The Alternative Investments Sector: Review of 2011
The flow of dreadful macro-economic news since the crash of 2008 has shaken consumers’ faith in traditional stock market based investments and investors are now increasingly considering putting their wealth into directly held alternative investments – tangible assets that provide diversification away from property and the stock market and often promise high returns.
Definition
As there is no official definition of alternative investments, it’s a term that can be open to widely different interpretations that can encompass everything from Hedge Funds to Stamp Collections. With this in mind, perhaps the most sensible starting point is to define alternative investments by what they are not. Alternative investments are not the more commonly held assets that we have been familiar with over the years such as stocks, shares, cash, property funds, bonds or fixed income products.
Alternative investments are: directly held non-regulated investments into tangible assets.
Benefits of Alternatives
Actually, alternative investments are nothing new and both institutional investors and high net worth individuals have long had access to alternative markets. In fact a recent report by Cap Gemini and Ernst and Young estimates that the rich put 10% of their wealth into alternatives. There are two reasons why they do this: diversification and performance
Diversification
Diversification is the strategy of spreading your wealth across a range of assets to reduce the risk of being over exposed in one area. If the majority of your wealth is in the property market or the stock market and these markets do badly, it will have a big impact on your financial wellbeing. If your wealth is spread across several asset classes, a downturn in one area can be offset by strong performance in another. A more common way of thinking about diversification is “don’t put all your eggs in one basket”.
What many investors came to realise after the market turmoil in 2008 and subsequent recession was that a lot of the assets they held were correlated – when one market performed badly, they all did. For example, many people’s wealth and assets are allocated like this:
- Shares and bonds (most pensions are invested this way)
- Property (home ownership)
- Cash (savings in bank accounts and ISAs, fixed income products from banks and building societies)
In the crash of 2008, all of these investments performed poorly at the same time. It’s clear that for many people, further diversification is needed -and alternatives are the perfect tool. The following chart compares how a portfolio of commonly held assets would have performed through the crisis with and without a 40% allocation to alternatives.
Conventional thinking was really challenged by the events in 2008 and people have been forced to question their assumptions. Nobody expected or predicted that:
- There would be a run on a UK bank as we had with Northern Rock
- That major UK institutions would be part nationalized as we had with RBS
- That giants of the markets like Lehman Brothers could fail.
Governments have done much to stabilize the markets and global economy since 2008, but many investors still feel uncertain about the economy and the markets. A sensible conclusion is to have an allocation to alternatives at all times.
Performance
Alternatives also hold out the prospect of enhanced returns. Alternatives such as gold, forestry or farmland have outperformed the stock market and the vast majority of managed funds over the last 10 – 15 years. With many people are realizing that their pension provision may be inadequate (a retirement fund of £100,000 would buy an income of only £6,000 annually at today’s annuity rates) investors are looking to alternatives to boost their pensions.
Other Benefits of Alternatives
One of the key benefits of alternative investments is that they are directly held assets – the investor owns something tangible with an intrinsic value that can never fall to zero, such as a piece of land, property, or gold bars. This eliminates counterparty risk; the value of the investment cannot disappear overnight as it can do when we see major company failures or stock market crashes.
Investors are also keen to avoid the volatility of the stock market. Stock picking and timing the market are notoriously difficult, but many alternatives offer termed investments with fixed annual returns – perhaps not as exciting as the stock market, but they do give investors more clarity and make financial planning less of a guessing game.
Alternatives are also an opportunity for consumers to invest according to their personal interest: perhaps into green or ethical sectors or perhaps into a concept they really buy into. Investing in alternatives can be a lot more engaging than considering the latest managed funds.
Alternatives and Investing in today’s Economy
The ‘goldilocks scenario’ of steady growth, stable interest rates and low inflation we had prior to 2008 is over and the property bull run has come to an end. Today’s economy is characterized by low growth, low interest rates, high inflation, volatile stock markets and fears of another shock to the system.
Investing in this environment is very difficult for ordinary folk who want to preserve their capital, save for retirement or earn a respectable income from their assets. The combination of inflation and low interest rates is especially damaging to savers who would normally feel that ‘cash is king’ and choose to keep their wealth in cash until things improve.
Many alternative investments are investments into sectors that do not rely heavily upon economic growth, such as agriculture or renewable energy. They can offer stability and inflation beating returns in an unstable world.
Alternatives and SIPPs
SIPPs (Self Invested Personal Pensions) are a key market today as investors increasingly choose to consolidate and take control of frozen or underperforming pensions. The average SIPP size is £70 – £80,000 and there are already over 800,000 SIPPs in existence (and the number is growing at 20 – 30 percent per annum). Alternative investments are SIPP acceptable, giving investors the opportunity to save for the future in a tax efficient structure.
Growth in Alternatives
The market in alternatives has grown very quickly, from an estimated 50 SIPP acceptable, directly held alternatives in 2007 to over 300 today. This growth has been driven by both consumer demand and the need for businesses to look for new sources of funding in the light of the tightened credit conditions and less readily available bank financing post 2008. In some cases the rush to market has led to some poorly put together projects and, unfortunately, some outright scams. For these reasons it is important to carry out thorough due diligence on any alternative investments and only work with credible partners with a deep understanding of the sector.
The Risk of Alternative Investments
By their very nature as uncorrelated, less widespread investments, alternatives can have different characteristics to more commonly held assets. Alternatives can be less liquid then cash and mainstream stocks and shares; it can be harder to determine their true market value and an independent valuation might be needed; when it comes to entering an investment, there may only be limited historical data available to help assess the opportunity; there can be high transaction costs, as well as on-going costs to consider; the exit from the investment can be vague or undefined. Investors must be aware of and consider all of these factors before investing.
Regulation of Alternatives:
Non-Regulated Investments are direct investments into assets which are not regulated by the Financial Services Authority (FSA), such as land or property.
In practice this means that neither the investment itself, or the product provider are scrutinized by the FSA and investors will not be able to complain to the Financial Ombudsman Service and will not benefit from the protections available through the Financial Services Compensation Scheme should the worst happen. Investors could lose all of their investment.
It’s important to note the difference between a directly held, non-regulated investment and an unregulated collective investment scheme (UCIS). With a directly held investment there is no structure around the asset that modifies the investor’s exposure or imposes any pooling of contributions, income of profits.