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Asset allocation has traditionally been thought of as the right mix of stocks (equities), government bonds and cash. Enough risk to generate returns but enough safety to meet unexpected expenses and not run the risk of a disastrous hit to your portfolio. When you are young the risk/reward ratio of holding riskier more volatile assets is in your favour, but as you get older investors typically want to taper their exposure to risky assets to ensure they have enough to retire on.
Benjamin Graham is often considered to be the founder of value investing and one of the most influential investors of all time. Graham recommended that investors should use a 50-50 stock-bond allocation as a baseline, and then shift as far as 25-75 in either direction, based on market conditions. Discussing the strategy in his book, "The Intelligent Investor," he recommended:
"The sound reason for increasing the percentage in common stocks would be the appearance of 'bargain price' levels created in a protracted bear market. Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgment of the investor the market level has become dangerously high."
Over the past few decades, the distinction of what constitutes an asset has evolved significantly. As the yield on traditional assets has gradually declined since the 1980’s, investors eager to increase their returns have looked elsewhere, often in esoteric markets away from view of the general investing public. Alternative investing is the process of using an expanded set of investment opportunities relative to those adopted by conservative investors.
This presents an opportunity for the investor with sufficient foresight to anticipate what the next up and coming alternative asset is likely to be. Institutional investors tend to wait before an alternative asset becomes investable. But that means the greatest value opportunities lie in being ahead of the curve and then being able to benefit from the surge in institutional interest. Once institutional investor involvement in an asset becomes mainstream the returns may start to disappoint.
What are the different types of alternative assets?
There is no uniform definition of alternative assets or definitive list of alternative assets - it will evolve over time as technology and economic incentives dictate. As markets for these assets and strategies expand and participation grows, more of these alternative investments are becoming suited to the needs of both private and institutional investors. The CFA Institute define the four broadest and largest categories of alternative investments as hedge funds, private equity, real assets, and structured products:
Hedge funds: Investment pools that are typically privately organised and invest principally in publicly traded assets, such as stocks, bonds, currencies, commodities, and derivatives. Unlike traditional investment pools, such as mutual funds, they can use leverage and sell short. Their essential characteristic is that they implement skill-based trading strategies that generate substantially different risk/return profiles compared with traditional long only investment funds
Private equity: This could involve early stage venture capital investments capitalising on the potential strong growth ahead of a company being publicly traded. Private equity funds also use leverage to buy out companies that are publicly traded and take them private.
Real assets: In contrast to financial assets which are claims on cash flow, real assets derive their value from their utility and their inherent scarcity. They include tangible assets like real estate, commodities, land and collectables (wine, art, and stamps). But they increasingly include scarce intangible assets such as intellectual property rights and cryptocurrencies like Bitcoin.
Structured products: Financially engineered products not available to traditional long only investment funds. These include products like collaterised debt obligations and other derivatives.
Why invest in alternative assets?
Earlier we noted that alternative assets have grown in popularity as investors, disappointed with the yields available on traditional assets have sought higher returns elsewhere. It’s worth considering the many other benefits of an exposure to alternative, often niche investments:
Not being able to access traditional finance: Some investors may not have sufficient funds to access the assets that wealthy or professional investors have access to. The ability to buy fractions of a share (offered by Robinhood and some other retail brokerages) has enabled small investors to gain a stake in companies that they may otherwise not have been able to.
Uncorrelated returns: Investors typically look to alternative assets to reduce the overall risk of portfolio, while also offering the prospect of high returns. Related to this is the need for an investor to protect his or her portfolio from outright losses. In April 2020, some oil traders found to their cost that commodities can drop below zero, despite the claims by commentators that they would always have a positive value.
Inflation protection: Precious metals - gold in particular - have always been sought to protect a portfolio from the impact of inflation. When central banks are debasing their currencies through money printing for example, gold and other scarce assets tend to do relatively well, but not always.
Potential for asymmetric returns: Alternative assets can often provide higher risk adjusted returns through alpha. Traditional assets tend to be very price efficient, and so there may be little or no edge from acquiring information. In contrast, alternative assets tend to be significantly less efficient and so the potential return from an investors’ information edge can be higher.
Potential for leverage: Most financial assets require an investor to stump up the full cost of the investment. This can make large scale investments difficult to access for most investors. One of the reasons why property is popular with investors is the ability to use leverage – a property investor may be able to buy a house by only putting down a 5%-10% deposit.
Outside the traditional financial universe: You are lucky if you live in a country where your right to asset ownership is respected by your government. Not all investors are so lucky. Many face the real risk of their investments being appropriated, even cash held in a bank account may be at risk. Investments in digital assets like Bitcoin have become more popular as a result.
Where fundamentals still matter: Traditional assets such as equities and bonds have become driven by passive investment funds that aim to achieve a certain risk/return profile. These funds dominate traditional assets and indiscriminately buy every asset in an index - irrespective of its valuation and merits as an investment. Value driven investors have become frustrated with many looking at alternative assets in which the fundamentals still matter. From both a valuation and a growth perspective, alternative assets can look very attractive.
