CIO Mailbag: What Are Alternative Investments?

by Tim Doyle, Chief Investment Officer, CFP®, MBA

For many, alternative investments (or ‘Alts’) remain shrouded in mystery, and for good reason.  For decades, many alternative asset classes have only been available to ultra high-net-worth investors due to accredited investor and/or qualified purchaser status requirements.  This meant that alternative strategies were not available to the vast majority of investors in the U.S.   However, markets are innovating and we’re seeing fewer barriers to entry when it comes to access to alternative asset classes so, in this CIO Mailbag, I thought it was an apt time to address one of the most common questions we receive which is, “What are alternative investments?”

When someone references ‘alternatives’, they typically mean any asset class or investment strategy that falls outside the scope of the traditional stock and bond allocation.  These asset classes represent ‘alternatives’ to publicly traded equities and fixed income.  However, not all alts are created equal.  On one hand you have fully liquid and widely accessible funds like gold exchange traded funds (ETFs), while others have extreme liquidity restrictions and specialized investment vehicles like private equity and hedge funds.

When it comes to portfolio construction, I view alternatives as diversifiers, inflation hedges, return enhancers, income generators and sources of uncorrelated risk.  Of course, as with any investment strategy, there are trade-offs to consider, so we’ll start by broadly summarizing a handful of the major categories of alts along with what they are, their benefits, and any risks or tradeoffs investors should consider.

Private Equity (PE)

What is it?

The most common form of private equity investing is when a PE fund manager buys a controlling (or significant) stake in a private company, improves it operationally/strategically, increases the company’s value, then exits via sale, merger or initial public offering (IPO).  Ideally, this exit should come with a hefty profit for investors.  Private Equity strategies can range from early stage investing (venture capital) to later stage investing via leveraged buyouts (LBO).  Leveraged buyouts are, by far, the most common and popular form of private equity investing.

The Appeal

• Historically, PE investing has offered higher return potential relative to public market equities like the S&P 500 Index.
• Illiquidity premium – investors are compensated due to liquidity restrictions imposed by private equity funds. This can be additive to returns over time.
• PE offers access to niche industries and sectors. With fewer companies filing for IPOs, private equity has been able to hoard the best and brightest young companies, particularly in the technology sector.
• Unlike public equity markets, private equity markets are highly inefficient. In part, this means that private market information is not ubiquitous and equally available to all investors. Therefore, using proprietary methodologies and strong professional networks, top PE managers can identify and source unique investment opportunities with the potential to add significant value for investors.

Downsides/Risks

• Illiquidity – private equity investments are highly illiquid, and typically come with strict lockup periods often ranging from 7-10 years. 
• Complex ownership structures – investors typically participate in private equity investments through complex limited partnership structures.  These investments can also create complexities when it comes to tax planning as PE funds produce K-1’s that are often generated and received after the tax filing deadline.
• The J-Curve Effect – private equity investments don’t take place all at once.  Capital is ‘called’ over time as the manager identifies investment opportunities.  Therefore, the investor can see significant outflows before any value is created and distributions are made later in the fund life cycle.  This is known as ‘The J-Curve Effect’.
• High Fees – most private equity funds charge significant fees which can be detrimental to net returns.  The most common fee structure includes a 2% management fee and a ‘performance fee’ where the general partner receives 20% of all profits above a specific hurdle rate.
• Valuations of private equity investments occur infrequently which can potentially mask volatility over time.

Private Credit / Direct Lending

What is it?

Private credit is a form of lending where funds provide directly negotiated loans primarily to middle-market companies. These loans include no traditional intermediary (banks) and are often senior secured and floating-rate, offering attractive yields and contractual downside protection compared to traditional fixed income investments. Private credit investments tend to exhibit lower volatility with most returns coming from recurring interest income rather than capital appreciation.

The Appeal

• Due to higher yields, private credit investments offer attractive income relative to public market fixed income.
• Underlying loans are primarily floating-rate, which means there is little sensitivity to interest rate fluctuations over time.
• The majority of loans are senior secured which means that they are backed by collateral and hold the highest repayment priority in the event of a default.
• These loans are directly negotiated so lending arrangements can include covenants that protect the lender.
• Private Credit offers diversification benefits as it has low correlations to publicly traded stock and bond markets.

Downsides/Risks

• Illiquidity – much like private equity, private credit funds often come with stringent liquidity restrictions.
• Credit risk – as with any debt, there is the potential for default in the event that the borrower is no longer able to make loan payments
• Underwriting risks – it is paramount that underwriting be effective in identifying which borrowers are at an elevated risk of default. 

Hedge Fund Investing

What is it?

Generally speaking, hedge funds are actively managed private investment pools that apply diverse strategies – including leverage, short-selling, and derivatives—to pursue absolute returns and minimize volatility.  Hedge funds are designed to be flexible and can invest across asset classes, geographies, and more in seeking performance that is uncorrelated to liquid public market investments like the S&P 500 index.

The Appeal

• Hedge funds offer the potential for uncorrelated returns and drawdown mitigation relative to liquid public market investments.
• Hedge funds offer diversification benefits and may reduce downside risk and volatility, especially during periods of market stress.
• Effective hedge fund managers tend to be adept at identifying and profiting from market inefficiencies.
• Hedge funds can be part of a strategy toolkit to hedge risk or exploit mispricings across markets.

Downsides/Risks

• Like many alternative investments, fees and expenses can be quite high.
• Many of the strategies employed by hedge fund managers are highly complex, and the use of leverage and derivatives can elevate risks.
• Transparency is limited due to lack of position-level disclosure, and hard-to-value assets make it harder to monitor risk and true performance.

