When the topic of investing pops up, the stock market is usually the first thing to come to mind, followed by other traditional categories of securities, like various types of bonds. However, different categories of assets, known as alternative investments, are equally viable trading choices these days, characterized by their complexity, unique structures, limited regulation, and often illiquidity.
The appeal of these assets is that they supply more diversification, reducing overall trading risk and enhancing returns. They can act as inflation protection while delivering access to distinctive opportunities not readily available in traditional markets.
All this said it is vital to note that investors must also measure the performance of these assets as they would with traditional investments, maybe even more diligently so, primarily because of the specific risk-return characteristics and specific regulatory requirements. Below, we get more in-depth regarding explaining these assets, what are the most established ones, the challenges investors face with them, and their portfolio performance metrics.
Types of Alternative Investments
For most people, traditional investments are institutional products, stocks, bonds, mutual funds, exchange-traded funds, index funds, options, and cash. Everything else falls into the realm of alternative assets. And from this batch, the most famous options are:
Real Estate
Real estate is a compelling alternative investment for many, primarily due to the potential for long-term capital appreciation and consistent cash flow through rental income. Unlike bonds and stocks, properties are tangible assets that can get physically managed/inspected, often providing multiple tax advantages like deductions on mortgage interest and depreciation.
Private Equity
The primary benefits of investing in privately held companies are the potential for high returns and the chance to create value through strategic decision-making. Though, longer investment horizons, higher risks, and illiquidity are in play here. So, those are things to be wary of.
Hedge Funds
For the uninformed, a hedge fund is an investment vehicle that pools money from several investors to employ different investment strategies, often incorporating alternative techniques, to create positive returns regardless of market conditions. Investors implement tactics like short-selling, derivatives, and leverage in hedge fund investing to maximize gains and hedge in market downturns.
Commodities
These are raw materials and tangible goods essential for everyday living. Agricultural products and energy sources are two examples. Hence, they are crucial to countries’ economies and can act as a hedge against inflation. Furthermore, they have a low correlation with traditional assets and can get accessed via multiple investment vehicles such as ETFs, commodity futures, mutual funds, and more. The main risk with them is the offset of supply and demand in local and global markets.
Cryptocurrencies
Cryptos showed up on the scene in 2009 when a mysterious person, or group of people, going by the moniker Satoshi Nakamoto released the first form of virtual money on the Web named Bitcoin. Since then, digital coins slowly expanded in popularity to see a massive rise post-2018, particularly in 2021, when the value of one BTC unit surpassed $60,000. These blockchain-powered currencies ensure transparency and immutability running on a decentralized system. While they are viable alternative investments, they have a reputation for extreme volatility, as evident by the fact that Bitcoin dropped over $40,000 in value in a few months between the end of 2021 and the middle of 2022.
Measuring the Performance of Alternative Investments
Measuring the performance of investments, traditional and alternative, permits investors to assess the success of their implemented strategies and make educated decisions based on objective data while aiding them in spotting the weaknesses and strengths of their adopted approach. That allows for effective risk management and portfolio construction. Also, accurate performance measurement boosts investor confidence, promotes transparency, and facilitates top-notch regulatory compliance in a growingly complex and diverse economic landscape.
Traditional Measures of Performance
Measuring the performance of investments, traditional and alternative, permits investors to assess the success of their implemented strategies and make educated decisions based on objective data while aiding them in spotting the weaknesses and strengths of their adopted approach. That allows for effective risk management and portfolio construction. Also, accurate performance measurement boosts investor confidence, promotes transparency, and facilitates top-notch regulatory compliance in a growingly complex and diverse economic landscape.
According to many, the standard performance measures are ROI – return on investment, risk-adjusted returns, and volatility, and these have a pivotal role in guiding investment decision-making.
ROI – Return on Investment
It calculates the profitability of an investment/trade relative to its original cost and is a fundamental measure that represents the percentage loss or gain generated over a specific timeframe. It is a simple method to stack up the well-being of different assets and enable traders to see the effectiveness of their capital allocation choices.
