The recent drop in interest rates has left many investors taking a hit, leaving savers in a tight situation. For those looking at ways to diversify further, an alternative investment might just be the way.

What is an Alternative investment?

An Alternative Investment is an asset class other than stocks, bonds and cash. These tend to be less liquid, riskier investments and are often seen as being less transparent. While these variables are different for each asset class and, indeed, individual investment, we remind investors that when considering any investment, you shouldn’t jump in without fully understanding both the investment horizon and potential risk.

There are a number of benefits of including alternatives in a portfolio. These include reducing stock market correlation, and the reduction of risk through additional diversification. Combined, these factors have the potential to lead to higher portfolio returns.

Supporting the claim, research from Robert W. Baird & Co shows that:

‘… Replacing 20% of a traditional portfolio (invested 60% stocks and 40% in fixed income) with a broad mix of alternative products reduces volatility by approximately 10% and, after all fees and expenses are accounted for, slightly increases returns.’

Do alternative investments belong in most individuals’ portfolios?, Wall Street Journal

Baird represents his findings using the Markowitz Efficient Frontier to show the drop in expected risk obtained through introducing alternative investments to a portfolio.

Markowitz Efficient Frontier graph showing how alternative investments can benefit a portfolio

Graph courtesy of Baird research – not to scale

Supporting Baird’s claim, The Chicago Mercantile Exchange concluded including up to 20% assets in managed futures ‘enhances portfolio diversity and therefore promotes greater independence from general market moves’.

Which alternative to consider should be determined by your personal understanding of that particular market. The good news is that the range of alternatives available to investors has increased substantially over the years. Here are a few examples.

1. Property

Commercial or Residential real estate can be a profitable asset to hold in any portfolio in both short and long-term strategies. Property investments can range as far and wide as buying undervalued properties, renovating, and selling for a profit, to buying a share of a commercial property through a peer-to-peer property focused crowdfunding website where the property is managed, and rented out, by the platform.

Further, their are a number of tax efficient vehicles that are designed for the property asset class. Real Estate Investment Trusts (REITS) and the Innovation ISA offer tax breaks to those who invest in property (and other assets in the case of the Innovation ISA) through them.

Property does have its downside as the market is generally cyclical and will go through periods of decreasing value. While this may impact some shorter-term investors, property, in the long-term, has generally shown to increase in value.

2. Antiques, art, wine and collectibles

While you may look at these as pastimes rather than investments, there are considerable returns to be made for those astute enough to recognise a smart purchase.

Wine has long been a source of not only enjoyment, but investment as well (read our article about investing in wine). In relation to returns, between 2003 and 2011 prices of the most sought-after wines rose by more than 250% (The Telegraph, August 2014). However, in the past two years they fell back by a fair bit, and someone who invested in a good portfolio ten years ago would have returns of 150%.

Antiques, classic cars, art, and collectibles have also seen price rises in recent years. However, these assets often rise and fall in cycles so it’s important to understand the asset trend and when the next downward may occur. Similar to property though, many antiques (but not all) appreciate as they become older and harder to find.

3. Hedge Funds

A Hedge Fund is a pooled fund of cash, managed by an investment manager who selects which securities and other instruments to invest in, these being outlined in the Hedge Funds Mandate.

Hedge funds have proven to be fairly good at gaining solid returns from investors though the fees are often high with the standard fee being around 2% of assets under management and the hedge fund managers take a percentage of the profits returned.

The key to hedge funds is that the diversify into multiple asset classes and complex structures that help to spread the risk. The rise of the hedge fund is often attributed to the bull markets found in the US in the 1920s, prior to the great depression. Today, several trillion dollars are under management by hedge funds.

4. Peer to Peer Loans

Peer to Peer Lending has been on the rise for the last decade in the UK with the market growing to several Billion pounds being lent out annually. Peer to Peer platforms cut out many of the middle men in the lending process and therefore, in theory, can offer both borrower, and lender, better rates than they would get from their bank.

Both individuals and businesses can borrow through the platforms giving a wide range of opportunities to investors to choose from and the minimum investment amounts start at the tens of pounds.

