Allocation to Alternative Assets in Traditional Assets Dominated Portfolio

These days, there is a growing interest in alternative investment space among many in India. Till just a few years back, these investments which are seen as exotic and risky were aimed more at institutional or ultra-HNI investors. But via various routes like alternative funds and aided by technology, these are now gradually becoming accessible to small investors as well.

What are Alternative Investments?

In the words of Investopedia (link), an alternative investment is a financial asset that does not fit the conventional categories of equity, debt, cash, gold, etc.

While there is no universally accepted definition for Alternative Investments, a prominent few examples are private equity, hedge funds, private debt, venture capital, certain categories of real estate (via fractional real estate investing), peer-to-peer or P2P lending, revenue-based financing, structured products and even rare collectibles/arts and wine!

Alternative investments can be structurally complex and are often not regulated heavily. And due to this, there is generally a lack of publicly available information which is another reason why smaller investors aren’t best suited for them in addition to the higher ticket size of the investments.

As you might have guessed by now, these are mostly illiquid instruments and are not traded publicly. So due to this, it’s difficult to properly assess their valuation on the go for most.

Also, many of these may require a longer investment period before any realizable value can be assigned to them compared to their counterparts in the traditional assets space.

Why invest in Alternatives at all?

That’s a good question to be fair.

What is it that traditional assets like equity, debt, gold, etc. do not offer?

While alternative assets attract investors as a way to diversify their investment portfolios away from traditional investments. One reason for this is that these have a lower correlation to traditional assets. Also, it won’t be wrong to say that it’s not just about diversification but the potential to generate attractive and comparatively higher returns during the time when traditional assets are facing headwinds.

I personally know a couple of large investors who invest heavily in art as a hedge against inflation! I know this sounds odd to small investors like us but that is how things are up the wealth ladder.

But while alternatives have the potential to enhance the return experience based on investors’ allocation, there is one risk. And that is that depending on the chosen alternative, one’s capital might get tied up for longer periods of time and some alternatives are subject to a much higher level of risks than others.

So, understanding this is extremely important before dipping your toes in alternatives.

But depending on the chosen alternative, it can act as either a return diversifier (to manage risks) or a return enhancer (to improve overall returns) in the portfolio.

Are Alternative Assets for Everyone?

While there is a definite spike in interest for alternative assets, the fact is that these are not meant for everyone. Don’t get it wrong. Alternatives have the potential, but it’s just that the structural nature of the investment products in this space is not suited for everyone’s risk profile.

Since HNIs want operational ease too when exploring alternative assets, alternative investments such as this have generally found favour with HNI investors till now. But things are changing and the interest from non-HNI space is increasing too. That said, most of the alternative options are best suited for evolved investors who have surplus funds left over after they have invested sufficiently in traditional assets (equity, debt, etc.) to meet their financial goal planning.

So, if you are considering these first, then set aside funds for emergencies, and start investing for goals like children’s education, retirement, house purchase, etc., using debt and equity. And once all these goals are being properly planned for and investments have begun, only then best to consider alternatives.

Assuming you have done all that, then comes the next question.

How Much Allocation to Alternatives?

Most of you already know the rationale behind the traditional 60-40 Equity-Debt portfolio. This allocation has stood the test of time for a long time and rightly so. But there is now an interest in mature HNI space that even this 60-40 can have an allocation to alternatives. This Fool article (link) shows how alternatives are slowly but surely finding a lot of interest from the upper side of the wealth pyramid.

But from where will this be carved out? Depending on the type of alternative products chosen, most probably from the debt part of 40%.

And how much?

A 10% or more move to alternatives is comfortably manageable for most HNIs. Or it can start small and can then be gradually scaled up in a few years’ time given the large portfolios of HNIs.

Some sophisticated investors are also pushing for a new allocation formula for the future, where Equity:Debt:Alternatives gets a 33-33-33 allocation. Proponents of this allocation feel that in today’s shifting economic landscape, the 60-40 portfolio might not make sense at all.

But to each their own. What works for someone may not for someone else.

Nowadays, even digital assets and cryptocurrencies are being looked at as possible alternatives. But it is still early days though 1% allocation to digital assets is being touted by many as a no-brainer given the asymmetric return potential that many of these have delivered in the recent past.

Summing It Up

The allocation to alternative investments is believed to increase the portfolio’s risk-adjusted return. But while there is a perception of alternatives being exotic and exclusive, that should never be the reason to get into them.

Once your allocations to core equity-debt assets are sufficiently established, you should first consider whether you have the necessary understanding or skills, and of course surplus financial resources to build up your allocation to alternative investments

And if you have surplus funds after taking care of all your financial goals, you can consider looking at alternative assets. But best to stick with those which are more regulated than others. Also, if you have doubts, do get in touch with an investment advisor to understand what’s best for you.

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