Risk-Adjusted Returns
These metrics appraise the returns produced by an investment correlated to the degree of risk taken. They aim to provide an assessment, comprehensively so, of an asset’s performance by factoring in the volatility or uncertainty linked with attaining returns. The two most renowned tools for measuring this are: the Sharpe and the Sortino Ratios. The first compares the excess return to its total risk/volatility, measured by the standard deviation of returns, and the second focuses on the downside risk.
Volatility
Volatility, mentioned above, is a statistical way to quantify the variability or degree of price fluctuations over time. It delivers insights into the price swings investors may see regarding the price of their held assets or the ones they plan on acquiring. Volatility can act as a risk gauge of an investment when associated with objective and risk tolerance. Note that it usually gets measured utilizing standard deviation. And for most traders it is an invaluable tool in the investing process.
Non-Traditional Measures of Performance
Standard performance measures aside, non-traditional ones can supply equally valuable insights into risk management and investment success. These delve into specific areas of the investment process, looking into factors like drawdowns, market risk, downside risk, illiquidity, and distribution characteristics.
Illiquidity Premium
The term refers to the extra return investors may get for investing in illiquid assets that are not so easily sold and bought. It compensates investors for the reduced ability to access funds immediately.
Beta Coefficient
An investment’s sensitivity to market movements gets measured via a bet, which shows the degree to which an asset’s price fluctuates relative to the market. One above one suggests higher volatility, while a below one beta indicates lower volatility.
Downside Risk:
What is the downside risk? It is a measure that focuses on the potential volatility of an investment in times of unfavorable market conditions, measuring to which extent an investment’s returns may differentiate from its expected value.
Skewness and Kurtosis
Skewness points to the asymmetry present in return distribution. A positive one is a sign of likely high positive returns, and a negative one suggests a high likelihood of negative returns. Kurtosis measures the distribution’s fat-tailedness or peakedness.
Drawdowns
They quantify the maximum loss from a previous high, assisting traders in grasping the size and duration of potential losses.
Challenges in Measuring Alternative Investments
As with anything else in life, measuring the success rate of alternative investments carries multiple challenges. And of these, the most feared are a lack of transparency, valuation difficulties, liquidity concerns, and benchmarking limitations.
It is paramount that everyone curious about getting into alternative investments is aware that, unlike publicly-traded assets, these have limited disclosure requirements. That means obtaining timely and accurate information about how many are doing in the marketplace can be super strenuous. Also, their valuation cannot precisely be reached as they usually include unique assets that are either illiquid or feature limited market activity, which can lead to discrepancies in reported performance figures.
Concerning benchmarking limitations, Traditional instruments designed for public markets are inapplicable to alternative assets because they fail to capture their risk-return attributes properly. Thus, that means that specific ones appropriate to them must get developed.
Addressing these difficulties, without question, demands a sector-wide effort. Only through labor from multiple entities working together can the obstacles listed here get overcome, and industries can develop standardized valuation methods, improve transparency, and build-up relevant benchmarks.
Case Studies
A few examples of how alternative investments have paid out in a big way are the sale of da Vinci’s Salvator Mundi painting in 2017 for $450 million, a previously undervalued artwork discovered in the early 2000s at a small auction.
Then, there is the story of a real estate investor in the US who, during the 2008 financial crisis, chose to buy property in Manhattan at a discounted price and raked in sizable capital appreciation after the market rebounded.
As discussed, cryptos have a reputation as highly volatile assets. And one person enormously benefited from this, as he purchased ten thousand Bitcoin in 2010 for around $30, and their value jumped to a staggering $60 million eleven years later.
Wrap Up
Investors seeking diversification would be wise to explore alternative assets as a tool to enhance returns in evolving markets. They should approach them carefully and with an understanding of how they should measure their health during the period they hold them. That can get done using conventional methods like ROI, risk-adjusted returns, and volatility. But for an accurate analysis, these must be blended with non-traditional measures, such as illiquidity premiums, betas, downside risk, etc.
Furthermore, investors must also know how to navigate the challenges linked with these assets, meaning valuation complexities, benchmarking difficulties, illiquidity worries, and low levels of transparency. Maneuvering around these obstacles is the only way to attain prosperity in this arena. So, keep that in mind when creating a robust performance methodologies tool belt, as having a terrific one is indispensable for positive outcomes in this dynamic landscape.
