Asset allocation is generally defined as the allocation of an investor’s portfolio across a number of ‘major’ asset classes: The main asset classes are: cash, fixed interest securities, bonds, equities and property.
An alternative asset's lack of correlation with other types of investments gives it potential to increase or stabilize a portfolio's return. As a result, alternative assets can complement more traditional asset classes and provide an additional layer of diversification for money that is not part of your core portfolio, though diversification cannot guarantee a profit or ensure against a loss.
But what is an alternative asset class? In a 2014 study from life insurance firm Jackson, 574 investors were asked to choose a definition of ‘alternative investments’ from a list, and 42 per cent selected "I honestly have no idea what alternative investments means." And the answer is not all that simple. The category of alternatives spans such a wide array of options, from private equity to tangible assets, such as art, wine and gold.
As with the main asset classes the decision on whether to hold these in your portfolio will depend on your risk appetite and personal preference. And how well they will hedge against bad preforming equities, whilst keeping within your set risk profile. It is important to note that alternative assets may be less liquid than equities or bonds for example. They may also be difficult to research. The unique properties of alternative asset classes also mean that some can involve a higher degree of risk often due to less regulation than other investments. But there are lots of options out there.
Property is considered to be one of the main asset classes. Many individuals like to hold property as part of their portfolio, perhaps because it is a tangible asset that you can see and touch, but most importantly property tends to be negatively correlated to equities and has the potential to create a real return. However property is a highly illiquid investment and can incur additional costs. Of particular concern is the new stamp duty detailed in the Autumn Statement. The levy will see an additional 3 per cent stamp duty on buy to let properties. But did you know that you can still hold property without the hassle?
Reits are now the standard way to hold investments in property. A trust owns the buildings and receives the rents they produce. They then pay out the vast majority of its rents straight to the shareholders. A Reit is about as close as financial engineers can bring you to owning a building direct, without the hassle.
Gold is often regarded as the safest type of investment as its value is not affected by inflation. Investing in art, fine wine and collectibles are also alternative assets that can help to avoid turbulent times within the markets. This is because their prices do not depend on other possible components of a portfolio, and they can act as a cushion when other markets are not doing well. A word of warning though, if you are just about to polish off those dusty antiques! Any gain over 6 thousand pounds on a single item will be liable for CGT. Tangible assets such as these are also often seen as a specialist form of asset. Public tastes and other factors make them a fairly speculative investment and one, which requires a certain degree of knowledge and expertise. They can also carry other concerns, such as storage and insurance. Don’t want to hold gold bullion? Consider buying into a gold fund instead.
Structured products are much more widely used nowadays. Many Structured products will come with a 100% guarantee, which investors view as a real safeguard, but products that come with ‘100 per cent capital guarantee’ should still be treated with caution. Remember they will still have exposure to inflation risk. If all you get back at the end of the product's term is your original capital sum, your investment will in practical terms have declined in value. Structured Products also have a variety of risks attached to them, including, counterparty risk. The so - called guarantees behind the majority of such products are provided by a third party such as banking institutions, or governments, and if such third party becomes insolvent the guarantees may not be met.
UCTISIII now makes provision for retail investors to have wider access to alternative investments, albeit in the context of a heavily regulated environment. Changes brought about by the MIFID Directive, have emulated in a much wider range of investments that may be sold to UK retail investors. UCTIS are generally regarded as having a high degree of volatility, illiquidity or both, and are therefore usually regarded as speculative investments. Investors into UTIS are likely to be sophisticated/professional or High Net Worth investors (HNWI).
Mention the word derivative and most us will think back to the days of Leyman Brothers and the 2008 banking crisis. Quite rightly, the complexity of derivatives should be noted. These sorts of instruments are often best left to the professionals. In a 2002 letter to Berkshire Hathaway shareholders, Buffett describes derivatives as “financial weapons of mass destruction”
A derivative as ‘ a financial instrument whose value is derived from the value of an underlying security. Futures and options represent two of the most common form of Derivatives. A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a 'call' option or a 'put' option. A call option gives the buyer, the right to buy the asset at a given price. A 'put' option gives the buyer a right to sell the asset at the 'strike price' to the buyer.