Additionally, UK investors can receive tax advantages when they lend through an Innovation ISA which eliminates taxes paid on returns.

5. Equity Crowdfunding / Angel Investing

The latest way for retail investors to add alternative investments to a portfolio, angel investing has exploded thanks to popular startup investing shows like Shark Tank and Dragons’ Den, as well as the emergence of online platforms offering this type of investment.

Angel investing enables vetted investors to assess investment opportunities pitched to them by entrepreneurs and decide whether or not to take an equity stake in the early-stage business. Nesta’s Siding with the Angels report shows that early-stage investors, often referred to as ‘business angels’, have been able to return an annual 22% IRO over a period of roughly ten years.

6. Annuities

Annuities first became available to individual investors in the early 1800s when a Pennsylvania life insurance company began marketing ready-made contracts to the public. In the 200+ years that they’ve been around the market has grown to over £5 Billion pounds in annual sales in the UK alone.

In short, an annuity is an investment that pays the investor a fixed some, per year, for life (or a set period of time) and can be inherited by an heir. Interestingly, annuities are considered an insurance product rather than a pure investment.

When looking at an annuity be sure to factor in the associated fees as they can add up quickly. Some annuities charge 2-3% per year and many have a high early withdrawal fee.

7. Venture Capital

Venture capital funds diversify investor exposure by investing into multiple early ventures. If one of the portfolio companies does well, the fund can return a healthy profit to investors. In the UK these funds can also offer SEIS and EIS tax benefits*, which can cover over 50% of the initial investment.

Venture capital, like angel investing, is one of the riskiest and most illiquid asset classes to hold. Investors are likely to wait between 7-10 years before they start to see money back, and most venture funds are lucky to return investors just their money back. This is a result of the underlying investments, early stage companies, having a high probability of failure.

In a typical VC fund the hope is that 1 company will do very well and more than cover the costs of all the losses realised in the other investments. Of the remaining 9 companies, 5-6 will completely fail, 2-3 will potentially return the original investment, and 1-2 may give some some form of positive return

8. Forex

Forex, often referred to as Foreign Exchange, is the buying and selling of different currencies that exploits fluctuations in the marketplaces (through arbitrage) or adjustments in market prices over time. Forex is an asset class that is often leveraged which can lead to great profits or losses.

The incredible thing about Forex is that the market literally never sleeps. Prices are constantly fluctuating as world events unfold and investors may wake up to find a natural disaster, or other event, has caused their holdings to rocket up or down.

The modern forex exchange market only dates to the 1970s but the trading volume has grown rapidly and over $5 trillion is traded per day.

9. Crypto Currencies

Crypto/Blockchain was all the rage in 2017 and, while the markets have cooled in 2018, there is still a lot of hype around the potential for the underlying technology, blockchain. Crypto currencies are digital currencies that aim to operate independently of a centralised governing body. Crypto refers to the cryptography used to ensure transaction of the currency is held safe, and the register of transactions is immutable (not able to be tampered with over time).

There are an increasingly large number of crypto currencies available, each claiming some form of unique offering, though most trace their origin to the original, Bitcoin. Those who got into crypto currencies before the craze hit in 2017 are likely to have made a small fortune. However, many who came at the tail end of the craze have likely lost.

With governments still debating over how they will be regulated, investors should be wary that some will be completely abandoned should they fall into the category of unregulated security.

A risky business

There are of course a number of individuals who don’t believe alternatives belong in a portfolio. One of these naysayers is George Papadopoulos, a wealth manager at Novi. George cites his reasoning in the lack of liquidity and transparency that surrounds some types of alternatives – a point that does hold true for certain alternatives.

What this means is you must be fastidious in your due diligence prior to committing your cash to an investment. Take a deep look at the investment requirements and ensure that your portfolio can accommodate the potential risk and longer-term holding positions that may be required.

* Risk warning: Tax relief depends on an individual’s circumstances and may change in the future. In addition, the availability of tax relief depends on the company invested in maintaining its qualifying status.