What are ‘alternative’ investments?

An ‘alternative’ investment is an asset that falls outside one of the conventional categories: generally, shares, bonds, and cash. The term is loose and could be applied to quite common areas such as property, infrastructure, and private equity, as well as more niche investments such as hedge funds, commodities and even collectibles such as art, classic cars and fine wine.

Why invest in alternative assets?

The chief attraction of alternative investments is they should offer ‘something different’. Depending on an investor’s needs, their allocation to these more ‘unusual’ assets may be aimed at boosting returns or generating income, but either way they should provide opportunities that don’t exist in the realm of traditional investments. It also makes diversification possible – the ability to spread risk without compromising returns too much.

Types of alternative investments

1. Private equity

Investors can usually easily buy shares and bonds listed on exchanges around the world, but what about investments that aren’t traded on public markets? Stock markets don’t have the monopoly on investment opportunities. On the contrary. Some of the fastest growing companies and investments are in the hands of private holders, often founders and exclusive bands of early investors in the case of relatively new companies.

Fortunately, there is a gateway for ordinary investors. ‘Private equity’ and ‘venture capital’ funds buy into unlisted companies and other areas that would otherwise be very difficult to access. Although the area can be higher risk, it is potentially a source of decent returns as sometimes the growth a company enjoys is strongest in its pre-stock market life – if it ever lists on a market all.

In this era of increased digitalisation, having access to these types of investments seems more important than ever. Some of the most innovative companies in the world today are private businesses, often because they are technology-based and have lower costs meaning there is little need to raise capital via the stock market to grow.

Worldwide there is estimated to be 400-500 ‘unicorn’ companies, privately held start-ups valued at over $1 billion. Private equity examples include BrewDog, Monzo or Babylon Health here in the UK, as well as Canva, BlaBlaCar, Vinted, Grammarly or SpaceX overseas. Former unicorns that have listed on a stock market or been acquired include Uber, Facebook, Pinterest, Alibaba, Spotify and Skyscanner.

Investment Trusts that include an element of private equity in their portfolios include Scottish Mortgage, an adventurous global growth trust, and RIT Capital Partners, a more diversified ‘multi asset’ Trust. If you’re interested in this area, follow the link to find more tips and guidance around private equity investment trusts.

2. Property and infrastructure

Various forms of property can provide a steady rental income, as well as the potential for some capital appreciation. The average private investor is unable to buy their own office block, warehouse or retail park, but property investment trusts can provide sensibly diversified access and have advantages over ‘open ended’ property funds, some of which currently have dealing suspensions due to the uncertain effects of Covid on underlying valuations.

Infrastructure assets can also make attractive investments. Revenue streams from roads, power networks, hospitals and schools are often fairly stable, independent of the health of the wider economy and backed by long-term revenue streams from government. Large, diversified investment trusts such as International Public Partnerships, HICL and 3i Infrastructure can potentially provide investors with a decent income-orientated return and welcome diversification from equity and bond markets. We believe infrastructure asset investing will play a vital role in the ongoing ‘energy transition’ as it will provide much needed capital for low carbon energy generation, storage and transmission to be rolled out.

3. Hedge funds

For decades ‘hedge’ funds have adopted more sophisticated techniques aimed at boosting returns and managing risk. Typically, a hedge fund pools capital from investors to invest in varied assets, sometimes using complex strategies such as shorting (selling assets to profit from falling prices) and leverage (borrowing to invest). The emphasis on a particular approach or strategy can make them less dependent on the overall direction of markets, though not necessarily.

Hedge funds are usually aimed at institutional or high net worth investors, though similar strategies (though without the excessive risks of leverage) are available through Targeted Absolute Return Funds. Funds in this sector vary considerably both in terms of asset class speciality and level of risk, though they generally look to generate returns from a variety of conditions – not just when markets go up.

4. Gold and commodities

It is quite straightforward for investors to add exposure to precious metals, industrial metals, oil and even agricultural products such as wheat or sugar to their portfolio. Exchange Traded Commodities (ETCs) follow the price of metals, oil or agricultural products, however they are generally aimed at shorter term traders and come with significant risks, particularly those based on derivatives rather than taking ownership of the underlying asset. For full details relating to the risks of a particular ETC you should read the relevant Key Information Document (KID) and Simplified Prospectus.

