Alternative Investments – 10 Myths and Misconceptions Debunked
Risk is present in any kind of financial investment. The higher the potential return, the higher the risk.
Perhaps the only investment that has the smallest risk is bank deposits but the return is very minimal. There have been instances where the interest rates are negative – what this means is you are paying the bank for storing your funds with them. Furthermore, the Central Banks of most countries only guarantee the safety of bank deposits up to a low limit.
With the increasing prevalence of black swan events rendering previously held assumptions of a traditional portfolio of stocks and bonds invalid, investors are increasingly looking for strong diversification plays to manage correlation risks.
Alternative investment is one of the possible options for these investors. However, as this asset class is much lesser known due to the lack of knowledge and understanding, many are wary due to the myths and misconceptions surrounding alternatives.
The root of their misunderstanding is over-simplification. This leads to some investors assuming that alternative investments are not relevant to investment portfolios, are illiquid, are beyond their reach, are too complicated, are not worth the risk, and that alternatives have the same nature as traditional investments.
This article seeks to demystify these misconceptions.
Myth 1: They’re All The Same
The term “alternative investments” encompasses an extremely wide range of opportunities, from rare coins to sustainable farmland. In fact, pretty much anything that does not fall within the definition of traditional stocks and bonds.
The more common alternative investments many are familiar with are venture capital, private equity, FX, hedge funds and real estate. For a comprehensive list, read this article.
It is therefore simply illogical to assume that each and every investment tool under this group has the same nature, risk, return, cost and strategy.
Doing that is like saying all birds are the same; akin to comparing a sparrow with an eagle. Can you treat a piece of land like a long/short equity fund? Clearly not. The expectations will obviously be different for both.
MYTH 2: It’s Only For Ultra Rich Investors And Institutions
Once again, this myth is due to the assumption that all assets under alternatives are the same.
In the past, perhaps a decade or two ago, this myth may have been true when there were fewer options and less financial awareness. Few people had the means to invest or the ability to not liquidate their assets for a long period of time.
Since the Great Recession in 2008, new product varieties have mushroomed under the alternatives class, fuelled by technological advancements, innovation in product structures and commercialization. Among them are crowdfunding, algorithmic trading, cryptocurrencies such as bitcoin, and so on.
In this modern age of investing, alternatives are getting more prevalent and accessible for individual investors to access them. We should not simply dismiss it as being an exclusive investment for the rich and savvy.
MYTH 3: Alternatives Are Too Expensive
This is with regards to the fees imposed on an investor. Fees vary greatly depending on the investment as well as a fund’s structure.
For example, mutual funds typically charge a management fee but not the performance fee. Hedge funds or alternatives typically will charge both management fees and performance fees.
Performance fee helps to ensure alignment of interest between the fund manager and the investor, as well as discourages excessive risk taking, especially when coupled with a high watermark feature. In other words, the performance fee is only paid should the fund perform.
Alternatives hence provide better alignment with investors through the use of performance fees, where you pay based on actual performance. Unlike the traditional guys charging management fees, most alternatives aim for positive absolute returns before they can charge any performance fees.
Therefore, depending on your goals and risk appetite, the returns can very much justify the cost.
MYTH 4: They Are Too Complicated And Non-Transparent
This myth arose mainly from considering all the different types of alternative investments as one entity.
The presumption here is also due to two more reasons: one – lack of knowledge, and two – lack of communication.
Investors need to conduct detailed research on the alternative investment of interest in order to fully understand what they are getting in terms of liquidity, diversification and return. The availability of information for some alts can be hard to obtain, which gives the impression of non-transparency.
- Investors also need to have regular dialogues with their fund managers or advisors to answer these questions:
- Is my advisor knowledgeable enough about my choice of alternative investment?
- Is my advisor open to understanding an alternative asset class in order to help fortify my portfolio by including an uncorrelated asset class that is alternatives?
- If my advisor is not open or able to consider alternative asset classes, are there other advisors that are willing or able to do so?
- Do I understand it well enough to proceed?
