Investing in Alternative Assets
TABLE OF CONTENTS
- What Are Alternative Assets and Alternative Investments?
- What Types of Alternative Assets Are Available to Retail Investors?
Most investors are familiar with basic investment vehicles like stocks, bonds, or ETFs. In the finance community, these are referred to as “asset classes.” Other popular asset classes include things like real estate and hedge funds, the latter of which is largely restricted to people with a certain amount of wealth (referred to as accredited investors). This brings us to alternative assets.
What Are Alternative Assets and Alternative Investments?
Alternative assets do not fall under the classification of traditional asset classes. They are more obscure investments like commercial real estate, farmland, private equity, venture capital, art, or even fine wines. The reason that alternative asset classes are becoming available to both accredited and non-accredited investors alike is because fintech startups are creating platforms that open doors to investing in these new alternative vehicles.
Why Invest in Alternative Assets?
A long-standing rule of thumb for investors used to be a 60/40 allocation between stocks and bonds. That ratio changes over time as investors become more focused on generating income to pay the bills when they can no longer work. General rules like these ensure a relatively balanced portfolio that manages long-term risk through diversification. Following the 2008 financial crisis, global interest rates hit historical lows and have remained depressed ever since, making bond investments less desirable. In parallel, fintech innovation has opened the door to new types of investments that were previously unavailable to retail investors, either because they aren’t accredited, or because they have less money to invest than the asset class’ minimum required investment. Some of the main benefits of investing in alternative assets include:
- Portfolio diversification – alternatives have low correlation with traditional assets, hence, making a portfolio more resilient in times of general market volatility and recessions
- Enhanced returns – with the right asset allocation, alternatives can grow the risk-return profile of a portfolio
- Increased income – alternatives can offer higher yields than traditional assets, especially in a low-interest-rate environment
Who Should Consider Alternative Investments?
The short answer is every investor. Thanks to the growing number of fintech startups and the loosening of investment regulations, the barriers to entry for many alternative investments have been lowered or have disappeared altogether. Retail investors can now own shares in multi-million dollar Picasso paintings and bottles of fine wines, can invest in pre-IPO startups, own a fraction of commercial real estate properties, or engage in peer-to-peer lending. Retail investors – both accredited and non-accredited alike – now have a much wider range of asset classes to choose from. The decision to invest in any alternative asset class then becomes one of risk appetite and the desired risk-return profile of each investor.
What Role Do Alternatives Play in a Portfolio?
The key benefit of alternative asset classes is diversification. If you invest all your money in one stock it is clear your success depends on the company’s success. Any number of things can go wrong, from a broad financial crisis down to simple management incompetence, and you’ve lost your hard-earned dollars.
Hence, investors choose a number of stocks to invest in. The rule of thumb is that a portfolio achieves ideal diversification somewhere between 20-30 stocks. Avoiding a large loss is still not guaranteed though. When the world economy suffers like in the 2007-2008 financial crisis, all stocks suffer. This is why smart investors allocate investments into different asset classes. For example, stock markets and fine art have a very low correlation, meaning price movements in the stock market only have a slight effect on the prices of art. If you put half of your investments into a stock portfolio and half into fine art, 50% of your money will not react to a stock market crash. (Of course, 50% is very high. Typically, high-net-worth investors will allocate around 6% to art.)
Sophisticated investors also use different asset classes to enhance the risk-adjusted performance of their portfolios. Each asset class has a distinctive risk-return profile because the higher your expected return, the more risk is associated with it. Bonds pay a fraction of a percent a year because they are very safe, guaranteed by sovereign states. Stocks are riskier, so you can expect to gain around 7% each year, but the chance of potential losses is much higher, and so on. If an investor chooses an ideal asset class mix in a portfolio, he or she will be able to achieve a higher expected return with a lower risk. (This is often measured by using the Sharpe ratio.)
Each investor needs to understand his or her risk appetite in order to decide what kind of asset class mix to use. An additional factor to think about is liquidity. Traditional asset classes like stocks and bonds are traded on exchanges and can always be bought and sold. It is much harder to sell an apartment or a piece of fine art when you need cash quickly, and this needs to be factored into the investment decision.
The investment amount allocated to alternatives should match each investor’s risk appetite and varies widely depending on the asset type(s) chosen. The below widget lists the wide variety of alternative investments available today and describes each provider out there to prospective investors. In the section below the tool, we’re going to explain each asset class in a bit more detail to help in the decision-making process.
What Types of Alternative Assets Are Available to Retail Investors?
