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 are alternative investments?
Alternatives are investments in asset classes 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.
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.
Antiques, art and wine
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 on 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%.
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.
Venture capital funds
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.
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.
Want to learn more?
On 20th September 2016, we held a free event, Where are the post-Brexit returns?, to discuss how investing in alternatives could help you yield returns.
With speakers including Simon French, Chief Economist at Panmure Gordon; David Toplas, a seasoned angel investor who has managed £2.2bn in property funds; and Dr Mark Payton, CEO of Mercia Technologies PLC, the evening was a huge success.
* 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.