- Do I understand all the risk factors involved?
- How will this new investment contribute to my portfolio as a whole?
- Is the fund manager or advisor giving regular updates on the strategy employed?
MYTH 5: Alternative Investments Aren’t Necessary
Currently, there is such an abundance of financial products on the market that some investors mistakenly think that alternatives aren’t required at all.
On the contrary, alts are needed to form a well-balanced investment portfolio. This becomes increasingly apparent in times of crises, when both equities and fixed income portfolios fall in tandem, prompting an increased need to search for asset classes that have a proven low correlation to the overall markets.
According to Nobel Laureate Harry Markowitz’s efficient frontier concept, diversification improves the portfolio’s risk-reward profile. This leads us to the next misconception.
MYTH 6: They Add More Risk To A Portfolio
Depending on the strategy and the underlying instruments, alternative investments may be able to help investors’ portfolios weather the turbulence of the equity markets by offering little to no correlation in terms of returns.
Due to the nature of some asset classes, an alternative investment fund manager may even be able to dynamically adjust its risk parameters in times of market uncertainty.
Hence, instead of adding more risk, the diversification factor of adding alternatives potentially helps in reducing the overall portfolio risk, thereby improving the risk-adjusted returns for investors.
MYTH 7: They’re More Volatile Than Stocks And Bonds
While some alternative investments can experience higher levels of volatility than traditional stocks and bonds, as a group, they are no more volatile than any other investments.
Their low correlation to overall market dynamics can serve as a volatility dampener. In addition, the less liquid nature of some alternative investments can benefit investors by discouraging behaviour-based trading.
Within the alternative investment asset classes, there exists assets that are less risky and volatile than others. Alts that are backed by tangible collateral tend to have low correlation to the stock market, protecting an investor’s portfolio from market volatility.
MYTH 8: Alternatives Go Up When Stock Markets Go Down
Those who have delved into the alternative investment space would know the ability of alts to perform in a stock market crisis. Yet there are instances of investors investing in alternatives making losses at the same time as stocks.
The problem lies in the confusion between low correlation and negative correlation. Low correlation simply means that sometimes alternative assets are positively correlated to stock market trends and sometimes they are negatively correlated.
Just because it is said that alts do not generally follow market movements, one cannot assume that all alternatives will always move in the opposite direction.
If your investment is an equity-based fund, naturally you will be somewhat affected by the market movements. Certain underlying instruments may serve to reduce the correlation and it is necessary to understand the nature of the instrument in your alternative investment.
MYTH9: They Underperform Traditional Assets
The reality to this myth is that some investors are trying to compare apples with oranges. The underperformance analogy was made famous by the historic bet Warren Buffet made by pitting S&P 500 index with a basket of hedge funds picked by a fund manager.
Yet this tends to be a red herring as the original intention for hedge funds was not meant to beat the S&P 500 for any set period. It is fundamentally designed to provide a different type of risk relative to the traditional asset classes (stocks/bonds).
Its purpose is to deliver better risk adjusted returns, which is often exemplified with its low correlation to the broader market performance.
MYTH 10: Investors Cannot Liquidate Their Alternative Investments
Liquidity is a huge concern among investors. The assumption is that their money will be stuck in this type of investment for a very long time. That may be true for certain assets. For example, certain hedge funds offering alternative portfolios that lock investors’ funds in for 5 to 10 years.
Yet again, this myth is another blanket statement. There is huge disparity in liquidity even within a single alternative asset class. There are both liquid and illiquid versions of alternative investments.
Limited partnerships, for example, have lock-up terms ranging from 30 days to 10 years. Hedge funds structure can offer quarterly, monthly, and even daily liquidity depending on the underlying of the alternative investment.
Conclusion
Alts have a place in nearly every investor’s portfolio. However, it is imperative to pick the right one based on your investment objectives, existing portfolio composition, affordability, and risk profile.
If you are not able to do this on your own, the advice is to engage the right expert in the field and let the professionals manage the investments for you.
