fiat currencies. Precious metals have, historically, acted as a stable, inflation-proof, avenue for storing value over time.” 

Collectables

Knight Frank’s Wealth Report earlier this spring confirmed that 2021 was a good year for investing in wine. Fine wine shared top-billing last year, alongside collectible watches, out of a range of luxury items including art, cars and jewellery, each of whose performance is tracked by the firm.

According to Knight Frank, fine wine and watches each produced a return of 16% over the period placing them at the front of the ‘alternative investments’ market for the year.

Dr Thomas Schröck, founder and ceo of The Natural Gem, says: “Gemstones are the world’s oldest form of investment assets, and have been used over 5,000 years as a safe investment option for lucrative returns over time. Despite this, many people are unaware of these alternative investment heroes and their financial benefits.”

Schröck says that, over the last 10 years, coloured gemstones have experienced some of the biggest price jumps in history: “Leading the gemstone space in terms of value and growth potential are rubies, sapphires and emeralds, that have increased in value by 5-8% year-on-year since 1995.”

He adds that good examples of lesser-known gemstones that have experienced consistent and stable price jumps over several years include, tourmaline, aquamarine and alexandrites.

Are alternatives right for you?

Possibly. Shard Capital’s Bill Blain says that alternatives reward smart, clever buyers who take the time to understand their complexity. But he adds that alternatives can quickly devour investors who try to cut corners: “The big issue investors have to be aware of is illiquidity. Because alternatives tend to be bespoke there is no liquid secondary market in these deals. Dealing with illiquidity should be a key investment parameter for any potential investor.

“Investing in alternatives is perhaps even more skilful than simple stock picking. The major threat at present is the risk of stagflation in Europe, so finding real assets that are inflation insensitive, for instance public utility equipment, is a key goal.” 

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