The streets of the central business district in Accra are littered with imposing buildings- a delectable blend of modern sustainable architecture and the ‘old money’ classical building style, monoliths of the colonial era of commerce. Within these walls had been shaped many defining deals and transactions. In some parts, the new had replaced the old, rising to meet the skies as if to exert their existence. In other parts, the old reminders persisted. A great blend. Thus, we are modern with a rich history. Both time periods have insights for us in investing– diversification, blend, variety. We see it fit to have a nice blend of different security classes which have their own parts to play in helping us meet our investment goals.
Fixed income securities, equities and cash are the most conventional types of investment vehicles. Many financial instruments are just plain bonds, fixed deposits, commercial papers, bank certificates of deposit, repos, ordinary shares, preference shares, exchange-traded fund shares, collective investment vehicle shares, cash, call accounts or some other more common instrument. We use them at various points for various transactions or to meet different investment objectives.
An alternative investment is a financial asset that does not fall into one of the usual investment categories– stocks, bonds/fixed income securities and cash. Alternative investments include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities and derivatives contracts. Real estate is also often classified as an alternative investment. They are termed ‘exotic’ because the are not the usual types of investments. However, they are very common and often used.
Courtesy: Business Insider Africa
Uses
The financial barriers to entry are often very high for these types of investments. The products are expensive and out of the reach of many retail investors so it is usually large institutional investors and high net worth individual investors who venture into most alternative investments. Nevertheless, these investments may be used as a way of reducing overall investment risk through diversification. Investing in alternatives can help smooth out portfolio volatility. Reason is, they usually have a low correlation with the more traditional types of investments. They offer exposure in arenas like real estate, the commodities market, even the art world — all of which can serve as a hedge when assets like stocks and bonds and the rest of the financial markets are suffering. For instance, in a period where interest rates are falling and investments in bonds lose their attractiveness, the value of a commodity, such as a precious metal, may still be high. The stock market could crash while real estate would maintain its value. An investor with substantial holdings in collectibles (expensive works of art) and equities may lose only little of his/her worth when the stock market is generally bearish.
Risks
Compared to their conventional counterparts, alternative investments are fairly illiquid. They are less regulated and they may have a less-structured legal framework to operate within. Extensive information about the products they derive value from is often non-existent, and the assets and transactions involving them are often rare. Investors may, therefore, find difficulty in valuing the investments. All these can make them much riskier than conventional investment securities. It becomes essential, then, that investors conduct extensive due diligence when considering alternative investments. Often, only those deemed as institutional investors, wealthy families or high net worth individuals get involved with most forms of alternative investment offerings. In many markets, access to some alternative investments can be limited to what are referred to as “accredited investors.” These are investors who have an annual income of at least $200,000 (or $300,000 for married couples) or a net worth of at least $1 million, and who also possess a higher level of investment knowledge than average investors.
Various Types
Alternative investments are many and varied. They include but not limited to the following:
- Real Estate
Investing in real estate can take many forms. The simplest are rental properties and real estate investment trusts and property funds. Additionally, real estate partnerships exist where two or more investors combine their resources to work toward developing properties or projects. That way, they spread risk, distribute duties among themselves, improve the potential outcomes and share proceeds from the investment in an equitable manner. It includes crowdfunding, agreements between friends (in writing), limited liability partnerships and companies and joint venture agreements. These sorts of partnerships can be a good source of passive income for investors.
- Derivatives
A derivative is a contract between two (but could be more) parties whose value is derived from an underlying asset. These underlying assets could be financial assets like stocks and bonds, their indices (eg. the Ghana Stock Exchange’s Composite Index), interest rates or currency exchange rates. The idea behind the use of derivatives is to reduce risk and make future cash flows more predictable. Companies can, therefore, reinvest more into their businesses. Most derivatives are traded over-the-counter, with parties and counterparties fashioning out the form they desire to trade in. A small portion, however, is traded on specialized exchanges like the CME Group, the Korea Exchange and Eurex.
Derivatives come in four broad forms:
- Forwards- contracts that obligate the buyers to purchase an asset at a pre-agreed price on a specified future date. The terms and underlying asset are customized as are suitable for the contracting parties.
- Futures- contracts that are very much like forwards but are standardized and traded on exchanges.
- Swaps- Derivative contracts that offer the exchange of cash flows between contracting parties. It usually involves the exchange of a fixed cash flow for a floating cash flow. Swaps can be based on interest rates, commodities or currency exchange rates.
