Alternative Investments Explained

A long established space, alternative investments in their true sense have existed since the mid 19th century, but over the last two decades especially, have formed increasingly larger portions of investor portfolios.

Alternative investments are financial assets that do not fall into the categories of traditional equities, bonds or cash investments. Some examples of alternative asset classes include private equity (PE), venture capital (VC) and property investments.

Due to their lack of correlation with traditional markets, alternative investments are - by nature - associated with a range of investor benefits, generally not shared by traditional asset classes. These range from reduced correlation to external volatility to a wider scope for portfolio diversification and enhanced potential to generate financial returns.

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While the traditional cornerstones of any diversified portfolio typically include equities, bonds and cash, these days Institutional Investors and Private Investors are increasingly looking to ‘alternative’ investments to bolster their asset allocation.

Norman Peterson
Chief Executive Officer, Growth Capital Ventures

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A form of direct lending to individuals and/or businesses, peer-to-peer (P2P) lending is often completed via online platforms that match lenders with potential borrowers. This occurs without an official financial institution participating as an intermediary in the deal, indicating potential for high risk, but also higher  returns and greater flexibility. One scheme that supports investors in maximising upside via P2P loans is the IFISA, which can enable investors to target inflation-beating interest rates on products such as property bonds, tax-free.

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Collectables are assets that most often hold value due to popularity or rarity. Most often pursued by investors that hold a specilialist knowledge or personal interest in a specific field, collectables are one of the oldest and most diverse alternative asset classes. Whilst some of the most popular examples of collectable investments have long included fields such as classic cars, art, wine and jewellery, recent years have seen a rise in popularity of less traditional areas such as digital collectables, or NFTs (none-fungible tokens).

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From generous tax reliefs to reduced market volatility, alternative investments, by nature, can provide investors with a range of additional benefits, generally not shared by their traditional counterparts.

Superior Returns
Whilst returns cannot be guaranteed, on the whole alternative investments have the potential to target considerably higher returns than their traditional counterparts. In part a result of their lower correlation to market fluctuations, less centralised nature and often more long term focus, this can make alternative investments especially attractive to experienced investors with less of a reliance on liquidity. 

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Reduced Portfolio Volatility
Largely due to their less centralised structure, alternative investments often display reduced sensitivity to traditional market fluctuations. As a result, alternatives can be more resilient when faced with external shocks, such as periods of inflation and recession.

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Eligibility for Tax Efficient Investment Schemes
Another benefit able to be accessed via the alternative investment space is the UK's range of tax efficient investment vehicles. In the case of venture capital, these come in the form of the EIS, SEIS and VCTs, and can provide investors with up to 50% income tax relief, capital gains tax exemption,  inheritance tax exemption and loss relief. Combined, these tax reliefs help to minimise the risk and maximise the returns associated with early stage investments.

The below table illustrates three potential outcomes of a £50,000 SEIS investment for an additional rate taxpayer, in which the hypothetical company fails, breaks even and triples in value. 

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Portfolio Diversification
Naturally, due to a vast range of asset classes existing in the alternative space in comparison to just cash equities and bonds in the traditional category, alternative investments allow for much broader, deeper level of portfolio diversification than traditional portfolios. Combining with this the range of sectors, geographies and levels of growth that can be targeted across the alternative space, this diverse nature of alternative investments allows for a more even and effective distribution of risk and returns in contrast to the comparably restricted limits of traditional investments.

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Investing for Impact

Whether it is by backing transformative startups or contributing to the development of regional property projects, alternative investments can allow investors to contribute to significant social, economic and environmental impacts whilst building their wealth. Certain, schemes such as the EIS, also offer investors enhanced limits for investments into knowledge intensive companies (KICs), furthering the potential for positive impact and returns.

Though often associated with a range of benefits, equally, a number of risks are typically linked with the alternative space that should be considered prior to any investment.  

Lower Liquidity
Many alternative investments may require a comparatively longer investment period before any return is realised. As a result, investors are likely to experience reduced liquidity. It is therefore crucial that sufficient funds are available to withstand this possibility.

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Less Regulation and Transparency
Regulations differ for many alternative asset classes, meaning that navigating and understanding the relevant rules and restrictions can become a complex task. In addition, the underlying assets of alternative investments are often difficult to value, which can lead to challenges in pricing and price transparency.

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Greater Complexity
With the alternative investment space accompanying a much broader range of asset classes, schemes, and vehicles - all of which possess their own set of rules and requirements - investing in alternatives can initially appear more complex than traditional investments. In turn, investors should ensure they conduct detailed research into the rules and structure of the investment route they follow before parting with capital. 

 

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Potential Loss of Capital
As with all investments, the risk of losing capital is present. Whilst investors can mitigate this possibility with thorough due diligence into opportunities and providers, and by mitigating risk with the reliefs and exemptions available under tax efficient investment schemes, the loss of capital is an eventuality every investor should consider prior to investing.

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Higher Minimum Investments
Some alternative investment platforms aimed at more experienced investors possess higher minimum capital requirements and additional qualifying criteria then traditional routes. Though this has led to alternatives being perceived as less accessible than traditional markets by some, in recent years alternative platforms on the whole have been made more accessible to private investors than ever before.

Alternative investments can be accessed via a range of routes, varying by asset class, investor experience and portfolio goals. Some of the most common methods are explored below. 

Direct Investment
One approach to investing in alternative assets is via direct investment. This involves investing into an opportunity directly from the source, without any intermediaries. This approach, for example, can often be selected when a company approaches an investor or informal angel network to pitch for investment. This route is most-used by experienced investors who possess a strong background in the given field.

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Co-investment Platforms
Unlike direct investments, co-investment platforms often source a number of opportunities for investors to select from at their will. Whilst platforms vary in their level of due diligence, more sophisticated platforms will employ a defined set of internal processes and benchmarks to qualify opportunities for growth potential and suitability. Co-investment platforms are usually fee-free.

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Funds
An investment fund pools investor capital to invest in a set portfolio of predetermined companies/opportunities, decided by a fund manager. This route can be attractive for investors seeking less research-intensive, minimal-involvement investments. Funds charge additional fees for this service.

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Online Marketplaces
An online marketplace, or online auction, is an e-commerce website built to connect sellers with buyers. Within the alternatives space, this is most relevant for collectables, such as art, wine, whisky and jewellery, or more recently virtual collectables such as NFTs (non-fungible assets).