Alternative Investments - 5 things to keep in mind

Alternative Investments - 5 things to keep in mind

Alternative Investments – hedge funds, real estate, commodities, private equity, structured products, and the like – as opposed to stocks and bonds.

But alternative investing is as much a mindset, as it is about specific investments. Alternative investment approaches are used every day by investors around the world, that are applicable to any investment decisions. Here are some of them:

1. Only care about absolute returns

The point of investing is to end up with more money than you started with. And that means you are looking for an absolute return: how much did you actually make, rather than “did you do better than some index or competing product”.

Although it’s good to review whether a particular manager has done better than the market or not, ultimately it doesn’t matter; if the market goes down, even if you’ve lost less than the market… you’ve lost money.

Invest in markets or assets that your analysis leads you to believe will do well; don’t invest in a product just because it’s likely to (or, worse, has in the past) “outperform the market”.

2. Understand that returns are one-dimensional, but risk is multi-dimensional

Return on a financial asset is simple to calculate. How much did you have at the point where you exited the investment, compared with the moment you entered the investment. Straightforward. However, alternative investment specialists are always much more focused on risk.

Risk, unlike return, is multidimensional, and you need to have a clear idea what risks are applicable to your investment. There’s volatility (the amount by which the price of an asset oscillates in the short term). There’s drawdown risk (the amount by which an investment can fall from peak to trough). There’s liquidity risk, both in the underlying market (how the price of an asset will change under liquidity stresses) and in the fund or investment structure itself (simply put, how easily can you get your money back). There’s manager risk (that the manager makes a mistake, or doesn’t perform as expected). There are any number of non-linear, operational, macro, and other risks that might affect your investment. Some you can remover, some you can mitigate, some may be integral to the asset... but risk is where the alternative investment professional focusses her time.

Make a list of what you feel the relevant risks are. Many will be risks about which you can do nothing, but understanding them will help you make better decisions about whether an investment is sensible or not.

Furthermore, if something unexpected happens while you are invested, if you’ve thought clearly about the risks in advance, you’re more likely to make better decisions.

3. Know where your return is coming from

Once you make an investment, you can’t control your return, but you can and should understand what will influence or drive that return. Your “world view” will lead you to investments, or combinations of investments, that reflect your world view. During the period that you hold the investment, you should monitor how this is developing or changing, more than the price or value of the investment.

This can be quite simple; for example “I think that more people will be interested in online advertising” so you buy Alphabet, or more sophisticated “I’m buying this building because I think the building next door will soon be renovated and make this one appear better value”. External events (geopolitics, the performance of other assets, competitive activity… and many more) will have an impact.

Constantly revisit your assumptions of the return drivers of the investment in case they change and you need to rethink your investment. Price performance is a measure of the supply/demand of an assets, not an indicator of its risk/return characteristics.

4. Obscure is good

When we’re asked to define alternatives, we often end up saying “well, anything that’s not traditional”. Actually that’s not quite such a lame definition; alternative investment practitioners know that the best opportunities are usually those that are not yet well known or exploited, and hence the field of “alternative investment” is one populated by investment ideas that may not be immediately obvious. Did you invest in cryptocurrencies three or four years ago?

This isn't about being a trendsetter. The more investors invest in an opportunity, the more its price will increase or the arbitrage spread will tighten... and the less attractive the opportunity will become. Finding interesting investments that are not yet well exploited is the secret to long-term uncorrelated returns and a less risky portfolio.

As an intelligent investor, you’ll often be looking at opportunities that aren’t obvious, or which are new to you.

Of course that means that you need constantly to be learning, to be studying, and to be looking outside your comfort zone. But so long as (see above!) you understand what the return drivers are, and you’ve made a sound assessment of the risks… obscure is likely to do better than well-known. And if all your non-specialist friends are now talking about, for example, bitcoin, then perhaps you should take care.

5. Diversification is the only free lunch – make sure you really are diversified

Diversification is the only really effective risk mitigator. Holding a mix of assets that are each good investments, but which behave differently, will leave your portfolio’s return intact, but lower its risk.

Holding both Apple and Alphabet isn’t a diversification; they’ll move with the U.S. stockmarket, with investor perceptions of tech-as-a-utility, and share similar risks in the event of, for example, a major cyber-attack, or a sharp fall in global stock markets. Diversification means creating an idiosyncratic portfolio of unrelated assets.

When an alternative investor says “diversify” what they really mean is that they’re constructing a portfolio with varied return drivers, liquidity characteristics, risk parameters, etc… not just different investments.

An alternative investor would, for example, prefer a mix of return drivers (some equity risk and some fixed income risk); a mix of liquidities (some real estate and some structured products); a mix of market risk and manager risk (some ETFs and some hedge funds), with the intention of creating a really robust portfolio with the best chance of consistently creating that absolute return.

Successful investing!