The 6 Biggest Pitfalls in Alternative Investing and Smart Ways to Dodge Them

Did you know that assets under management in the alternatives space is tipped to hit US$30 trillion by 2030? This asset class has seen extraordinary growth in popularity in recent years, moving swiftly from the sole domain of institutions and wholesale investors to becoming broadly accessible to retail investors. Even if you aren’t exposed in your personal portfolio, there’s a high chance there are alternatives in your superannuation.

Alternatives have become popular for a range of reasons, such as access to potentially higher returns (and risk) in private markets, or diversification from assets like equities and public fixed income markets. But they also come with a range of risks and there are concerns that investors may not fully grasp what they are entering into. After all, alternatives are a very broad grouping for assets that don’t necessarily share many characteristics beyond not being shares or bonds.

Before you enter this space, you should take the time to understand what alternatives are and how to avoid the biggest pitfalls of investing in this asset class.

What are Alternative Investments?

Unlike asset classes like equities or fixed income where it’s pretty clear what you are investing in, alternatives is a ‘motley crew’ of options.

Alternatives cover investments outside of traditional assets like equities, cash or bonds.

There are typically eight types of alternatives. You can revisit this article for a more detailed explainer of them, but in short:

1. Private equity
2. Private debt/Private credit
3. Hedge funds
4. Real estate
5. Commodities
6. Collectibles
7. Structured products
8. Cryptocurrencies

Their correlation to each other and traditional asset classes varies – some strategies within hedge funds, for example, do have a level of positive correlation with each other and with global equity markets.

They also range in complexity – consider investing in gold bullion (commodities) as being much simpler than a hedge fund which might use a range of strategies like derivatives.

The 6 biggest pitfalls and how to manage them

1. Assuming complexity means higher returns

It’s easy to slip into the view that the more complex a strategy is, the better the returns will be. That’s not necessarily the case – the market can change everything and different periods will suit different strategies better.

For example, passive index strategies might be regarded as simple, but the SPIVA scorecard published by the S&P Dow Jones Indices shows that 75% of active funds underperformed their index benchmark over the 10 years to 2023.
There’s also been studies suggesting that on average, hedge fund ETFs underperform benchmarks – remember this is an average, so there are outperformers out there too; it’s a reminder of doing your research. It’s also worth noting that hedge funds typically perform better in periods of market volatility (because certain strategies like convertible arbitrage or event-driven strategies are designed for these scenarios) so using them in that way is a strategic choice.

An added concern is that some of the biggest investment fails (in any asset class) often occur when an investor failed to understand what they were actually investing in – it was too complicated for them, so they didn’t appreciate what risks they were actually taking on.

What this means for your portfolio?

You don’t have to pick something complex to generate returns in your portfolio – simple can work too.

What is important is understanding how the particular strategy you have chosen will work in your portfolio as a whole. The more complex strategy might be right for you depending on your particular targets, or you might be fine using something simpler. Don’t focus on complexity, focus on portfolio fit.

Finally, if you (or a financial expert you have approached to help you) don’t understand how it works (you don’t have to be an expert on derivatives trading, just a basic understanding of what a fund invests in and how it works), then how can you truly determine if it’s suitable for you and appreciate the risks you may be taking on? Know what you are investing in and the risks involved.

2. Liquidity

Different types of alternative investments have different levels of liquidity. For example, collectibles and real estate are generally termed as illiquid because the market for these can vary. They are not always easy to shift if you urgently need money.

Even within a type of alternative, you can find different levels of liquidity – this can relate to the structure of the vehicle (such as a publicly listed fund compared to an unlisted managed fund), how the fund manager invests and whether they include a liquidity buffer or individual variation in the underlying assets.

Consider private credit.

A listed form of a private credit investment, like Metrics Income Opportunities Trust (ASX: MOT) or the MA Credit Income Trust (ASX: MA1), are considered more liquid because of the ability to trade on public markets despite the underlying assets (give or take whether the trust is trading at a premium or discount pending demand). By contrast, unlisted managed funds like Remara Credit Opportunities Fund or Rixon Income Fund, may have restrictions on how quickly you can withdraw or redeem funds with certain notice periods required.

When liquidity becomes a problem is where investors have failed to take this into account and suddenly find themselves needing to free up cash for an emergency but unable to access their funds.

What this means for your portfolio?

Having illiquid investments is not right for every investor. Take the time to understand if they are suitable for you and what this means for your broader portfolio. Ideally, if you use illiquid investments, you may want to consider how you offset this in other parts of your portfolio with more liquid investments, like equities, or a cash emergency buffer to avoid selling investments in an emergency.

If you are investing for a specific goal, make sure to take the time to understand liquidity constraints for when you have reached the goal. If you are trying to save for a home in five years but the alternative investment you select has a 10-year lock-out period before you can access your principal invested, it is probably not the right choice for your portfolio.

3. Chasing performance and timing

A common mistake that transcends asset class is chasing past performance. Just because last year’s returns were exceptional, doesn’t mean this year’s returns will be. This can be particularly true of alternative investments, particularly those which are designed to outperform in specific conditions.

