Unpacking the concept of ‘Alternative Investments’

Chantal Marx, FNB Securities Economist.

With the introduction of financial innovation, retail investors now have more access to varied alternatives than ever before. In light of the changing ‘financial ‘ecosystem, investors may consider looking outside their sphere of traditional instruments towards alternative investment options.

Traditionally, alternative investments were only utilised by large institutions and ultra-wealthy families or individuals. This was because of relatively large required capital outlays, illiquidity, and complexity. “Investors everywhere seek a higher yield in today’s competitive environment. Following a period of strong asset price appreciation post the global financial crisis, growth asset return expectations have adjusted accordingly. And with interest rates at record lows, very little is expected from cash instruments,” says Chantal Marx, FNB Securities Economist.

Apart from muted return expectations, volatility is anticipated to play a significant role over the next few years as divergent growth and monetary response profiles dominate the macro economic landscape globally.

There are two major advantages to investing in alternative products. She explains that “depending on the product chosen, alternative investments can boost the expected return profile of a portfolio and in a balanced portfolio, investing in alternatives can offer the benefit of diversification. Diversification is meant to reduce market risk and volatility.”

However, Marx advises that potential investors need to understand that there are unique risks inherent to alternative investments – namely:

• Many of these products have high and complicated fee structures. Most hedge funds, for example, have management fees (~2% per annum) and performance fees (~20% of excess return) attached;
• Alternatives are often less liquid, particularly in periods of stress;
• Many alternative investment structures are more complex and less transparent than traditional investments, making it difficult for untrained investors to understand what they are investing in and difficult for even trained investors to value accurately;
• Certain alternatives, like commodities, often have too much risk or volatility attached to them and often do not perform as expected;
• The benefits of diversification are limited. During the global financial crisis, for example, diversification offered limited protection as correlations between many ordinarily unrelated asset classes increased sharply.

While any alternative investment could seem risky on a stand-alone basis, it remains a good diversifier to a traditional balanced portfolio. “By carefully considering the allocation to alternatives within a broader set of investments, portfolio risk may even fall and the risk/return profile could improve. The risks inherent to alternatives can also be mitigated by choosing wisely,” concludes Marx.