Alternative Investments for Ordinary Investors
June 25, 2019
Alex Christodoulakis - Co-founder & CEO @ Daedalus.
The universe of investments has expanded at a stellar rate throughout the last century and there was no time in history in which investors have had this many investment vehicles to choose from. While this is a positive development, investors around the globe need to execute thorough due diligence when building their portfolios and allocating capital, so as to reap significant benefits from this massive growth of the industry.
Although traditional asset classes such as equity and fixed income still dominate the investment industry, mostly due to their easy access and convenience, non-traditional asset classes, or the so-called alternative investment vehicles, are expanding rapidly and provide investors with an opportunity to achieve much better returns, while at the same time improving the risk profile of the overall portfolio, if utilized properly. In this article, we will take a very high-level look at the available alternative investment vehicles for investors in an attempt to unveil the opportunities and challenges in investing in these asset classes, but also question the equality of access among different investor segments.
What are the types of alternative investments available?
In tandem with the evolution of the investment landscape, alternative investment vehicles have emerged to account for any type of investment that is possible in today’s world. Some of the most notable alternative investment vehicles are:
- Hedge funds
- Private equity funds
- Venture capital funds
- Real estate investments
- Fine art & precious metals
- Structured deals, products and portfolios
All of these investment vehicles have a unique profile and characteristics, which differentiate them from traditional asset classes.
Diversification and uncorrelated returns
As mentioned above, different characteristics of each alternative investment class are the very reason that has been at the forefront in providing returns that are uncorrelated to those provided by equities and bonds, the traditional and most easily available choices, when unsophisticated individuals are about to decide where to allocate their capital. Simply put, an asset class with uncorrelated returns to the overall portfolio can improve overall performance, while also decreasing portfolio’s ups and downs (i.e. volatility).
Warren Buffett, arguably the most successful investor of all time, advises not to put all eggs into one basket. The underlying investment principle is obvious – achieving a sufficient level of portfolio diversification is essential to generate attractive returns consistently and decrease maximum drawdowns, even when macro-economic conditions are not favorable. A mix of uncorrelated or low correlated investment products significantly improves the diversification of a portfolio, which can be easily achieved by combining traditional asset classes with alternative investments.
It is important to note that with the emergence of ETFs and their rising popularity, the absolute meaning of diversification has changed significantly. Today, every investor can easily and instantly allocate part of his portfolio in market indices, such as S&P500 stocks. Although at the beginning this was considered a cost-efficient way of creating a diversified portfolio, a saturation of this investment style has dramatically increased underlying correlations of the primary ingredients of such ETFs, the single stocks. As a result, anyone who follows the financial news can observe that when big players move, almost all the market moves in the same direction. In other words, even though 50 years ago, diversifying across 25 stocks was admitted to be enough, effective diversification today has moved from stock-level diversification to asset class, style (long-short, momentum, value, etc.), geography or even investment horizon diversification.
The alpha of investing. In simple terms, the alpha of an investment strategy is the return it provides, over the returns that correspond to the risk profile of the strategy. How this relates to alternative investments? Well, in addition to providing diversification benefits, alternative investments have the potential to provide very attractive risk-adjusted returns, often surpassing returns provided by traditional asset classes.
Let’s have a look at the big picture of the profile of the most important alternative investment classes, as some examples can illustrate the different approaches that ordinary investors can use to decrease their investment risks and improve performance.
Historically, private company performance has remained intrinsically different from that of public company performance, and an investor can capitalize on this by investing in a private equity fund while holding equity market investments. Below graph plots the returns of U.S. Private Equity Index against the Russell 3000 Index. As expected, the U.S. Private Equity Index has outperformed the Russell 3000 Index by a considerable margin over the 30-year period ended in 2015.
Performance of U.S. Private Index vs. Russell 3000 Index:
Over the years, real estate investments have shown little correlation between equity market performance, which provides a reason to consider investing in real estate securities, whether this means private real estate investments, real estate investment funds, or even bonds and relevant products, structured around real estate large-scale deals.
Housing vs. Stock through the years:
Apart from their role as portfolio diversifiers and genuine sources of alpha, alternative investments and real estate, in particular, can be used as a tool to negate the impact of inflation. Understandably, higher than expected inflation results in a lower than expected real return on investments, which is one of the most significant risks of investing in inflationary time periods. However, an investor can easily offset the impact of inflation by investing in real estate securities, funds or real property, as their value has a positive correlation with inflation.
Therefore, real estate investment values appreciate in tandem with rising inflation, which becomes a natural hedge against it. Many active asset managers in the world, including Ray Dalio, often allocate a sizeable portion of the overall investment portfolio to property investments in an attempt to both diversify, but also tackle inflation from eating out profits. As shown in the graph, the inflation hedge provided by real estate investments is something no investor can afford to miss, making real estate an essential part of an investor’s portfolio.
Real-estate vs. Inflation:
(Source: Urban Core Advisors)
One other benefit of alternative investments is the ability to expand the portfolio horizon to new and emerging opportunities. For example, the boom in the technology space has opened a plethora of investment opportunities. Venture capital funds are also a classic example of funds that try to benefit from the anticipated growth of very small companies who have attractive business profiles and charismatic leaders. Often, these venture capital funds exit these investments by way of an Initial Public Offering, but investors who wait too late to buy shares from an IPO miss out the opportunity to participate in significant growth stories. Newly listed companies such as Lyft, Uber, and Beyond Meat are classic examples of how once small companies made it real big and provided double-digit returns for early investors.