- Options- contracts that give the buyer the right, but not the obligation, to purchase or sell the underlying asset at an agreed price on a date in the future. The buyer can exercise this right on the date agreed (maturity date) or before the date, depending on whether the contract is a European option or an American option.
Another type of option contract is a swaption. It is an option contract which gives the buyer the option (but not the obligation) to enter into a special swap agreement with a counterparty on a specified future date.
- Private Equity and Venture Capital
Private equity is simply equity capital that is invested in a company that is not a public limited liability company. Usually, private equity investors pool resources to form a fund, a private equity fund, that invests in private companies. These companies may be distressed but have growth potential. Private equity is usually employed to take over ownership or controlling interests (more than 50% of share capital). The fund would usually have a plan to exist ownership of the company by selling the acquired shares. Proceeds of the sale are then distributed to the owners of the fund.
Venture capital is very much like private equity. However, target companies are usually startups with no track record or very young companies, have rapid growth potential and a need for mentoring. Venture capital invests in a minority stake (less than 50% ownership) with an exit plan to sell the shares they acquire and distribute proceeds to its owners.
- Hedge Funds
A hedge fund is a pooled investment fund that widely uses complex trading, portfolio construction and risk management techniques to improve its returns through short selling, leverage and derivatives trading. The funds aim at generating high returns and are constructed to take advantage of certain identifiable opportunities in the market. Withdrawals may also be restricted and permitted only at certain intervals (quarterly, semiannually, annually or even bi-annually or biennially).
Courtesy: Business Inside Africa
- Commodities
Commodities are basic goods that are used in commerce and that are interchangeable with other goods of the same kind and are usually tradable, almost like financial securities. Tradable commodities can be divided into four categories-
- Agricultural: grains (corn, wheat, rice, etc.), cotton, sugar, silk, cocoa, etc.
- Livestock and Meat: cattle, pork bellies, mutton, etc.
- Energy: crude oil, liquefied natural gas (LNG), gasoline, etc.
- Metals: gold, platinum, silver, palladium, copper, etc.
Commodity prices are driven by the basic principles of supply and demand. Investors therefore constantly review global economic developments and technological advances to gauge what supply disruptions are likely and how they would affect commodity prices.
It is critically important that commodity standards are agreed-upon to ensure fair trading of goods that meet acceptable standards of quality.
- Collectibles
These are items that are worth much more that their original price. They may be works of art (paintings, photography, sculptures, tapestry, etc.) and are usually rare items (such as historic coins and stamps). This form of investment is quite complex. Whereas the attraction of most investment vehicles is driven basically by their intrinsic value, the prices of collectibles are based more on what people are willing to pay for them. Though they may not be affected by market swings, thus be a good hedge, the less savvy investor may want to proceed hesitantly with investing in them.
Courtesy: Analytics Insight
- Cryptocurrencies
A cryptocurrency is virtual or digital currency that exists on a distributed and decentralized ledger. It takes the form of tokens or ‘coins’. Most cryptocurrencies remain intangible, though some have transcended the digital world into the physical world credit cards. Cost of transactions involving cryptocurrencies are significantly low, adding to their lure. There are well over 5,000 different cryptocurrencies but the most popular, by far, is the Bitcoin. As at mid-May 2021, the market capitalization of Bitcoin stood at $814 billion. Other popular cryptocurrencies include Ethereum, Litecoin, Cardano, Stellar, Chainlink, Binance Coin, Tether, Monero and Bit Cash.
There is a high potential for cryptocurrency. Increasingly, cryptocurrency is readily accepted as a store of value. It may not be fully ideal for transactions if there are better alternatives, however. Its value may lie with its usefulness as a means of exchange, like traditional currencies. Although its use is increasing (cryptocurrency has made crowdfunding and raising capital more transparent and opens the possibility for people to publicly ask and seek for funds or donations), it is still not a mainstream currency type and this may take a while.
Conclusion
Alternative investments hold potential for portfolio diversification. They may be beyond most retail investors but institutional investors and high-net-worth families and individuals should find them useful investment vehicles.
About the Writer
Kwadwo is a Senior Investment Analyst at OctaneDC Limited and heads OctaneDC Research. Prior to joining OctaneDC team, Kwadwo was a Fund Manager at Dalex Capital and has over a decade experience in fund management and administration, portfolio management, management consulting, operations management and process improvement. You may contact him at [email protected] or +233244563530.
