Alternative Investments: A Key to Asymmetric Returns and Portfolio Diversity

"Alts" can create alpha

Alternative investments are wide-ranging, complex, and pose unique challenges. But they also have the potential to produce “asymmetric returns” and add diversity to a portfolio. The ultra-wealthy know this. You should too.

This article first appeared on the ClaraInvestments.com at https://clarainvestments.com/alternative-investments-a-key-to-asymmetric-returns-and-portfolio-diversity/

Risk vs Reward and the Potential for Asymmetry

Risk and return, the yin and yang of investing, are often thought to be inseparable. But in alternative investments (aka “alts”), this dynamic can sometimes be different.

In the public markets, where individual investors compete with multibillion-dollar firms and computerized trading, the risk/reward tradeoff is hard to escape. The only (unfair) advantage is getting material non-public information (aka insider trading). But that’s a one-way ticket to the slammer.

Alternative investments, however, have the potential for asymmetric returns, meaning the possibility of achieving higher returns relative to the risk taken. This is because they operate in less efficient markets, where skilled investors can identify and capitalize on opportunities that are not readily available in traditional markets. Creating an unfair advantages is the strategy with alts. And it’s perfectly legal.

When it comes to investing, stocks and bonds are the bedrock of most portfolios, offering stability and a known risk-return profile. But it’s worth looking at a wider range of alternatives, and discussing their unique advantages and drawbacks.

Why Not Just Stick with Stocks and Bonds? Follow the money

There is nothing wrong with stocks and bonds. I have them both. But they have their limitations. Stocks, for instance, can be volatile, especially during economic downturns, and their performance is closely tied to the overall market. Bonds, on the other hand, typically offer lower returns, which may not be sufficient for investors seeking higher growth and beating inflation.

For the everyday investor, alternative investments typically make up a small portion of their overall assets. Retail investors have about 5% of their portfolios in alternative investments.

But what about ultra-high-net-worth investors (those with a net worth of at least $30 million)? According to a 2021 survey by the investment firm KKR, this super wealthy group had 50% of their assets in alternative investments. What do the ultra wealthy know that we don’t?

Understanding Alternative Investments

Alternative investments encompass a wide range of financial assets that are not publicly traded stocks, bonds, or cash equivalents. They offer a way to diversify, potentially enhancing returns and reducing risk through exposure to a wider set of assets and strategies.

Here are some examples:

• Private Equity: Investments made in private companies, often with the goal of acquiring a stake and improving the company’s performance.

• Venture Capital: Funding provided to startups and early-stage companies with high growth potential.

• Real Assets (my favorite): Investments in physical assets like properties (residential, industrial, retail, storage) and infrastructure (airports, bridges).

• Hedge Funds: Pooled investment funds that use various strategies to generate returns.

• Private Credit: Loans or debt securities issued by private companies, often with higher yields than public bonds.

• Derivatives: Financial instruments whose value is derived from an underlying asset or index.

• Cryptocurrency: Digital or virtual currencies that use cryptography for security and operate independently of a central authority, such as Bitcoin or Ethereum.

Benefits of Alternative Investments

• Diversification: Alternative investments provide a way to diversify beyond traditional assets. By adding assets that have low correlation with the stock market, investors can reduce overall portfolio risk. This can be particularly valuable during market downturns when traditional assets may perform poorly.

• Higher Return Potential: Alts have the potential to offer higher returns than traditional assets. Skilled managers can identify opportunities that are not accessible in public markets. For example, private equity firms may invest in companies with high growth potential, leading to substantial returns over time.

• Market Inefficiencies: Alternative markets are often less efficient than traditional ones. Prices may not always reflect the true value of assets and access to information might be proprietary or highly localized. Skilled investors can use this asymmetry of price and information to buy undervalued assets and sell overvalued ones, potentially generating higher returns than would be possible in a public market.

• Niche Strategies, Markets, and Expertise: Alts allow investors to access niche markets and strategies. For example, a hedge fund may specialize in a specific sector or investment strategy, giving investors exposure to unique opportunities that create alpha (above-average returns). Real estate operators can specialize in niche local tax strategies or develop specialized value-added strategies that would be hard to scale in public markets. The saying “riches are in the niches” holds true with alts.

• Capital Dislocation: Supply-demand imbalances or disruptions in capital flows can create opportunities for outsized returns. During times of economic uncertainty, distressed assets may become available at discounted prices. An example is when Warren Buffett purchased $5 billion in preferred stock of Goldman Sachs during the 2008 financial crisis and received a 10% dividend and warrants to buy additional common stock. He simultaneously shored up Goldman and made a huge profit.

• Tax Advantages: Alternative investments can come with unique tax benefits that can enhance overall returns. For example, investments in real estate can offer depreciation allowances that reduce taxable gains, leading to lower tax liability. Oil and gas investments have very favorable depreciation/depletion tax treatment.

Drawbacks of Alternative Investments

• Less Oversight: Alternative investments are often less regulated than traditional assets, leading to fewer investor protections. Alts can be “buyer beware” investments.

• Illiquidity: Many alternative investments are illiquid, meaning they cannot be easily sold or converted to cash when needed.

• Fees: Fees for alternative investments can be higher than those for traditional assets, cutting into overall returns.

• Higher Minimum Investment: Alternative investments often require a higher minimum investment, typically starting at $50,000 and sometimes reaching $1 million or more.

• Tax Complications: Tax reporting for alternative investments can be complex, with investors receiving a K-1 form instead of a standard 1099 and requiring more preparation and planning.

• Limited Accessibility & Transparency: Many alternative investments are only available to accredited investors, and the investments themselves can be opaque. Evaluating them can be challenging.

• Leverage: Alts will often use debt to boost returns. But leverage also increases risk, with the potential higher losses, or in some cases, a total loss.

• Sponsor Vetting: The experience and track record of the sponsor are crucial factors in evaluating alternative investments and deciphering the good from the bad can be challenging without some guidance. This is why we created the Clara Investment Group, LLC.

Alternative investments can be compelling for investors looking to diversify their portfolios and enhance returns. However, they also come with complexities and risks that require careful consideration. They are not the right choice for everyone, especially those just starting out on their investment journey.

But by understanding the benefits and challenges of alternative investments, investors can make informed decisions that align with their financial goals and risk tolerance.