Real Estate Investment Trusts (REITs) aren’t new. They’ve been around since the 1960s. These vehicles are exchange-traded and act like ETFs for real estate investors. Equity REITs manage and operate a portfolio of income-producing properties and earn rent. Mortgage REITs lend money to property owners and earn interest on the money lent. Hybrid REITs are a mix of both. Investors like REITs because their correlation with the broader stock market decreases the longer you hold them. Their main risk in a market downturn is the probability that tenants cannot make rent or mortgage payments. A great example is Realty Income Corp (NYSE:O) that has a compound average annual total return of 14.6% and a compound annualized dividend growth of 4.5% since its launch in 1994. The REIT holds more than 6,500 properties under long-term net lease agreements. We’ve been holding a position in O for quite a while now in our dividend growth investment portfolio.
Commercial and Residential Property
There are a handful of startups looking to provide alternatives to REITs that offer a wide variety of real estate investment products. These can be equity (ownership) or debt (mortgage financing and refinancing) and depending on the deal structure offered, some of them only accept accredited investors. A company called PeerStreet offers a collection of standalone deals that are valued on an individual basis with clearly defined target returns and potential downsides. EquityMultiple is another startup that caters to accredited investors and focuses on commercial real estate projects crafted by professional real estate developers. These projects take advantage of economies of scale and certain tax breaks and behave much differently to private real estate deals.
While investing in single large real estate deals remains the prerogative of the rich, crowdfunding opportunities are available for anyone since the passing of the JOBS act in 2012. Crowdfunding platforms have no entry barriers and investors can choose from a wide variety of projects to buy themselves shares in.
Farmland is another up-and-coming opportunity that’s currently only available to accredited investors. One study showed how farmland has the best risk-return profile compared to equity securities, bonds, cash, and other real estate assets over the past 40 years. Additionally, farmland has a low correlation to all the above-mentioned asset classes so it acts as a defensive investment in a well-diversified portfolio.
Right now at least two startups offer platforms that let accredited investors get exposure to farmland. For more West coast tree fruits and nuts exposure check out San Francisco startup FarmTogether which is focusing on West Coast opportunities where mostly permanent crops can be found.
Moving back east a bit you’ll find AcreTrader out of Fayetteville, Arkansas, which has already closed on more than a dozen farmland deals and claims more than 10,000 subscribers.
Timber is a unique investment opportunity in the real estate asset class. Its main attribute is steady biological growth. A tree’s wood volume increases about 2-8% annually and trees also yield additional price gains when they grow into bigger product classes (small trees are only suitable for paper production while large trees are great resources for furniture and houses).
Timber also has an attractive risk-return profile and low correlation with other asset classes as biological growth is not affected by market cycles. Unique risks include physical risks like fires, insects, and infections. If you’re interested in the asset class, a company called Harvest Returns provides opportunities for farmland and timber in the investment tool above. Their offerings are a mix – some of them require accreditation, some don’t.
Publicly traded VCs
Investing in startups has largely been off limits for retail investors in the past. In order to become a “limited partner” and place money with a venture capital firm to invest, you need to be wealthy and connected. There are a few publicly traded VCs though that provide access to a portfolio of startups selected by experienced professionals. The upside is shares in publicly traded VCs will have lower correlation with other stocks in your portfolio. The downside is that many of these VCs have underperformed traditional equity investments in the past.
While most publicly traded venture capital firms haven’t performed very well over time, there are some hybrid investment vehicles worth looking at. Publicly traded Scottish Mortgage Investment Trust invests in some of the world’s fastest growing public and private companies with a long-term time horizon. Also check out Alumni Ventures Group which lets accredited investors invest alongside some of the world’s most notable venture capital firms.
Pre-IPO Shares of Startups
There are two reasons to invest in pre-IPO shares of startups. Companies that have an initial public offering (IPO) tend to have an increase in share price on the first day of trading. Renaissance Capital has measured the average first-day pop for IPO shares for the period 2015-2019:
First-day returns between 11%-18%? Great for an arbitrage opportunity. Anyone willing to speculate a bit would consider pre-IPO shares, while long-term investors who are looking to snag a growth opportunity early on are also drawn to these investments. If you bought shares of Google on the first day of their IPO you’d be sitting with a +1,161% return today. If you invested in their Series B, your return would have a few zeroes added to it. There are a handful of pre-IPO markets for investors today where investing in single deals requires accreditation and high minimum investments. For retail investors with minimal capital, there are at least two marketplaces that offer pre-IPO funds with low investment minimums of a few thousand dollars.
Another way to invest in this type of asset is a SPecial Acquisition Company or SPAC. In this scenario, investors sign over a blank check to a VC company like Social Capital to invest in later-stage startups according to its investment strategy. The benefit? You can invest alongside a known VC in some late-stage startups. The risks? Very similar to the risks of investing in a publicly traded VC. Also, we’re seeing SPACs like Virgin Galactic, Hyliion, and Nikola Motor Company trade quite irrationally. Buyer beware.