An example of this is in hedge funds which are often designed for particular market activity which may see stellar returns in volatility and underwhelming performance in more muted market conditions.

Or alternatively, there may be an unusual reason for particular returns in a year – one stock may have gone gangbusters but the rest of the strategy had more average returns so that year may not be replicated.

Some investments are also designed not to ‘shoot the lights out’ but rather offer defensive positioning – in this instance, you aren’t looking for a double-digit premium over equity indices but rather a better risk ratio and volatility performance over cycles as measured by Sharpe and Sortino Ratios – some fund managers will share these in their updates. You can also often find these on broker and analyst websites. It might actually be a source of concern if a defensively designed investment suddenly offered huge returns.

Similarly, be wary of trying to time the market for a better return – while it may work in your favour, it can also backfire and many investors have learnt this the hard way.

What this means for your portfolio?

The old wisdom about past performance holds true – to an extent. When you look at performance, you want to see consistency of returns and risk levels over multiple market cycles. Where there is an unexpected spike or fall that can’t simply be explained by general market volatility, there should be clear explanation within fund manager reporting about why and whether the fund manager has made changes.

If you can’t access multi-cycle performance for a particular investment, another option is looking at the long-term track record of the particular fund manager you are looking at and how they have managed similar portfolios across cycles.

4. Forgetting fee structure

Some types of alternatives – particularly hedge funds and private markets funds – will have more complicated fee stacks to account for the higher level of management required in these funds.

It’s not always as simple as a straight management fee and can really eat into your returns. It’s also something to be aware of if you have a set ‘fee budget’ in mind for how much you want to pay for your investments.

Some things to watch for include: establishment fees, contribution fees, step-down fees, performance or carried interest fees, fund expenses and withdrawal fees. You can read more about these here.

What this means for your portfolio?

When you are looking at performance over time, you’ll need to factor in how fees affect the final result. Some fund managers will present their returns post fees, while others don’t so take the time to check the presentation in reporting and consider some simple calculations to give you an idea of whether the fees are worth the returns.

You’ll find details on the fee stack within the investment memorandum or product disclosure for the investment you are interested in using.

Bear in mind that even simpler investments, for example commodities like silver or other precious metals, might have additional storage costs to factor.

5. Overestimating diversification

One of the key reasons investors look at alternative investments is for diversification – but some alternatives do have positive correlations to other assets.

It’s not as simple as investing in a hedge fund and assuming that gives you adequate diversification in your portfolio. The strategies within that hedge fund might actually use traditional asset classes like equities and fixed income and therefore the performance might have some alignment with the rest of your portfolio.

You might also find that different assets react similarly to market movements – consider real estate and private credit which can both be affected by interest rate movements.

You may also want to consider the level of diversification within your selected investment too. For example, in private credit, depending on your overall portfolio, it may be valuable for your selected fund to be diversified across credit types and maturities.

What this means for your portfolio?

Look back to your portfolio in total to see how a particular alternative investment you are considering will work alongside your other investments and how it might perform in different scenarios.

Having alignment with other asset classes is not always a bad thing, but you’ll need to consider how you diversify in other ways to manage that.

Having expert advice to explore your portfolio as a whole can be valuable.

6. Ignoring your portfolio strategy

Another mistake common to any asset class is selecting an investment without thinking about your portfolio or your strategy.

It doesn’t matter how amazing a particular fund is, or the returns it offers, if it simply doesn’t match your portfolio strategy then it isn’t going to offer you the performance you actually need.

Putting a high-risk, illiquid investment in a highly defensive portfolio with a consistent income need is simply going to risk your ability to meet your goals – and potentially mean you lose money.

Likewise, if you have a high-growth strategy, picking an investment that offers consistent income but no growth isn’t going to get you where you need to be either.

What this means for your portfolio?

Rather than starting with the investment, start with your portfolio – and this can fall nicely into regular reviews with a financial expert.

Assess your investment goals, needs and circumstances and how your current portfolio fits with this. Then consider what gaps there are. The gaps will tell you where to start your investment search and help you rule out those investments that don’t meet your portfolio needs and goals.

This is not necessarily about avoiding all risk – or taking a heap of risk, but rather considering what your portfolio needs to meet your goals and how that particular investment fits with and works with the rest of your portfolio.

Applying traditional wisdom to alternative investments

Just because an asset sits outside the traditional investment realm of equities, bonds and cash, doesn’t mean the tried-and-true rules of investing don’t apply.

Avoiding the biggest pitfalls in alternatives comes back to the basics.

• Know your portfolio strategy and the gaps
• Consider how liquid an investment is and what that means if you need to access your funds
• Research the investment you are interested in and understand what you are actually buying
• Look at performance across cycles, not just the most recent returns
• Check the fees
• Diversification is always important

You don’t have to shy away from alternative investments, but take the time to understand what you are investing in and whether it’s right for you. This is not a set-and-forget approach; be active in your research, portfolio management and consider expert advice.

Funds Mentioned

Disclaimer: This article is prepared by Sara Allen. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.