The risks involved with alternative assets
Some of the major benefits of investing in alternative assets also represent their major drawbacks.
Not as liquid as they appear: Innovation may provide the ability to trade in and out of the price of an illiquid asset, for example farmland or property. But that doesn’t mean the underlying asset has suddenly become more liquid. In times of crisis the underlying market can suddenly freeze resulting in a rapid drying up in liquidity.
Changes in fashion: Collectables may appear to be the most tangible of assets – after all you can still appreciate the beauty of a piece of art or drink the vintage wine. But from a valuation perspective, collectables are vulnerable to changes in fashion and wider shifts in society. Works of art by Vincent Van Gough may be worth millions today, but in his lifetime, he famously struggled to sell his paintings.
Other costs not applicable to traditional assets: There may also be fixed costs associated with tangible assets, which often have to be stored securely and insured (precious metals for example). Others such as property and forestry involve high investment in maintenance to ensure the asset doesn’t degrade.
They no longer become alternative: As investment funds move into alternative assets, one investor's portfolio may start to resemble another’s. In the event of a market sell-off the diversification benefits of the alternative asset may not be as strong as you expect.
Competition eroding returns: If skill and deep sector insights are strong factors in driving returns then high returns might attract other players into the sector, eroding the opportunities to find value.
Greater volatility: Many alternative investments (e.g. digital currencies and collectables) exhibit highly volatile prices.
Being scammed: Unlike traditional asset markets, many alternative assets are unregulated. This increases the onus on the investor to know what he or she is buying and avoid purchasing counterfeits. Caveat emptor – buyer beware.
Alternative assets should not be judged by their overall aggregate performance. Each alternative asset market has its own characteristics that makes them valuable under different market conditions. In this article I focus on some of the things to consider and lessons to learn from three alternative asset markets: precious metals, collectables, and venture capital.
Alternative asset 1: Precious metals
Gold and other precious metals are often used as a hedge against uncertainty. Gold prices peaked in 1980 at $850 per oz when the Soviet Union invaded Afghanistan, which also coincided with the Iranian hostage crisis at the US Embassy in Tehran. The rise to 2011’s record peak of $1,920 per oz came as several of the Arab Spring revolutions descended into civil war and Greece was brought to a standstill by a general strike against the Eurozone’s austerity demands.
Note that gold is a "fiat commodity" – one that has value as an asset if and to the extent that enough people believe that it has value. As a fiat commodity currency, gold’s value will be largely determined by its attractiveness relative to other fiat currencies – the fiat paper currencies issued by central banks. Gold then also becomes attractive to investors when central banks are printing money, e.g. quantitative easing.
Anyone that bought gold in 2011 would have been disappointed. Prices fell by 45% between 2011 and late 2015. Over the past 4-5 years gold prices have rebounded to close in on the 2011 highs. The Corona crash shook the gold market like other asset markets – over the course of a two-week period in March the shiny metal lost and then recovered 15%-20%
The lesson to take from the gold market is that although it typically offers a hedge against geopolitical and financial uncertainty in the long-run, the short-run can be subject to sharp fluctuations.
Alternative asset 2: Collectables
Many investors will be familiar with collectables as an alternative investment. These typically include rare art, fine wine, original postage stamps and classic cars. Investing in collectables requires deep insight - understanding not just what is in demand right now but also correctly anticipating how that will change in the future. Two less well-known collectable assets include Magic: the gathering cards and the soft toys known as Beanie Babies.
Magic: the Gathering (MTG) was the first trading card game and was launched in 1993. The game of strategy has grown in popularity and is played by millions of people worldwide. Cards with an advantage in the game are in high demand with players often willing to pay a significant premium. Cards that are rare are also in high demand while many are highly sought after for their aesthetic appeal.
MTG cards are traded in the same way as other collectables. If investors anticipate that demand for certain cards will outweigh supply, then they can profit from holding the ‘asset’ in anticipation of higher prices.
In mid-2020 the supply for some of the rarest MTG cards became even more acute. The story stretches back to 1994 when MTG introduced a card called "Invoke Prejudice" which appears to depict a horde of hooded Klansmen. The card’s action allows a player to counter creatures of a different mana colour. There are 5 colours of mana in the game: white, black, blue, red and green.
The global civil rights activism that occurred in the aftermath of George Floyd’s death prompted MTG’s parent company to review racist references on its cards. "Invoke Prejudice" along with several other cards were removed from play and from the official MTG database. Existing holders of banned game play cards knew that there will be no new supplies coming onto the market. The price of "Invoke Prejudice" cards more than doubled after the announcement, rising from €150 to almost €350 in less than two weeks.
Invoke Prejudice price chart
source: cardmarket
Even soft toys have become collectable assets. In the late 1990’s a soft toy range known as the Beanie Babies was launched. Initially retailing for about $5 each, they soon rose six-fold as collectors and then speculators soured the internet for genuine Beanie Babies. Many of the rarest editions rose 10-fold at the time.
