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March 2018

Demystifying alternative investments

Alternatives are prized by investors. They're also in short supply.

Alternative assets are as prized as blue diamonds. Unfortunately, they’re just as rare – most of what glitters in the investment universe is actually rhinestone.

That’s because for all their perceived distinctiveness, most investments that carry the ‘alternative’ label tend to be made up of fairly ordinary underlying assets. More often than not, their only distinctive features are higher management fees and insufficient compensation for the fact that they are hard to buy and sell.

This shouldn’t be surprising. Most assets tend to behave in the same way because they are influenced by the same fundamentals, such as changes in interest rates and inflation. That’s why we’ve rejected most of the alternatives we’ve looked at.

Yet while true alternatives are hard to find, that doesn’t mean they’re not worth the effort. Particularly today, when bonds and equities tend to move more closely together than in the past.

Holding a separate group of assets that follow their own independent course is the sort of diversification that makes investors less vulnerable to broad macroeconomic forces.
And even if pure alternatives aren’t available, finding ones that have the right mix of bond- and equity-like characteristics can also help – as long as they come at an attractive price. A key asset allocation skill is not to overpay for diversification. Expensive assets are a drag on portfolio returns regardless of whether they move in lockstep with the broader market or not. 

Just wearing fancy dress?

A close look at property highlights some of the problems investors face when assessing alternative investments. Property comes in two forms: a building site and the final construction. Owning a building site is much like owning stock in a high-growth company with the expectation that the return will come in the form of a capital gain. Meanwhile, the finished building broadly acts like a debt instrument, the main difference being that its coupons are called rents. So it’s not an alternative in the sense that it isn’t immune to the traditional driving forces of bonds and equities.

But that’s not to say property does not offer investors diversification. It can protect against inflation and has contractual cash flows that aren’t necessarily fully synchronised with traditional asset classes. 

a volatile universe

Comparing the range of long-term returns for alternative and traditional asset classes

Range of annual returns

Source: Datastream, MSCI, JP Morgan, Prequin, HFRX, NCREIF. Returns are indicative. The private equity, hedge fund and commercial real estate index data are comprised of funds that may be closed to new investors and not be easily reproduced. Data covering period 20.03.2008-20.03.2018 except for commercial real estate which is to 31.12.2017. 

Private equity is an asset class that gains from the fact that debt has tax advantages. It’s an investment best suited to long-term stable institutional pools of capital, like endowments and sovereign wealth funds, which can take advantage of the extra returns available as a trade-off for locking up money over long periods.

Elsewhere, there are infrastructure assets – such as toll roads, airports or hydro-electric projects. But because they’re typically contracts with the public sector, they end up mimicking the public bond market, albeit with lower liquidity and higher fees. Nor do they offer the prospect of equity-like capital gains.

Expensive alternatives and those that aren't even assets

Many investors are attracted to alternatives like artworks, wine, stamps, diamonds, rare cars etc. But these are, in fact, speculative assets. The decision to buy tends to be based on the expectation that someone will pay a higher price at a later date for something with no obvious intrinsic economic value. And they’re often hard to handle. Selling a portfolio of these assets can take many months and considerable legwork – all the while incurring significant insurance and storage costs.

Alternatives like artworks, wine, stamps, diamonds, rare cars etc. are, in fact, speculative assets.

As for commodities, not only do we not see them as alternatives, we don’t even regard them as long-term assets. There’s no evidence that commodity prices rise over time. In fact, technological improvements – be they more efficient machinery, better processes or something like the mid-20th century’s Green Revolution, when thanks to scientific innovation and technology, agricultural productivity rocketed – have generally contributed to a downward trend in long run commodity prices.

What’s more, commodities are often liabilities. Take timber. It generates no income, you have to pay to store and insure it and, over time, it rots. Forests, on the other hand, are assets. Investors can choose the pace at which trees are harvested and planted as well as the species mix, whether slow growing deciduous or fast evergreen.

Glittering gold

Gold is also interesting.

Gold price, dollars per ounce

demystifying alternative gold

Source: Bloomberg. Data covering period 31.12.1979- 22.03.2018.

Not because of its commodity characteristics, but because it acts as a proto-currency. It’s true that, as with other commodities, gold doesn’t generate an income and incurs storage and insurance costs. But it isn’t a wasting asset, doesn’t tarnish and has historically worked as a store of value. And in a time when yields across assets generally are wafer thin or even negative, gold’s lack of income generation stops being a mark against it.

Gold comes into its own when people start to worry about central banks using the printing press to erode away the value of currencies, as well as during times of political turmoil and war. People buy it as a safe haven. Today’s worries about North Korea, the erratic Trump presidency and central banks’ growing balance sheets underscore its attractions as a long-term investment.

Research has shown that it also works as a hedge against stocks during normal market conditions.1 Which is to say that it works as a portfolio diversifier.

Valuing alternatives

Overall, most assets labelled “alternative” aren’t when looked at closely, they behave just like conventional assets. But there are some viable options available. The big question investors need to ask is whether the returns are sufficient to compensate for these assets’ typical lack of liquidity. What’s most important to remember is that whether the asset you buy is conventional or “alternative”, the price you pay for an asset will have a meaningful impact on your ultimate return.