Alternative Assets are all the rage in the asset management business these days. Private equity, hedge funds and real estate are all sometimes touted as the alternative assets that will, depending on the sales pitch, either protect your portfolio from the next global financial crisis or boost your returns into the stratosphere.
An alternative asset is simply any investment that is not positively correlated to the two major existing asset classes: stocks and bonds. Investing a portion of your portfolio in alternative assets should increase your returns while reducing your risk. That is the theory, anyway.
In reality, most of the assets considered alternative by the mainstream financial industry actually aren’t very alternative at all. Instead these “false” alternative assets are pushed by large financial firms because the big banks and brokers already understand them well. In other words, they are conventional assets that have been repackaged to look new and different.
Another reasons giant financial companies like “fake” alternative assets is that there is sufficient liquidity to buy or sell hundreds of millions or even billions of dollars worth of them without overwhelming the markets. It is a case of investing for philosophical and practical convenience rather than investing for maximum return.
Private equity, for instance, refers to equity placements that are not listed on any public stock exchange. But at the end of the day, private equity is actually just common stock in companies that cannot access the public capital markets for whatever reason – usually due to the issuing company being too small, too distressed or privately held. This means their correlation with traditional stock markets is more or less total. Even worse, private equity is rather illiquid due to being unlisted; buying and selling (especially selling) is difficult.
Hedge funds are a catchall for limited partnership investment vehicles targeted at institutions and high net worth individuals. Hedge funds can invest in almost anything and pursue a myriad of different investment strategies, both long and short. However, “investing in almost anything” is really a euphemism for investing in almost any “paper” asset.
Once again this brings us straight back to the public equity and debt markets. Sure, hedge funds can invest in private equity too, but private equity is just common stock in disguise. Therefore, hedge fund correlations with the broad market averages are generally very similar, unless your fund likes to go short. But then again, you can easily short equities in your E*TRADE online brokerage account yourself. There is no compelling reason to throw management fees at a hedge fund to do it for you.
Real estate perhaps has the best claim in the group to truly being alternative, but even this asset falls short. When most people mention real estate, what they are really mean is developed real estate (buildings of some sort) that is rented out to tenants. It doesn’t matter whether the real estate in question is a warehouse, mall or apartment complex; the concept is the same.
But real estate’s Achilles heel is that it is almost universally funded via debt – the ubiquitous mortgage. So in a financial crisis, when banks aren’t granting mortgages, you can expect the value of real estate purchased with debt – pretty much all real estate – to decline substantially. Indeed, this is exactly what we saw happen in the Great Recession of 2008 – 2009. Unsurprisingly, this causes real estate to become very closely correlated to stocks and junk bonds during crisis scenarios.
So what are the real alternatives to these pseudo alternative assets? The answer is art and antiques, of course. These little known sleeper hits of the investment universe have little correlation to either stocks or bonds. And although they may decline in value marginally in a financial panic, they will surely rebound quickly once the worst of the crisis passes.
Art and antiques are as close to an undiluted claim on future global GDP as one can hope for in this world. But isn’t that all that any prudent investor is really looking for these days – a simple, safe, and tangible investment that will grow predictably for decades to come?