In the same way that MTG created artificial scarcity by retiring certain editions, the creator of Beanie Babies did the same when the product was launched, and albeit unintentionally created an unprecedented boom in the soft toy values. Collectors eager to have the whole set, searched everywhere for the rarest editions. At one point, Beanie Babies constituted 10% of all sales on eBay!
Magazines with prices of the toys fuelled speculation. Asset prices are reflexive: they both reflect the reality they are supposed to represent but they also influence it. The knowledge that these $5 toys could potentially be worth thousands fuelled the boom. The bubble eventually burst when the creator retired a large number but then appeared to go back on the decision. Confidence collapsed and the bubble burst in the same way that the South Sea bubble did 300 years ago.
Those collectors and speculators that rode the wave and resisted the temptation to sell when the market crashed may still be sitting on a gold mine. The rarest Beanie Babies are still collected over 20 years later. The 1997 Princess Bear was dedicated to Princess Diana. As of 2019 it was estimated to be worth $665,000.
The MTG and Beanie Babies market demonstrates the unique insight that is required to dig out value propositions, the assets most likely to have huge asymmetric payoffs and the patience to ride out the inevitable price volatility.
Alternative asset 3: Venture capital
Venture capital (VC) involves investment in small early stage companies in the hope that they will thrive and mature to the point that they will eventually be traded on the public stock-market or be acquired by a large firm. For a venture capital firm, investing in these small firms is akin to picking up lottery tickets: a large probability of a small loss across most of the firms (around 80% of VC investments don’t pay off), but a small probability of a huge payoff. The hard task is identifying those companies most likely to pocket the huge payoff.
Venture capital investment often requires an investor to tie up their money for a long period of time. This makes sense given the timescale of the investments. A VC firm does not want investors running for the exits just before one of their lottery tickets comes up with the winning numbers.
Venture capital provides three sources of return. First, the concept of ‘first mover advantage’. This is the idea that initial investors in a promising firm or sector tend to reap the greatest rewards. Second, the illiquidity premium. Investors must balance the inability to withdraw their funds or monitor day to day performance with the prospect of outsized returns in the future. The third benefit is diversification. Unlike investors who just have their funds in traditional assets, venture capital provides a way of diversifying their risk and return.
The perception of the likely returns to venture capital are typically skewed by those few ‘unicorns’ that rapidly turn into billion-dollar companies. Investments in biotech and technology companies are fraught with risk and highly volatile. While some companies return 1000 x or more to their VC investors, others quickly go bankrupt.
The lesson investors should draw from venture capital is that every trade or investment is a bet. Many of those bets will turn out as a loss, but that’s all part of the process towards long-term investment success.
Assetization
Both the traditional and the alternative assets I’ve discussed in this article can be bought and sold, commodified, and used as a means for speculation. However, the purpose behind many assets is to provide a durable economic rent, whether that is rental income from property or the yield on a bond.
Technology has enabled almost anything to become an asset. Assetization as it is known is defined as the process of converting something into an asset. Platforms such as Uber and Airbnb mean that cars and homes can be used as an asset to generate additional income for the owner. Even consumer goods are becoming assets: clothes, jewellery and furniture are examples of products ‘assetized’ through technology platforms.
Technology now means that instead of having to own the entire asset – often at considerable expense – an investor can own a portion of the asset and be entitled to any resulting economic rent. For example, online platforms enable investors a slice of an asset via fractional share ownership (e.g. Robinhood) and crowd funding investments in early stage start-ups (e.g. SeedInvest).
Sports trading is an extension to the realm of alternative assets and one where assetization is also occurring. Launched in 1999 Betfair is a betting exchange that allows market participants to buy or sell odds on the outcome of a sports event. From football and tennis to several other sports, millions of dollars are traded on the outcome of a single sporting event. Mercurius enables investors to gain access to their systematic trading strategies, employed to spot and take advantage of mispricing in the sports trading market. By providing a platform for investors to share in the returns, Mercurius has also ‘assetized’ the sports trading markets.
The 100-year portfolio
The truth is that it is impossible to judge the performance of any asset – traditional or alternative – over the period of a quarter or even a year. It needs to be judged over the course of an investment cycle. Although investors may try and time adjustments to their portfolio to suit different economic and investment climates, it’s very difficult to accomplish in practice. According to Artemis Capital investors should instead think about what they would include in their portfolio if they had to leave it alone for 100 years – a portfolio that can profit irrespective of underlying market conditions:
"Many investors assemble a varied portfolio of asset classes thinking there is safety in diversification, but in a crisis, the portfolio is exposed as a leveraged long-growth portfolio with no real diversification at all. Another class of investors believes they can always time the wild cycles of risk when, in fact, they can barely manage the demons of their greed and fear. The greatest threat to 100 years of prosperity is neglecting the lessons from long-term financial history and having no true diversification against secular change."
Alternative asset classes are likely to grow in both size and breath as economic incentives and technology enables hitherto unimagined items to become assets. The risks associated with alternative assets include greater volatility, changes in fashion and competition eroding returns. The opportunities for early adopters though include the potential for asymmetric and uncorrelated returns. For frustrated value investors, the most attractive characteristic of many alternative assets will be that they remain a place where fundamentals still matter.