Equity crowdfunding became a reality for non-accredited investors in 2013 under Title II of the JOBS Act in which equity crowdfunding was legalized. This means that non-accredited investors can now buy shares in a private company, provided that it only raises up to $1 million in a single year. We’ve been very cautious about these kinds of transactions for a number of reasons:
- When retail investors invest along seasoned VCs, they reap the benefits of a professional team’s due diligence and experience. Investing alone increases risks significantly.
- The deal structure automatically disqualifies real high-potential startups for three reasons. First, $1 million is not much money to properly scale a business with. Second, filing requires too much effort for a relatively low amount of investment. Third, one of the key reasons that startups look to be funded by VCs is because of the expertise and connections they receive access to. This is usually not available in a crowdfunding deal.
As we looked at equity crowdfunding marketplaces like MicroVentures and service providers for startup equity tracking, we concluded that equity crowdfunding is more appropriate to develop lifestyle brands instead of the next unicorn. Also called “Regulation A+ IPOs,” equity crowdfunding transactions can be beneficial for small enterprises with linear growth but will probably not provide a ticket to financial independence for investors.
Initial Coin Offerings (ICOs)
ICOs are very similar to Kickstarter campaigns in the sense that investors are pre-funding business ideas for so-called tokens that can later be used as credits to purchase whatever service the startup is going to offer. People who buy ICO tokens are not investors, they are future customers of some product or service that doesn’t even exist yet. This places all the risk on the customer and none of the risk on the issuer and should be avoided. Period.
While a small number of ICO tokens carry some form of equity, most tokens simply provide the “opportunity” to spend it on a product that hasn’t even been created yet at sometime in the future. This led to a proliferation of ICO scams.
ICO tokens are based on blockchain technology which does have many valid use cases and promises to transform sectors like legal tech, logistics, and many others. Cryptocurrencies like Bitcoin apply the same technology and can be valid investment assets in their own right. Standalone ICOs are not an investment or an asset class.
Art, Wine, and Other Collectibles
Investing in art has been an opportunity restricted to ultra-high-net-worth individuals who like to hold about 6% of their investments in fine art. The value of art in private hands is estimated at $1.7 trillion, of which $67.4 billion changes ownership every year. Masterworks is a startup that wants to democratize the art market by offering shares in blue-chip art along with some mid-late career artists like Banksy. The startup uses a proprietary pricing database to find artists gaining momentum and offers investments in a number of their works.
Top artists have outperformed the S&P 500 over the past 18 years and come with the added benefit of close to zero correlation with other alternative and traditional investments. While art investments are not very liquid, Masterworks is setting up a secondary market where investors can trade their shares to help increase liquidity. A competing startup called Maecenas only targets accredited investors and uses blockchain tokens to keep track of ownership transactions.
Fine wine is similar to art in that it both outperformed the S&P 500 by +1,000% over the past 20 years, and that it’s uncorrelated to traditional asset classes. A startup called Vinovest lets anyone invest in the asset class from $1,000 upwards. The company employs three of the world’s 280 Master Sommeliers as consultants, and combines their insights with proprietary machine learning algorithms to find the next cult wine to invest in.
The value proposition for collectibles is similar to art and wines. There is a wide variety of assets that are uncorrelated to traditional investments and that have a niche market like unique sneakers, rare watches, vintage cars, comics, and collectible card games. The investment selection tool above lists three startups in the space and promises very low minimal investment, open access, and a target return of 9-12%. If you’d like to try out this novel concept, Rally might be one to check out as they’re the only startup at the moment that offers a secondary market to trade your shares on.
Investing in People
Intellectual Property Royalties
Royalties are income streams that Intellectual Property (IP) owners receive for the use of their IP. Royalties from industries including music, book publishing, television, film, or pharmacy can all be listed on the Royalty Exchange platform. Creators list a portion of their income stream for a specified term on the platform and investors can bid for the rights of the item. Here’s an example auction item for the rights of early releases from the international country music duo High Valley:
(You know what happens when you play a country music song backwards? You get your dog back, you get your wife back, you get your trailer back… Anyways.) The platform provides a huge variety of listings from upcoming artists all the way to top performers. Past listings included rights for Jay-Z’s Empire State of Mind track and Ben & Jerry’s trademark royalties for the Cherry Garcia flavor. Royalty Exchange also operates a secondary market to boost liquidity.
Income Share Agreements (ISAs)
A startup called Vemo Education has developed ISAs as an alternative to traditional student loans. For example, let’s say you’re a rising senior Economics major with an ISA of $10,000. Based on your anticipated salary in that field upon graduation, you pay 3.38% of your $47,000 salary for 100 months. At the end of the contract, you would have paid back $15,673, and fulfilled the terms of your ISA.
As the product term is set (typically around 10 years), investors carry the performance risk of each individual. If the graduate is a top performer, his or her high salaries will pay back the loan many times over. On the flip side, if things don’t go well and the individual ends up working in human resources, they’re still only expected to pay for 100 months, even if the payments remain below the original loan amount.
A good income share agreement platform is Edly which claims to be the “only complete ISA funding solution” preferring to work with schools that are committed to providing students with strong employment opportunities. We spoke at length with their founder and were really impressed by what they’ve been able to accomplish.
Cryptocurrencies are digital currencies that do not have a physical form or real assets backing their value. They exist on distributed ledgers like blockchain that are impossible to hack because there are thousands of entities that all talk to each other and keep the entire ledger synchronized. The most famous cryptocurrency is Bitcoin, but there are many others with meaningful market capitalizations.
Cryptocurrency accounts are not named accounts but are identified with a private key. This is why Bitcoin and its peers have also become the payment method of choice for anything illegal globally. Transactions on the blockchain are peer-to-peer and the price of any cryptocurrency is determined by supply and demand on crypto exchanges. The number of cryptocurrencies (including Bitcoin) in circulation grows gradually and most (but not all) have a hard limit after which their numbers will not increase. Bitcoin’s correlation to equities is close to zero at the moment.
As the hype around this new asset class grew over time, financial institutions and startups started to build an infrastructure around these assets. It is now possible to short cryptocurrencies with eToro, and to gain exposure to Bitcoin through companies like Bitcoin Investment Trust.
You probably wouldn’t lend $7,000 to your neighbor so they can remodel their kitchen, but you might lend them $10 alongside 699 other people who also lent them $10 too. That’s the idea behind peer-to-peer lending, and it works pretty well. Companies like Lending Club allow you to loan out money to people at interest rates that match the riskiness of the loans. We’ve used Lending Club before and it works well. However, just be prepared for those default rates to increase when people lose their jobs en masse. Startups like Upstart use machine learning to provide more accurate interest rates for borrowers that more closely reflect the risk being taken by the lender.
Another lending opportunity – available to accredited investors – is to participate in loans that are backed by assets that act as collateral. Asset-based investing used to be restricted to hedge funds and institutions, but a company called YieldStreet now offers this product to individuals. Asset types vary greatly from commercial real estate to marine vessels and legal case proceeds.
Commodities are goods that are uniform in quality, irrespective of their source. Good examples are basic foodstuffs like wheat flour, livestock feed, and crude oil. Commodity goods are interchangeable, and from an investment perspective, often refer to a group of basic goods that are in demand globally. Popular commodities include raw materials for the manufactured products that consumers or industrial customers end up buying. There are five ways to invest in commodities:
- Investing directly on an exchange
- Through commodity futures contracts
- Buying commodity-themed Exchange Traded Funds
- Buying shares of companies producing a chosen commodity
- Go buy a bunch of commodities and store them somewhere
Whether it is gold, grain, oil, or something else, each type of commodity behaves differently. Investors need to know the market dynamics related to the specific commodity to navigate its global markets. As a retail investor, it’s probably safest to choose a thematic commodity ETF to invest in.
Robo advisors are online wealth management service providers that provide portfolio management advice based on algorithms rather than human financial planners. They do the same thing human wealth managers do: measure investors’ risk appetite and calculate an optimal asset allocation taking into account age and future life events. Taking the human advisor out of the loop lowers overhead, but maintains advice quality, as many advisors are little more than glorified salespeople supporting exorbitant fees.
Robo advisors are a bit of an outlier in an article about alternative assets because what they do is invest money in traditional asset classes. The reason why we decided to include them is threefold. First, they disrupt the existing wealth management landscape by offering really competitive fees to anyone. Second, robo advisors democratize financial advice as they require no minimum investment or accreditation. Third, they are a great field for disruption by big data and AI.
We’re still waiting for AI to have an impact, but the number and specialization of available robo advisory tools have grown to a whole sub-industry. Startups keep trying to disrupt the new status quo but true disruption will be down to the first real AI advisor.
Hedge Fund Strategies
Hedge funds are actively managed alternative investment funds that employ different strategies to achieve excess return (also called alpha) compared to the broader market. As these investment vehicles face less regulation, they can make use of riskier financial products like derivatives, short positions, and high leverage, in hopes of outperforming the market. This added risk is why hedge funds are only available to accredited investors.
Several startups are trying to change the model by crowdsourcing algorithms to set up new algorithmic trading strategies. If you’re an excellent data scientist you can also give it a go.
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