Diversifying Your Portfolio Through Alternative Investments

Alternative investments can largely be defined as investments that do not follow the traditional structure and asset class, such as stocks, bonds, and cash. Stocks, bonds, cash, etc are conventionally popular choices of investment amongst investors. It is observed that the majority of the investors limit their diversification by only investing in traditional investments as they do not have a clear idea about alternative investments.

The critical characteristic and the most significant advantage observed of alternative investments is that there is less correlation between the movement of these investments with that of traditional assets. In other words, the relative performance of the alternative assets is in low correlation with respect to conventional assets during different phases of business cycles and market fluctuations. Thus, adding these unconventional investments as a part of the portfolio could be a good way of minimizing risk and volatility via diversification.

Another characteristic is the low liquidity of some alternative assets, especially private equity and hedge funds. Both these assets have a specific lock-in period; thus, investors cannot withdraw their funds as per their requirements. In addition, some private real estate investments also have less liquidity. Other characteristics of alternative investments are high risk, lesser regulation, high fees, and low transparency. They also incur complex tax and legal compilation. If you’re unsure of whether adding alternative investments to your portfolio is a suitable option for your financial requirements, consult a financial advisor for further assessment and guidance.

Types of alternative investments

There are various types of alternative investments. The most common ones are real estate (this includes commodities and infrastructure), private equity, and hedge funds, as discussed below.

1. Real estate:

Ownership of physical assets such as commodities, infrastructure, and real estate comes under this asset class. The primary advantage of investing in this asset class is that it generates cash flows at par with inflation rates, thus more often than not, securing investors from inflation risk.

2. Private equity:

Purchasing ownership in companies through equity or debt, which is raised in private markets instead of public is referred to as private equity. These investments have very low liquidity and high risk. Only a few investors (generally HNWIs)  have access to these investments.

3. Hedge funds:

It is a type of private investment which pools capital from investors and invests it in different assets using complex strategies. They are not as strictly regulated as mutual funds and charge a high fee.

How to invest in alternative investments

For the longest time, alternative investments were traded mainly by accredited private and institutional investors that qualified minimum required income. The requirement ranges from more than $200,000-$300,000 for joint income and $1 million for individual income. In the case of qualified investors, the portfolio should be worth more than $5 million individually or jointly.

Recently, even retail investors have access to these assets through mutual funds, exchange-traded funds, and alternative mutual funds.

[See: How to Build an Investment Portfolio]

There are broadly three methods of investing in alternative investments. They include:

1. Fund Investing

Under this type of investing, the investor gives capital to a fund, and then the fund identifies, selects, and invests the contribution on behalf of these investors. For this service, the investors are charged a fee (associated with the amount of funds being managed). In addition to this, a performance-based fee is also paid if the fund manager can obtain superior returns. Since investors do not actively manage their funds here,  this method of investing is referred to as an indirect form of investing in alternative investments.

The fund investor has no power to over guide the underlying assets included in the pooled fund. One can invest in all major alternative investment types through this method of investing. The advantages of this investing include better diversification and lower capital requirement, whereas the disadvantages include higher costs and conducting detailed due diligence.

2. Direct investing

Contrary to fund investing, this investment method involves the investor investing in an asset without any intermediary directly. For instance, if we consider investing in private equity, the investor can directly purchase a stake in a company without using a fund. Direct investing gives the investor the freedom to choose among different investments and methods of financing. This method of investing is reserved mainly for experienced investors and is majorly applied to real estate and private equity investments.

Substantial funds such as sovereign wealth funds can also use this method for investing in oil and gas, natural resources, and infrastructure. Advantages of this method are- high degree of control, flexibility on the choice of assets, and no additional fees. Disadvantages include the requirement of knowledge and experience on the part of the investor to make profitable decisions, greater due diligence compared to fund investing, and no access to available diversification benefits from a fund manager.

3. Co-investing

This method is a middle ground between fund investing and direct investing since the investor can indirectly invest in assets through a fund manager. However, at the same time, he has the right to invest directly. An investor can invest in an asset directly by purchasing the assets besides investing through a fund. The investor has the chance to increase his knowledge and experience by learning from the decisions made by the fund manager. Even though co-investing has less fee and high freedom relative to fund investing, it does require as much due diligence and is prone to selection bias of the investor.

4. Due diligence

Due diligence is, in general terms, the research that an investor does before entering into an agreement or investment. Conducting due diligence is important irrespective of the method of investing you choose, even in the case of fund investing, where an expert manages the fund. The investor needs to conduct due diligence in order to choose the fund to invest in.

The important components to consider while conducting a classic due diligence process are as follows:

  1. Checking if the management is experienced and delivers quality service and also the overall reputation of the firm.
  2. Analysis of prior and current performance.
  3. The investment strategy of the firm in terms of target markets, underwriting, investment sourcing, and more.
  4. Accounting and auditing methodology.
  5. Risk management in terms of leverage risk, currency risk, and other performance risks.
  6. Legal evaluation, involving a review of fund structure, litigation, etc.
  7. Analysis of contracts that includes associated fees and expenses, agreement terms, limited partnership, conflict, and more.

Role of alternative investments in creating a diversified portfolio

Risk and return go hand-in-hand. The more return you desire, the more risk you need to take. Hence, diversification is a popular strategy used by investors to ensure good returns with minimal risk.

Diversification plays a pivotal role in minimizing the unsystematic risk associated with portfolio management. It is an essential characteristic that should be present in the portfolio to secure high returns while having less exposure to risk.

To explain further, let us assume an investor’s portfolio has stocks, bonds, and precious metals like gold. If the market is highly volatile and the stocks tumble, the steady and low-risk bond yields can lower the losses and, thereby, the total risk of the portfolio. It is also observed that gold prices soar with increased market volatility, again hedging the risks. Therefore, alternative investments have provided improved portfolio diversification.

Investors can incur quite a few benefits from diversifying their portfolio, such as (1) access to increased investment opportunities from different asset markets other than traditional ones. (2) decreasing unsystematic risk (risk specific to a particular asset category) (3) obtaining optimal returns with low risk (high yields due to alternative and traditional investments and decreasing exposure to market cycles).

Conclusion

Investing in the contemporary world is no longer limited to stocks and bonds. With changing needs and an inflated lifestyle, investors wish to garner maximum returns from every investment and avenue possible. Alternative investments provide them with this opportunity. Through these investments, even common investors can invest in private equities, estates, and even hedge funds, which earlier remained only available to certified or elite individuals. Though the risk is high, through a combination of fund and direct investing, an investor can arrive at his optimum portfolio that neither requires large expertise nor constant monitoring.

Looking to invest in alternative assets?  Connect with a qualified financial fiduciary to effectively plan your investment roadmap. Use Paladin Registry’s free advisor match tool to match with qualified advisors who may be able to help you with your specific queries and create customized plans for you. Answer a few questions and get matched with 1-3 fiduciaries suited to meet your unique financial needs. You may also set up a free initial consultation with them before deciding to hire one.

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