Alternative Assets - Here & Now

In 1952, Nobel prize-winning economist Harry Markowitz introduced modern portfolio theory. This theory suggested portfolio performance would be maximized by reducing risk through diversification. Modern portfolio theory led to the popular portfolio diversification strategy of allocating 60% of assets to stocks and 40% of assets to bonds, a strategy that has been heavily used for the past 70 years.

However, with the growing sentiment that alternative assets are strong performers, coupled with their increasing accessibility, investors are rethinking what their portfolios should look like.

In 2020, pension funds allocated an average of over 30% of their portfolios to alternative assets, while high net worth individuals allocated 26% of their portfolios to alternatives.

With current market conditions in mind and alternative investments evolving into a liquid, transparent industry, these assets only continue to grow in popularity.

Introducing The World of Alternatives

An alternative asset is an investment in anything other than public equity, bonds, or cash-like vehicles. Traditional investments like public stock are traded in liquid financial markets and are heavily regulated by the U.S. Securities and Exchange Commission or other regulatory bodies. Meanwhile, alternative assets may be managed by private companies, traded in historically less liquid marketplaces, and span an increasingly diverse list of investments. Both alternative assets and traditional assets can offer investing opportunities in the same industry. For example, you could purchase shares in publicly-traded agricultural companies (traditional investment) or invest directly in farmland (alternative investment).

The alternative investment space is made up of so many unique, and continually-expanding opportunities. One of the most common alternatives is real estate with specific industries such as commercial, residential, or industrial properties. Oil, gold, or silver are examples of commodities that can be purchased digitally or physically. Digital assets are an emerging alternative investment with one in eight Americans having traded cryptocurrency in the past year, while many collectibles have experienced tremendous growth in value in 2021. Investors can also add agricultural alternative assets to their portfolio including direct farmland ownership through FarmTogether, farmland REITs, or commodities.

Utilizing Alternatives In Your Portfolio

Why are so many investors turning to alternatives? The unprecedented situation of today’s financial markets has investors thinking creatively. Equity valuations are historically high as the price of investing in public equity has never been more expensive. Through 2021, bond markets experienced steep price declines in response to signals of interest rate hikes and reduced quantitative easing practices. Inflation - which has hit a 30-year high - has not been beneficial for traditional investments in the past.

For investors wanting to explore non-traditional portfolio options, the past performance of alternative investments make the asset class an interesting possibility. From 1992 to 2020, both farmland and commercial real estate were less volatile investments than U.S. stocks, as these alternatives had standard deviations less than half that of equities. Alternative investments have performed well during prior inflationary periods; across numerous high inflation periods in the past, farmland and gold have performed exceptionally well. Alternatives also outperformed equities over the past three decades. From 1992 to 2020, farmland yielded an average return of 11% compared to the average return of U.S. stocks of 8%. Specific collectibles like baseball cards also outperformed the S&P 500 in prior years.

An Evolving State of Accessibility

Alternative investments had traditionally been difficult to invest in. Here’s a look at how the industry has evolved to better cater to investors.

Initial Investment Minimums

Alternative investments used to be synonymous with large upfront capital requirements. Historically, you would have had to pay millions of dollars to invest in a Picasso painting or to operate your own farm. Today, those capital requirements are becoming less of a prohibitive barrier. Earlier this summer, the digital fractionalized sale of Fillette au beret by Picasso sold partial ownership stakes in the piece for a minimum investment of only $6,000. Investors can also get started with fractional ownership of an operating farm through FarmTogether with as little as $15,000.

Investment Transparency

The early days of alternative investing were often plagued by lack of clarity around regulation, asset valuation, benchmarking, and communication. Largely in response to the 2008 financial crisis, investors began to demand greater transparency around alternative investments. After the 2008 recession, 17% of investors - up almost 6x from before the recession - cited transparency as the most important consideration for evaluating whether to hold alternative investments already in their portfolio.

More than a decade later, 82% of alternative managements currently believe their organization has effectively responded to investor demand for transparency. A vast majority of firms now use some sort of social media, and there’s more industry-wide benchmarking guidance on unique asset classes. Companies have come to realize transparency directly improves investment performance as alternative investment funds that provide standard reporting templates with highly detailed and granular data to their investors generate returns 10.2% higher than their peers.

Investment Illiquidity

In the past, alternative investments have traditionally been considered illiquid investments, making it harder to evaluate their worth and more difficult to buy or sell. Modernization of how assets are offered now allow investors to more easily invest. Instead of having to directly purchase an apartment complex in Houston, there’s numerous crowdfunding investment opportunities with more liquid markets. There’s also emerging secondary market opportunities for investors to more easily close out of their holdings or buy into a previous offering. Even though alternatives remain less liquid than public investments, there’s several potential benefits to this. Assets more difficult to buy or sell have generated higher returns in the past strictly because they are more difficult to access. In addition, private equity investments were less volatile during the pandemic than public equity.

Investing Fees

The early days of alternative investments were fraught with high fees. Today, only 30% of hedge funds now charge the traditional “2 and 20” fee arrangement, while hedge funds have also begun offering more first loss programs where investment managers share in potential investment losses. The role of technology has also played a part in minimizing the cost of managing alternative investments. Private fund administrators have specifically noted that technology has allowed them to offer higher quality service for lower fees.

The Rise of Fintech Platforms

Undoubtedly, one of the biggest factors in increasing investment accessibility has been digital platforms and technology. Prior to technological intervention, investing in physical precious commodities was not liquid, transparent, or efficient. Just twenty years ago, the way commercial real estate opportunities were listed, communicated, or explained was vastly different. With digital transformation spending projected to grow more than 20% annually over the next decade, the way businesses operate and interact with clients appears to be positioned to continually evolve.

Digital platforms now create entire ecosystems and communities around otherwise illiquid markets. From vintage wine to private equity to farmland, these otherwise difficult markets to enter now have a digital presence for investors to easily get started on. These digital platforms typically leverage crowdfunding - by pooling together funds from various sources, ownership is divided across a number of investors. This creates opportunities for ownership stakes to be as large or small as investors want with shares of partial ownership exchangible on digital platforms. These fintech platforms reduce the required capital to get involved in investing in an asset, facilitate communication between the investor and asset manager, and develop a liquid market for an otherwise illiquid asset.

Alternative Assets: Growing Accessibility

Advancements in technology and investment platforms have made alternative assets increasingly accessible to a wider range of investors. While alternative investments may have once been challenging to incorporate into portfolios, recent developments have simplified the process, making it easier for investors to explore and engage with these options today.