Alternative Investment for new Investors

Alternative Investments for New Investors

?Sanjay Mohanty

Deepak Maheshwari

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Alternative assets (also known as alt assets in short) refer to investments that fall outside of the traditional asset classes such as stocks, bonds, or cash investments. Due to their alternative nature, these investments may be less liquid than their traditional counterparts, generally more opaque, less regulated and may require a longer investment period before any material value is realized. Examples of alternative assets include private equity and venture capital, hedge funds, private debt, infrastructure, real estate, natural resources, crypto-assets, art, and collectibles.

While estimates vary about the size of the global alternative investment industry, Preqin predicts that the alt asset industry will hold US $ 17.16 trillion by the end of 2025 with private equity and private debt being the biggest drivers of growth in the industry. Having said that, the industry is dwarfed by the sheer size of the global public market which is approximately US $ 93 Trillion. Since 2000 there has been a significant uptick in alternative investments globally with institutional investors and high net worth investors increasing their exposure to alt assets – from 5% to 30% or more. They’ve done so to largely address the risks associated with an uncertain geopolitical environment, rising inflation and volatile financial markets.

In India alt assets have crossed Rs 5.35 trillion and the industry has grown eight times over the past five years since the Securities and exchange board of India (SEBI) introduced alternative investment funds (AIFs) in 2012. The industry has approximately 750+ registered AIF’s.?AIFs in India are not allowed to make any invitations to public to subscribe to their securities. They are held as privately pooled investment vehicles and must raise funds through private placements only.

Historically, the alternative asset classes due to their high minimum investments and illiquid structures attracted primarily institutional investors who dominated the industry and made it prohibitive for smaller investors to be involved.?However, times are changing. It is now becoming easier to access the benefits of alt assets than ever before. New technologies, crowdfunding methods, legislation, and deregulation now allows qualified investors to participate in a broader range of alternative investment opportunities.

With opportunities gradually opening for investors in alt assets in India it is important for new investors to understand this sector and consider options to add alt assets to their portfolio. The three main reasons for considering alt assets in a new investor’s portfolio are:

Portfolio diversification. Alternative investments have a lower correlation with stocks and bonds. Certain currencies and precious metals, for example, inversely correlated with the rest of the market. Diversification is essential for every well-structured, risk-managed investment strategy. By including assets driven by different macroeconomic factors, the portfolio may become increasingly stable during market volatility.

Enhanced return potential. When added strategically, the right asset mix may improve a portfolio’s returns without necessarily increasing the blended level of risk.

Diversified income potential. Alternative investments may provide a higher yield or cash distribution than typical assets, such as bonds or a savings account. With low real interest rates, many new investors are actively on the ‘hunt for yield.’

Risks of Alt Assets

Like any other investments alt assets carry both benefits and risks. Before entering this space, new investors must carefully understand and evaluate the risks and return matrix of their investment choices. Understanding what one is getting into is perhaps the first step in any investment process. Investors working alone or with their financial advisor should be clear that they understand the logic behind adding alternatives to their portfolio. Some of the key questions to understand are: What is the underlying liquidity of the investments? What is the liquidity of the fund? What is the fee structure? In what types of environments does the alternatives assets expect to perform?

While advising our clients on alt asset investments specifically in the PE/VC space, we come across many new investors who are late to enter an asset class or feel compelled to enter that space due to the hype surrounding that asset class. We always advise our investors clients to first understand the value proposition of that asset class and also how it fits with their overall their investment strategy. Key questions that any new investor in this space should ask themselves are: Does an alternative investment correlate with their other holdings? How liquid is the investment if cash needs to be raised? Is it a fund of funds, or a specific investment style?

New investors also need to understand fund diversification, analyse reported performance numbers of the alt assets, gather as much details as possible about the use of leverage by the fund, the exit strategies of investments, including timing and realization price and wherever possible, undertake an independent valuation of illiquid underlying assets on a periodic basis.

Apart from investment risks, an often-overlooked aspect by new investors is the equally important element of operational risk. This includes (a) knowing whether the fund managers understand the regulatory environment and legal issues and have controls in place for the alt asset product to comply with all applicable regulations (b) whether the fund has an appropriately structured team, with separation of duties and the skill to manage compliance, performance measurement, valuation, and operations and (c) whether compliance procedures are in place to ensure the safe custody of investors assets?

Conclusion

As India’s GDP and wealth grows the alt asset space is poised for significant growth in the coming years. The alt asset industry will continue to attract new investors and more sophisticated products and structures. Before rushing headlong into the alt asset market new investors should bear in mind that the future is inherently both risky and exciting; so are alternative investments. According to Professor Randolph Cohen of Harvard Business School who teaches a course on Alternate investments “as with most things that are exciting, alternatives combine opportunity with danger, so you have to be careful,”.

Like any other investment asset class, one cannot plan for every possible scenario, but gaining knowledge, studying historical and current trends, and making informed choices with your investment portfolio is perhaps the best advice we can proffer new investors in the exciting and fascinating world of alternative investments.