Finally, hedge funds, one of the most important alternative investment vehicles, provide investors the opportunity to benefit from the significant skills of highly qualified fund managers. These fund managers are veterans in their respective industries and use a variety of tools, including hedging strategies (thus the name), to allocate funds efficiently to generate alpha. While in today’s environment an ordinary investor cannot have access to such services, offered by highly qualified, experienced fund managers on a personal level, investing in a hedge fund proves to the best way to avail the benefits of hedge fund exposure. It is commonly accepted that hedge funds provide returns that are uncorrelated to the movements of the relevant markets they operate. In other words, a successful hedge fund manager would generate returns coming only from the alpha of his investment strategy. Wondering when this can be more important? As you have guessed correctly, it is especially in the times when the financial environment gets tough, prospects of the overall economy don’t seem optimistic and of course when recession appears to be waiting in the corner. Does this ring a bell?
Apart from experience-based examples, in-depth research has also demonstrated the significant role alternative investments can play in providing a better risk-adjusted return over comparable traditional asset classes. Harry Markowitz, the Nobel Prize winner for economics who introduced the Modern Portfolio Theory, explained in detail how an investor can use a combination of traditional and non-traditional investments to achieve a higher rate of return for bearing the same amount of risk. Essentially, a portfolio with non-traditional investments has the ability to generate a higher overall return while keeping the overall risk of the portfolio at the same level.
Markowitz Efficient Frontier:
(Source: Baird Financial Advisor)
Difficulty of Access
Even though there are many benefits associated with alternative investments, this discussion would not be complete without identifying the inherent difficulty of investing in alternative investments.
In today’s environment, many alternative investments come at a very high cost to investors, compared to traditional investment vehicles. At times, such costs might not be transparent at first sight so the services of a qualified professional might be required to analyze the costs involved.
Alternative investments are complicated by nature. Hedge funds generally deploy a variety of hedging tools, algorithm-based trading strategies, and rules-based investment decisions, which make it difficult to understand the underlying exposure and risk of these products. On the other hand, systematic investing strategies tend to attract many retail clients who do not have any clue about how such behave, which might lead to significant losses. Private equity funds have many technical terms that need to be understood which makes it difficult for an average investor to evaluate the fund performance accurately. At the same time, real estate investments carry the burden of bureaucratic procedures which might take days or months to complete.
Moreover, the success of alternative investments is usually driven by the ability and quality of the management involved in the process. For example, some hedge funds such as Bridgewater Capital, continue to outperform their peers and traditional funds, whereas many other hedge funds fail to make ends meet. There are real estate companies who consistently buy attractive properties in prime locations and rent profitably while other real estate companies pay premiums to acquire properties in prime locations resulting in losses even though there’s a high demand for such properties. In hindsight, management quality and experience remain a decisive factor in the success of alternative investments.
As discussed, if used appropriately alternative investment vehicles have the potential to provide significant benefits to an investor’s portfolio. However, there is a common problem for ordinary investors and this has to do with how accessible are the high-end and most sophisticated opportunities to them. Can everyone freely invest at similar quality deals, or ordinary investors are condemned to take the change after smart money has made the first move?
It seems that the answer to such questions is discouraging. Despite the above-mentioned characteristics that may prohibit ordinary investors to grasp the many benefits of alternative investing, the most significant burden often comes in the form of the high unit value of the alternative investment assets. Whether an investor wants to purchase a real estate unit, a piece of fine art, or even get exposure to hedge funds, private equity or venture capital funds, high minimum capital requirements render such investments inaccessible for the great majority of the world. It is this very point that raises serious concerns about democracy in the investment process and equality of opportunities.
It is a common secret across the bottom 95% of the investment spectrum that by every swing of the economic cycle, high net worth investors gain more, to the expense of lower net worth investors. It doesn’t take a rocket scientist to relate this fact with the lack of access of ordinary investors to sophisticated, well-structured alternative investment deals. Those deals and opportunities that increase returns, diversify portfolios and reduce risk; the ones that generate alpha, no matter what the state of the economy and the performance of the traditional asset classes.
There is no doubt that ordinary investors who are prudent and persistent enough to chase those alternative opportunities and back them by a thorough understanding of the products, risks, and due diligence will be the ones the long-term winners of the investing arena.
Daedalus: Democratizing Access
This is the exact pain point that we have identified in Daedalus. An inequality that shouts for correction and which we couldn’t ignore. Daedalus is an investment platform that transforms real assets, like real estate, fine art, hedge funds, structured portfolios, VC and PE funds into digital (security) tokens. In that way, no matter your starting capital, Daedalus allows you to get exposure to those investment opportunities that will transform the performance of your portfolio.
Our aim is to bring those highly sophisticated opportunities closer to ordinary investors, democratize, once and for all, the whole investment process and give everyone equal access and equal opportunities.
About Daedalus: Daedalus is an investment platform for Alternative Investment Funds, allowing wealth managers, investment advisors and private investors to access sophisticated opportunities.
Join our platform and get access to our exclusive investment opportunities.
Alex Christodoulakis - Co-founder & CEO @ Daedalus.