Contracts for Difference are another from of derivative and were developed as a way for clients to short sell the market while using leverage. Essentially they are a contract to exchange the difference between the price you open the contract and price you close the contract at. They may be used to speculate on the future movement of market prices regardless of whether the underlying markets are rising or falling.
The complex structure of derivatives and CFDs mean that they are unlikely to meet the investment needs and objectives of retail investors. Really they are used for hedging by institutional investors. So tread with caution and instead use your resources to build a long-term value investment, which leads to capital appreciation over time.
What about Corporate bonds? Most corporate bonds offer fixed interest payments for the life of the bond and they usually offer higher yields than government bonds too, although the high-yield potential is generally considered as having more risk. Individuals who want a steady income from their investments, while preserving their principal, may want to include these in their portfolio.
Venture Capital Trusts and Enterprise Investment Schemes are another common alternative investment. Venture capital trusts provide investors with the opportunity to invest in a range of companies. Enterprise investment schemes will offer investors an opportunity to invest in one company and so this type of investment is often seen as quite high risk, as there is very little diversification here but any turbulence in the markets is unlikely to have too greater effect on your return.
Both of these options also offer viable solutions in helping mitigate tax liability. Typically anyone investing into equities will pay 0.5% stamp duty and then there is of course the tax on dividends. For VCT’s income tax relief of 30% can be claimed up to £200,000 per tax year and for EIS’s 30% tax relief can be claimed on investments up to £1 million. Keep your investments for long enough and you can even negate Capital Gains tax completely, and in the case of investment into an Enterprise Investment Scheme you may also be able to avoid IHT after a 2 year period. It is imperative to keep up to date with the rules though, In the 2015 UK Summer Budget, the chancellor defined various new qualifying rules for these schemes.
The idea of crowd funding is one of the latest in funding innovations. Small business owners that are being turned down by high street banks now have an opportunity to appeal directly to small investors. Thanks in part to the popularity of early-stage-investing TV shows like Dragons Den, which have sparked curiosity in even the most prudent of folk. Equally, whereas investing in small businesses was previously the domain of the very rich, this new concept allows a much wider audience of investors to participate. A fairly new phenomenon though, it doesn’t come without its risks. Private equity is not for everyone and often requires a long-term focus; many investments may take years to produce any real profit. Like hedge funds, private equity also typically requires a very large investment.
But which alternatives to select should not be your only consideration. As we can see from VCT’s and EIS’s, tax planning can play an important role in your investment strategy too. Not only is it important to get your asset allocation right it is equally essential to consider how you hold your portfolio, as certain investments will allow you to mitigate taxes on the growth of your money.
Tax is never far from the minds of most of us, making it an essential part of money management. It is vital that we understand the taxes we are likely to be subject to before making any decisions - getting it wrong could prove to be very costly. Remember too, when it comes to alternatives that these types of investments are often not regulated, and thus are not party to investor protection schemes.
So how much of your portfolio should be made of alternative investments? Research suggests that ‘replacing 20% of a traditional portfolio with a broad mix of alternative products reduces volatility.
Generally speaking, allocating 10–20% of a portfolio to alternative investments is considered appropriate. This is a large enough allocation to be impactful in terms of enhancing returns or helping to reduce risk, without being so large that it dominates the overall portfolio.
One thing is certain, that when it comes to investing, diversification is paramount and the possibilities for diversification are vast, however, we should do so in a fashion and style that does not put our wealth, savings, and investments under undesirable risk. Ultimately, there is no one-size-fits-all solution to building an investment portfolio. How you allocate towards different asset classes will be just as much about your tolerance to risk as it is about your expectation of returns.
If you don’t want the hassle of picking funds and underlying investments or you don’t know where to begin when selecting alternatives, then it is prudent to seek the advice of a qualified financial adviser. Consider too the option of using a discretionary fund manager. A DFM will mange your portfolio for you and with so many time conscious professionals out there with little knowledge around the complexities of asset allocation, a Discretionary Fund Manager can often be the perfect option.
Despite unique risks and considerations, alternative investments can be useful tools to improve the risk-return characteristics of an investment portfolio. They can increase diversification and reduce volatility and they can offer the potential for enhanced returns.. But like everything in the world of investing, you need to look before you leap. This is especially true in the world of alternatives.