What is... | November 14, 2011

What is an alternative asset?

When returns on investment are not what you expect, what alternatives are out there to help grow your assets?

Alternative assets have been a hot topic among certain investors, financial advisers and media. This has been partly driven by the low interest rates seen in many countries over several years as well as increased volatility in share markets since the 2007 global financial crisis. Given these conditions, many investors are looking at alternative assets in the hope of finding financial products to produce either higher or more stable returns.

Alternative thinking
Many people describe alternative investments as anything other than cash, shares, bonds or property.Often, investments such as hedge funds, private equity, options, futures and commodities are considered to be alternatives. Investments in wine, postage stamps and art could also be considered to be alternatives – or alternative alternative assets.

But beware: this classification purely by product type can be misleading or confusing. What may be an alternative investment for one person could be mainstream for another. Much depends on an individual’s attitude to financial risk and their level of financial knowledge.

One person’s alternative asset
Some people invest their savings in a bank account to reduce risk losing money. For these people, the risk involved with investing in shares makes shares an alternative investment. Such an extreme aversion to risk is unusual, with one 2008 study showing about 14% of European shares are owned by individuals.

Furthermore, individuals’ attitudes to risk could (and probably should) change over time, particularly as they get close to reaching an investment goal. Think of the lifecycle approach to investing. So what we see as “alternative assets” is likely to change.

The lesson is that there is no single definition of alternative assets – even financial regulators do not use one – that can guide investors.

The search for yield
However defined, investments in products that are neither cash, equity, bonds or property have reportedly become more popular. Developments following the global financial crisis may have played a role.

Returns from shares, which form a major part of many investment products and pension funds, suffered sharp falls during the crisis. This lowered long-term rates of return, making it difficult for people to meet their investment goals. Several major shares indices have had negative returns over the past five and ten years.

Furthermore, the movement of share prices over short periods, their volatility, has remained high making it even more difficult for individuals and institutions to manage investment risk. Low interest rates in many parts of the world also make it more difficult to achieve desired rates of return.

These trends encouraged some people to look for investment products that may deliver higher returns. This is known as the search for yield.

Examine the structure
This search has led to a rise in financial products that guarantee a minimum rate of return or protect from loss. Known as structured financial products, they are typically made by combining a number of complex financial products (such as futures and options) to form a package that can be sold to investors.

Not traditionally considered alternative investments, these structured products may be very difficult for some to understand. The UK Financial Services Authority has noted the rising popularity of structured financial products and has been examining their design and whether they are appropriate for many investors.

Buyer beware
Non-traditional investments may be appropriate for some. However, any investor must look carefully at what is being offered and the risks involved. ING Group chief economist Mark Cliffe warns investors in his video lessons from the financial crisis against putting money in products they don’t understand.

Complex products may also carry high upfront and ongoing charges, which can reduce returns, or may be illiquid and hard to sell quickly (think also of art, wine and stamp alternative investments here).

Managing the balance between investment risk and the return required from those investments can be tricky. However, as economist Chris Dillow writes there are ways to think about this without feeling pressured into investments, alternative or otherwise, that you do not understand.

InvestingSharesRiskBondsAsset allocation

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics