The case for alternatives has never been stronger. So, what are they?

Everywhere you look, market concentration and crowded trades abound. In Australia, around half of the ASX 200 is made up of the 10 biggest companies, with Commonwealth Bank the recent poster child of concentration.

In the US, the top 10 companies account for around 35% of the S&P 500, with the Magnificent Seven as the main offenders.

In both markets, such levels of concentration have rarely been seen in modern market history. Elsewhere, gold has become a crowded trade, as have short positions in the US dollar.

So, the case for alternatives, with their promise of diversified returns and, in some cases, a lower risk profile, has arguably never been stronger.

But alternatives are a broad church, with a wide spectrum of risk/return profiles. They have also traditionally been the domain of institutional investors, the super wealthy, or family offices.

Many years ago, my wife and I were waiting patiently to board a flight. An announcement rang out. “Ladies and gentlemen, we are ready to board. We are currently welcoming all first-class passengers”.

I’ve always felt like this was an apt metaphor for the world of investing – particularly alternatives. But things have changed over the past five years, with more and more alternative strategies available to retail investors.

Access, of course, is one thing. Understanding is another. So, with Livewire’s Alternatives in Focus Series upon us, we’ve taken the liberty of doing some of the groundwork for you. Below, we’ll unpack what falls into the “Alts” bucket, and some of the risk and return characteristics of the various asset classes.

This list is by no means exhaustive, but hopefully it helps in understanding whether alternatives are a good fit for you and how you might go about adding them to your portfolio.

Over the coming weeks, we’ll be featuring insights from a handful of alternative managers, as well as editorial content to help colour the risks and opportunities.

What are alternative investments?

The definition of what constitutes an alternative investment is incredibly broad. Many people will simply define alternative investments as any investment that isn’t in traditional assets such as equities, fixed-income, or cash.

However, even that description can lead to a very nuanced discussion. For example, if you short a stock, is that a traditional investment (as it is related to equities) or not (as it’s not the conventional way of investing in stocks)? The answer may differ depending on who you have the conversation with.

One widely accepted way of defining alternative investments is to focus on the distinctive characteristics that set them apart from traditional asset classes:

• Diversifying return streams – Alternatives often have a low correlation with shares and bonds, helping investors build more resilient portfolios.
• Access to specialised and less efficient markets – These strategies can uncover opportunities in areas where fewer investors operate and where mispricing may exist.
• Innovative structures and flexible risk-return profiles – Alternatives use a broader toolkit to pursue returns, manage risk, and capture value in different market conditions.
• Expertise-driven and long-term in nature – Many strategies rely on specialist skill and a patient approach, aiming to deliver consistent performance over time.

The broad church of alternatives

From tangible real assets to complex financial instruments, the spectrum of alternatives is wide and varied. Here’s a breakdown of the main categories and what makes each unique.

Real Assets

Do you own an investment property? Yes? Well, congratulations, you are already an investor in an alternative asset.

Real estate is an example of a real asset – direct ownership in a non-financial asset that can generate income or appreciate. Other examples include land, infrastructure, commodities, natural resources and collectibles. This category can also include the ownership of intangible assets such as intellectual property and other royalty streams.

Private equity and credit

One of the fastest-growing alternative asset classes covers private markets – both equity and credit.

Private equity investors will purchase direct equity stakes in unlisted businesses (i.e., not traded on public markets) or acquire 100% of a company and take it off public markets. In the latter case, the private equity investor often takes control of the business, driving operational improvements before selling to another buyer at a profit.

Private credit investors, on the other hand, will provide debt financing to companies whose risk profiles may make funding from traditional financiers difficult to obtain. This can often be found in situations such as non-bank lending or mezzanine financing, where the debt sits in between senior, secured debt and equity. Lending to distressed companies is also another example where private credit investors may seek opportunities.

Given the highly illiquid and sometimes risky nature of private equity investments, investors often have their capital tied up for a predetermined period – known as a lock-up period.

Venture capital

An offshoot of private equity investing is venture capital or angel investing.

Whereas private equity companies tend to purchase established, cash-flow generating businesses, venture capital investors focus on young, start-up companies that have little to no track record, have yet to generate positive cash flow, and whose products might not be fully developed at this stage.

Venture capital investors provide the capital young businesses need to scale and grow into viable businesses, after which the venture capital investor aims to exit its position.

Given that venture capital-backed companies are extremely young, it is incredibly risky, with around 75% of companies not returning any cash to investors. However, the model is structured so that a small handful of successful investments can generate returns strong enough to cover that loss and provide a profit to investors.

Hedge funds / alternative strategies

You may be familiar with your typical equity fund that pools investor capital to invest in a portfolio of stocks.

A hedge fund is kind of like this, but its investment mandate allows it to access a far wider, more complex set of opportunities that are typically uncorrelated with traditional markets. This is often due to hedge funds having less regulation than traditional funds, given their sophisticated investor base.

Hedge funds also aim for absolute returns rather than relative outperformance against a benchmark, such as a traditional managed fund.

Other alternative strategies include shorting, derivatives, arbitrage, event-driven, and market-neutral strategies.

Cryptocurrency and digital assets

The newest, and arguably fastest-growing asset class that could be considered an alternative investment are cryptocurrencies and other digital assets.

Crypto assets are tradeable digital assets protected by cryptography and distributed ledgers. Common examples of crypto assets are Bitcoin, Ethereum and non-fungible tokens (NFTs). It’s an asset class still in its early life cycle - though adoption is growing by the day - and critics argue it's yet to find widespread use beyond speculation.

Crypto assets tend to be incredibly volatile and remain lightly regulated. This, along with low barriers to creating and advertising their own crypto assets, has led to significant losses from scams.

Increasingly, crypto assets have also shown a high correlation with equity markets, which is why there is still debate over whether crypto could be considered an alternative asset and in which category it would fit.

Collectibles/niche/specialised assets

Finally, alternative investments also include collectibles and other specialised assets.

Fine art, wine, vintage cars, classic watches - the list of items that fit into this category is endless. For example, did you know that the value of Hermes’ famous Birkin bags has increased by as much as 14% per year between 1980 and 2015, according to some studies?

Collectibles and similar assets lack the cash flow generation that typically drives an asset's intrinsic value. Instead, such assets derive their value from scarcity, cultural appeal, and other intangible factors that are often unquantifiable.

Risk vs return

As noted above, Alts are a broad church, which means the range of risk/return profiles across the various asset classes is equally broad. Whilst some alternatives carry a lower risk/return profile than, say, equities, alts tend to be less liquid and sometimes opaque, and therefore riskier than traditional investments.

The trade-off for those ‘riskier’ assets, however, can be increased diversification and potentially stronger long-term performance.

The key, as with any investment but perhaps even more so with alternatives, is for investors to understand what they are investing in and the risk/return profile of the specific opportunities.

Beyond stocks and bonds

On top of potentially strong returns on investment, the biggest benefit of alternative investments is their ability to increase portfolio diversification, something that might be of interest to many, given the world we highlighted at the top.

Although they offer the potential for strong, uncorrelated returns, investors who have invested only in traditional markets also need to understand that alternatives often have less liquidity and can be opaque in their structure.

One thing is certain: the world of alternative investing is no longer an exclusive opportunity for insiders. Alternatives are increasingly available to retail investors, so it makes sense to understand whether they are a good fit for your investment objectives.

With that in mind, stay tuned over the coming weeks as we dive into the world of alternative investments.