The ETCs that physically own precious metals such as gold are more straightforward. Some believe gold is an asset class in its own right as it has been used as a means of exchange and a display of wealth for much of human history. Today, Gold often becomes the go-to asset in times of crisis, but more importantly, it represents an ‘independent’ currency that cannot be debased. Paper currencies lose their value over time as more money is created, which is why interest rates on cash are often not enough to keep up with inflation – the rising prices of goods and services. In contrast, gold supply is finite, and expensive investment is necessary to discover and extract more of it.

This can make gold a useful diversifier in a portfolio. It doesn’t tend to be correlated with other commonly-held assets such shares or bonds – in other words, the price tends to do its own thing and it can rise when other assets fall – and vice versa. In theory, over very long periods (think decades rather than years) gold should rise (or fall) at roughly the rate of inflation (or deflation), though this assumes that any new supply from mining is roughly equal to additional demand.

Although gold can be a great diversifier in a portfolio it does also come with several disadvantages. It has little practical use owing to its high cost and it yields no income. During ‘normal’ economic times it can become deadweight in a portfolio, or worse because it can be unpredictable and potentially volatile due to geopolitical events or supply and demand imbalances. If you’re interested in this area, check out my article that weighs up whether gold is a good investment.

5. Unorthodox investments

The list of possible alternative investments seems to be endless, and investors should always be suspicious of more obscure areas – particularly investments that are unregulated. These could feature poor structures, high charges, bad governance and could even be scams. There are lots of fraudulent traps for the unwary – just google ‘ostrich farms’ – but it’s not just absurdities to be sceptical of. Be wary of any high, ‘guaranteed’ returns and always check if a business offering an investment is regulated using the FCA’s register available on their website.

There are, of course, lots of bone fide investments in unconventional areas too. Investment Trusts, for instance, offer access to such diverse areas as music royalties, aircraft or shipping leasing and speciality lending. There’s lots more information on these Trusts and many others on the Association of Investment Companies website, but do be aware that a variety of specific risks surround such investments and these can be hard to assess.

6. Bitcoin and cryptocurrencies

Cryptocurrencies such as Bitcoin are very popular right now. There are reasons to think that blockchain or other technologies behind them are revolutionary and a great growth story, but the risk involved in the individual coins and tokens is exceptionally high and in lots of cases poorly understood. These alternative investments could rise as more people back their adoption, but ultimately could be worth very little.

They are also unregulated and if assets are stolen or lost there is nothing that can be done. The Financial Conduct Authority (FCA) warns that consumers should be willing to lose all their money when investing in the space.

Ultimately, we remain sceptical that Bitcoin meets the necessary criteria to be considered an investment or a currency: It doesn’t provide a systematic return over time and it doesn’t necessarily provide a safe store of value. Many of those currently drawn to it are speculating that it represents a future widespread form of money, but this seems a leap of faith given various forms of digital currency could emerge to compete with it, including ones issued by central banks.

It’s also important to recognise that those championing Bitcoin or other cryptocurrencies generally have a vested interest in their success, and that because it is an unregulated space they can 'ramp' them with few consequences.

Pros and cons of alternative investments

Pros

• Alternative assets can play an important role in diversifying a portfolio – spreading risk without hurting your returns too much
• They can also provide exposure to unique investment opportunities that are usually inaccessible through public markets
  
  

Cons

• The more niche investments, such as art or classic cars, can contain risks that are hard to assess
• A long time horizon tends to be necessary to fully reap the benefits of an alternative asset, as it may take years or decades in some cases for your investment to deliver strong returns
• In some cases, there can be issues of liquidity – the ease at which they can be bought and sold – so its important to assess the structure of the alternative investment as well as the underlying assets themselves

To sum up? Stick to what you know

The principle “if you don’t understand it, don’t invest” tends to be a wise one to follow when it comes to alternative investments. This also applies to other things that enthusiasts get involved in such as fine wines or whiskies, antiques, stamps, classic cars and so on. Experts in these areas might sometimes make decent returns but for the uninitiated it can be difficult to fully appreciate the market dynamics and the risk. There is nothing wrong with turning a passion or pastime into an investment opportunity or side hustle – you might even have a real edge – but if you don’t have the knowledge then it may be best to steer clear.