Cryptocurrencies (Bitcoin)

What is it?

Bitcoin is a decentralized digital asset that has a fixed supply schedule (a 21 million cap), is secured by a global network (Proof-of-Work) and is transferable peer-to-peer without the need of a traditional financial intermediary (bank).

The Appeal

• Increased adoption over time has resulted in accelerated appreciation relative to traditional asset classes like stocks and bonds.
• Due to the 21 million Bitcoin cap, there is a scarcity element that can impact future pricing if demand increases and supply is constrained.
• Bitcoin is increasingly viewed by some investors as a store of value similar to precious metals like gold.
• Bitcoin has a 24/7 global market to facilitate transactions.  Through increased institutional adoption, investors can gain access to Bitcoin via efficient investment vehicles like spot ETFs or via custody solutions through institutions like Fidelity.
• Bitcoin is a decentralized financial network that does not rely on traditional intermediaries like banks.

Downsides/Risks

• Bitcoin remains extremely volatile and has a history of steep drawdowns.
• Political and regulatory risks could impact investors’ ability to own and transact in Bitcoin across the globe.
• Bitcoin produces no cash flow for investors unlike traditional assets like stocks and bonds.
• While Bitcoin can offer diversification benefits, there have been times when Bitcoin is highly correlated to the stock market during times of market stress.
• There are security risks related to owning Bitcoin.  Theoretically, the Bitcoin network could be subjected to hacking that could destabilize the market. 
• Bitcoin is a ‘bearer’ asset, meaning that whoever holds the private keys to the Bitcoin owns the Bitcoin.  If an investor self-custodies Bitcoin via a soft or hard wallet, they can lose access to their Bitcoin if their private keys are either lost or stolen. 

Precious Metals / Gold

What is it?

Gold is a scarce, non-yielding real asset that is used as a store of value and has historically been utilized as a currency/reserve.  Gold prices are primarily driven by changes in the U.S. dollar, movements in interest rates, changes in risk sentiment, and central bank demand.

The Appeal

• The gold market is robust and investors can gain exposure to gold in any number of ways, including physical gold coins/bars, gold exchange traded funds (ETFs), and even by purchasing the stock of gold mining companies.
• Gold can serve as a portfolio ballast during times of economic stress as, over the long-term, gold has low correlations to stocks and bonds.
• Significant, ongoing central bank demand can help to push prices higher.
• Gold has long been considered an inflation hedge as the value of the physical commodity should rise along with the prices of other real assets in an inflationary environment.

Downsides/Risks

• Unlike traditional stocks and bonds, gold produces no yield or cash flow to investors.
• When it comes to owning physical gold (coins/bars), markets tend to be less efficient and buyers will likely pay a premium while sellers will have to discount prices.  There are also physical security risks related to transporting and storing physical gold coins/bars.
• While gold may serve as a buffer against volatility, it has experienced significant drawdowns over time so downside risk still exists.

Importance of Manager Selection

However, one crucial element of investing in alternative asset classes is manager selection.  In public stock market investing, there tends to be relatively little difference between the top performing fund managers and the worst performing managers.  As you can see in the chart below, when it comes to large cap stock funds, the top performing investment managers produced a 10% return with the median manager return falling around 9%. 

Source: JP Morgan Asset Management Guide to the Markets

Clearly, you’d hate to be locked-in for seven to ten years with a private equity manager producing annualized returns of just 1.1%.  Therefore, it is vital that investors identify the best and brightest fund managers, which poses significant challenges for investors.  At Destiny Capital, we partner with institutional players like Fidelity and private market specialists like iCapital to find the best of the best alternative investment managers. 

Furthermore, we are seeing innovations in the alternatives marketplace that are reducing barriers to entry when it comes to investor access to alternative asset classes.  We are seeing more funds that are suitable for the majority of investors with improved operational efficiency, lower fees, increased liquidity, lower minimums, and more.  This is an exciting time for investors and, at Destiny Capital, we envision a future where alternative investments will play a larger role in adding value to investor portfolios.  I should also note that there are many alts that were not highlighted in this mailbag post, including real estate, real assets, infrastructure, and more. If you have any questions about alternative investments, how Destiny Capital utilizes them, and whether or not they are suitable for you, please reach out to your Client Wealth Strategist to learn more.

Important note and disclosure: This article is intended to be informational in nature; it should not be used as the basis for investment decisions. You should seek the advice of an investment professional who understands your particular situation before making any decisions. Investments are subject to risks, including loss of principal. Past returns are not indicative of future results.  Advisory services provided by Destiny Capital Corporation, a registered investment adviser.2024 YCharts, Inc. All Rights Reserved. YCharts, Inc. (“YCharts’) is not registered with the U.S. Securities and Exchange Commission (or with the securities regulatory authority or body of any state or any other jurisdiction) as an investment adviser, broker-dealer or in any other capacity, and does not purport to provide investment advice or make investment recommendations. This report has been generated using data manually input by the creator of this report combined with data and calculations from YCharts.com and is intended solely to assist you or your investment or other adviser(s) in conducting investment research. You should not construe this report as an offer to buy or sell, as a solicitation of an offer to buy or see, or as a recommendation to buy, sell, hold or trade, any security or other financial instrument. THE IMPORTANT DISCLOSURES FOUND AT THE END OF THIS REPORT (WHICH INCLUDE DEFINITIONS OF CERTAIN TERMS USED IN THIS REPORT) ARE AN INTEGRAL PART OF THIS REPORT AND MUST BE READ IN CONJUNCTION WITH YOUR REVIEW OF THIS REPORT.   Disclosure – YCharts