After swimming around comfortably in the pool of investing, you might have come across this term “alternatives” while doing your laps. Alternatives, or alternative investments in full, are assets that do not belong to the common mainstream asset classes/financial instruments, namely equities (shares/stocks), bonds and cash.
There are several alternatives; some are asset classes, investment vehicles, methodologies, or a combination of the former two/three. Examples include real properties, hedge funds, private equities, cryptocurrencies, derivatives, etc. The Bedokian Portfolio already contains two alternatives, namely real estate investment trusts (REITs), an equities-property hybrid, and commodities (gold, silver and oil).
Alternatives are usually included due to their different correlations with equities and bonds, thus providing more diversification and hence, better returns with lesser risks in an investment portfolio.
Writing about alternatives would warrant an entire book, or a series of books, depending on how much details are written. I would give a very short summary of the various alternatives available out there. I had covered commodities and REITs in the eBook1, so I would not state them here.
Property is referred to as immovable property, for example land, houses, apartments, buildings, factories, warehouses, etc. They are generally used to earn rental income, and there is a huge potential in capital gain when its value increases, especially when the property is in a prime location, and/or in an increasing economic growth environment. Properties are leveraged items; unless one is rich enough to pay it off in one shot, a loan is needed to be taken out to fund the purchase. Therefore, for a property investor, a typical strategy would be using the rental income to cover the mortgage payments, with either divesting in the future to realise capital gains, or for keeps for legacy reasons.
Private equity, or PE for short, is an investment in a company that is not publicly traded in the financial markets. There are two main approaches of PE: venture capital (VC) and leveraged buyouts (LBOs). Some of you may have heard of VC, where a VC firm would put a stake in start-ups or small companies with huge potentials, and either sell them to larger companies or list them publicly a few years down the road. A lot of well-known companies that are listed in the markets currently were funded initially through VC, such as Alibaba, Google, etc.
For LBO, a PE firm would buyout a private company using debt or leverage (thus the term), and just like VC, the acquired company would eventually be sold or listed a few years later. Whether VC or LBO, the common thing between the two is that the PE firm would have some say in the management of the funded/acquired companies, ranging from advisory to direct control.
PE is in the domain of sophisticated (accredited and institutional in investment talk) investors, who are usually high net worth individuals, funds, investment firms, etc.
Hedge funds are funds that use different strategies to earn returns for the investors who have a stake in it. Though hedge funds buy and sell shares most of the time, which may seem on the surface that they are no different from equities, it is the strategy(ies) employed that make them stand out.
Some of the selected hedge fund strategies include:
Equity Long/Short: Purchasing of a company’s (or some companies’) shares while at the same time short-selling others’, usually across sectors or industries.
Market-Neutral: Similar to equity long/short, but the approach involves both longing and shorting within the same sector/industry. It is “neutral” in a sense as this strategy is not concerned on where the markets are heading, but rather exploiting the relative performances of the companies within the sector/industry.
Dedicated Short Bias: As it goes, shorting is the name of the game, although a few hedge funds adopt a net short method (i.e., short positions more than long positions).
Global Macro: A strategy which makes use of the geo-political and socio-economical situations around the world. Investments are not just limited to equities, but also other asset classes.
Arbitrage: Arbitraging is an art or skill of identifying mispricing of the same security across two or more markets, and make a profit from it. Here is a layman example: at a given time, if an item is selling at S$1 and S$1.50 at locations A and B respectively, I would buy it at location A and sell it at location B.
Event Driven: This approach utilises happenings in the corporate world and takes advantage of the expected mispricings, such as mergers, acquisitions, spin-offs, etc.
Multi-Strategy: As described, it means a hedge fund could employ two or more of the strategies mentioned above.
Just like PE, hedge funds are in the domain of sophisticated investors.
A relatively new asset that emerged from the shadows of the Global Financial Crisis of 2008/2009, cryptocurrencies (or cryptos for short) are gaining widespread popularity and traction in recent years. The great ancestor of cryptos is none other than Bitcoin, which is also famous for the accompanying blockchain technology. Though they are touted as a form of digital currency for the future, as of now they are mostly used for speculative trading.
Collectibles are items that are likely to worth more the longer they are kept, and some examples include artwork, antiques, rare coins, stamps, wine, etc. On the crypto front, there are also non-fungible tokens (NFTs). The difficulty of having collectibles as an investment is the appraisal and valuation of their current and potential worth, unless you hire an expert to look into them or you are an expert yourself.
Derivatives are a category of investment vehicles that derive (the root word) their value from an underlying asset. In other words, you do not really own the asset using derivatives, but rather they sort of mimic the asset class itself by following the value.
Derivatives are used more for trading than investing, and most derivatives lose their value over a certain time, such as within the next few days, weeks or months. Examples of derivatives include futures, options, warrants, swaps, contracts-for-differences (CFDs), etc. There are also stacked derivatives, like options on futures and options on swaps.
In Part 2, I shall share further on how to incorporate alternatives into your portfolios.
1 – The Bedokian Portfolio (2nd Ed). Chapter 5 Commodities; Chapter 6 REITs p45-50.