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Understanding the benefits – and risks – of alternative investments

To grow, preserve and diversify wealth.
Image: Shutterstock

While a relatively small amount of the wealth of high-net-worth Africans is invested in alternative investment vehicles such as private equity, there is a high degree of interest in private equity and venture capital investments. More investors are seeking exposure to alternative investment vehicles to grow, preserve and diversify their wealth.

Alternative investments are defined as investments that do not fall into one of the traditional asset classes such as shares, bonds and cash. Prominent sub-alternative asset classes include venture capital, private equity, hedge funds, structured products, private debt and direct property. There are also the more esoteric sub-alternative asset classes like art or exotic cars.

Previously, alternative investments were considered too onerous to access, high-risk or complex for many investors, but now they have become more mainstream and are accepted as an attractive means to diversify a portfolio and typically generate better inflation-beating returns than traditional public market investments.

How alternatives are considered to add value in a portfolio

A key and fundamental element of investment management is creating a well-balanced, diversified portfolio. Ultimately, diversification works to safeguard investors’ portfolios against volatility in certain sectors to allow for a more consistent overall portfolio performance. Different industries and sectors do not perform at the same time or at the same rate. When applying a diversification strategy to diversify your portfolio, you are less likely to experience major drops, because as some sectors encounter tough times, others may be thriving.

Alternative investments cover a broad range of sectors and sit on the upper end of the risk spectrum but often achieve higher returns than more conventional asset classes. The expected return of an entire portfolio – constructed of traditional asset classes – increases when adding the higher-yielding return of alternatives, which is uncorrelated to the rest of the portfolio.

Types of alternative investments

  • Hedge funds

Hedge funds have evolved from an institutional type of investment instrument to become more mainstream. As of around three years ago, there became a construct of a Retail Investor Hedge Fund (RIHF) investment vehicle that is governed by the Financial Sector Conduct Authority, and most of these are tradeable daily and offered by reputable financial services providers.

While hedge funds may have been portrayed as high risk, high return, get-rich-quick schemes in the past, the genesis of hedge fund investments was not to create high alpha instruments, but to act as a portfolio stabiliser and diversifier in that they provide a hedge against other asset classes.

As the environment was not regulated initially, the positions hedge fund managers would take were aggressive and somewhat irresponsible. However, regulators stepped in to understand these alternative investment vehicles, limit positions of this nature and create a more controlled and predictable return environment.

  • Section 12J

Section12J is a tax incentive that was introduced by government in 2008 to drive the South African SMME economy by linking seekers of capital (entrepreneurs) with providers of capital (investors). The aim is to stimulate entrepreneurship by incentivising holders of private capital by way of tax dispensation to invest in opportunities outside of formal financial markets.

The logic is that the investor has direct input in the business by way of assisting with mentorship, craft, and access to different markets.

The underlying asset class of Section 12J is private equity or venture capital and legislation governing the act has been tightened over time and regulatory requirements have become more stringent to ensure investors are remaining within the spirit of what S12J is trying to achieve.

While started in 2008, S12J only took real form and shape over the last five years and is a near R10 billion industry as it stands. It offers an opportunity for clients in that it gives access to a part of the economy that is difficult to access but can be lucrative in terms of returns generated.

  • Private equity and venture capital

Private equity provides an opportunity to make investments into real, physical businesses with a long, proven track record while venture capitalists invest in smaller and medium-sized companies that are in early development phase.

In the past, this asset class – especially in South Africa – has typically been limited to institutional investors such as pension funds. Now, individual investors can use private equity or venture capital to invest in the real economy.

As with any investment, there are associated risks. The asset class does not sit on a formal, listed exchange, so the granularity of information regarding the investment is subjective, and less regular. There may be a lack of visibility of price points for a business, and few indicators of true value. Pricing is driven by an audit process and the ultimate sign of value is determined when an investor buys or sells. This differs to the domain of traditional public market asset classes, where thousands of opinions eventually arrive at a single pricing point.

However, the beauty of private equity is that the fund manager would typically own a significant stake in the underlying business, which creates alignment between the investor and fund manager. While the ability to unearth growth and real value is much harder to come by in this space, private equity managers can find investment opportunities that are more controllable from a day-to-day management perspective.

Accessing the right alternative investment

An investor who is looking to add alternatives to their portfolio can consult a professional investment advisory firm that specialises in alternative investments, or an advisor who understands the lay of the land. This advisor would be able to assess the investable universe of alternatives and present a handful of opportunities that fit according to an investor’s risk profile individual needs, and goals.

An investment advisor will help to mitigate associated risks by selecting private equity investments or funds that are managed by a team with a long tenure of working together. A reputable PE, VC or S12J manager is one that can prove that they have successfully invested, managed and sold various companies over a long period of time.

A typical time horizon for an investor in an alternative investment is around five to seven years but can be extended to 10 years if necessary. Typically, fund managers target a return above 20%, over a five to seven-year period, measured as an Internal Rate of Return. From a money on money perspective, managers target to return three times the invested capital before fees over the same period. A PE manager would typically charge 1.5-2% per annum and share 20% of the upside after meeting the minimum targeted return.

Alternative investments offer advantages such as the potential to earn larger returns than traditional counterparts, but these returns are not guaranteed. Hence the allocation should be limited to 10-12% of an investor portfolio – a mechanism of mitigating risk. If the investment works out the way it is intended to, it could be a big potential kicker to an investor’s portfolio.

Kuhle Kunene head of Multi-asset fund solutions at Standard Bank Wealth. 

COMMENTS   1

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Basically it boils down to the reality that the fees forfeited on most alternate investments mean you incur a CERTAIN cost of probably around 4% in exchange for a potential gain of what?

what is a “hedge fund”? There is no free lunch! A hedge by its definition should return a lower risk adjusted return than a pure punt. So classic example is you have long bet on Mexican corn farmers (want rain) but hedge it with a long bet on Mexican holiday resorts (don’t want rain). You WILL warn less but you will lose less also. But yet, hedge funds extract the highest fees.

It is all screwed, but hey : the hedge funds take 4% on each side of the bets…

End of comments.

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