Using Alternative Assets to Build a Balanced Portfolio
However alternative assets tend to be what your banker wouldn’t recommend you to invest in because they’re not easily accessible, or it’s hard to get good guidance on what to do with them.
Because these investments aren’t as popular, they are often less liquid or are required to be held for longer before returning a profit. However, it could easily be debated if these assets are less liquid because they are alternative, or if they are labelled alternative because they are less liquid. In any event, the specific types of assets that are most often put in this category include private equity, venture capital, hedge funds, real estate, collectables and commodities. As well as the rising ecosystem of digital assets such as cryptocurrencies, Decentralized Finance tokens and NFTs which in some ways would also be considered ‘alternative’.
How Do These Investments Manage Risk in a Portfolio?
Diversification has always been at the heart of portfolio risk management. A well-diversified portfolio is one with a mix of assets and a mix of asset classes. The broader the diversity, the lower the risk involved. For example, investing in the public equity and bond market, as well as some real estate, has often been touted as being a solid strategy for diversification.
When you invest in the public market, you only have access to public companies. However, a lot of returns are to be found elsewhere, in the private market. In that market, you find upstarts big and small and it has been a hunting ground mostly reserved for the Venture Capitalists (VCs) and Private Equity (PE) firms. Unfortunately, the costs associated with running a VC or PE fund means that these firms only raise big tickets from wealthy investors. Hence, getting access to the private markets is difficult for many. The good old 60% equity, 40% bonds rule offers some diversification but can’t protect a portfolio against systemic market risk, as it is still 100% invested in the markets.
Digital Assets Can Bolster Diversification
For decades, hedge funds have looked for an asset class that can shield from such systemic risk problems, an asset uncorrelated by the volatility in the wider market. Many feel that cryptocurrency and the new use cases offered by blockchain technology are the answer to the above problems.
Some cryptocurrencies represent a new breed of young companies seeking to disrupt entire sectors of the economy such as you would typically find in the private markets. Others offer entirely novel use cases, and their valuation as such might offer better protection against traditional market risk. Most of these come with the added advantage of being highly liquid, as even some of the smaller digital assets still trade in the tens of thousands of dollars per day. On top of this, virtually all of them are available from very small amounts, such as less than €1, which enables even retail investors to build a diversified portfolio.
Parameters to Look at for Alternative Investments
There are of course still a variety of parameters you need to consider for each asset and asset class to know whether you should add them to a portfolio. We’ll go through each of these now:
How much of a return of investment are you likely to see, if any, with a given asset class over the period you are looking at investing for. For example, equity markets have returned 8% to 10% between 1926 and 2019. Meanwhile, the bonds market returned between 4 and 6% in the same timeframe.
What is the loss you are theoretically exposing yourself to with a given asset class over the period of time you are looking at investing for? It may look like equities are more interesting than bonds based on returns, but a portfolio with 100% equities could have lost as much as 43.13% in a given year between 1926 and 2019. There were, in fact, 26 out of those 94 years that represented a loss for equities. For a portfolio with 100% bonds, the worst year was only 8.13%, and only 14 out of 94 years had a loss. If you want to be sure to have your money in 4 years, equities might be a little too risky, meaning volatile, for your needs.
This is addressing how easily you can convert these investments into cash, meaning sell them. This is essential when looking at asset allocation. Say you need money in 5 years as you are planning on buying a house. In that event, it’s probably best not to invest that money with a Venture Capitalist who says any potential profits won’t come back to you before 10 years. In this scenario, while you might then be “paper rich” after 5 years, you still won’t be able to use any of that money for the house because you can’t sell your shares to anybody. Equities, on the other hand, can be traded fairly quickly and easily, on average.
Correlation to Other Assets and Asset Classes
For most of the past two decades, a negative correlation with equity has meant U.S. Treasury bonds have acted as a hedge when stock markets tumbled. So bond prices tended to rise when equities prices fell, and balanced portfolios suffered smaller losses than portfolios with 100% equity. The idea is that you want diversity across assets that aren’t all correlated. If you have a basket of investments that always rise and fall together, your returns will look more or less the same as they would if you had, say, gone all-in on any one of them.
Looking at the unit price of the assets you’re interested in is also key to properly diversifying. If you had €5’000 to invest, for example, you probably wouldn’t want to purchase a single share of Amazon priced at €3’000, as this would immediately be over 50% of your portfolio and make further diversification fairly difficult. However, cryptocurrency, as mentioned can be bought in very small units, easily under €50, or even €1.
If you can find an asset or asset class that you can afford, is liquid enough for your investment horizon, has a return and risk profile that works with your goals, and is as un-correlated as possible to the rest of your portfolio, then you have likely discovered a solid opportunity.
A look at historical returns, with data
To emphasize the point we are trying to make, here are 3 simulated portfolios from 26 September 2019 to 12 February 2021, based on actual past performance of the IWDA ETF as well as a portfolio managed by the OSOM Crypto Autopilot.
Each line simulates investing €1000 a month the first month then €500 a month the following months.
- In black, the line shows the portfolio growth if that money is “invested” in a savings account. With a final amount of €9000
- In red, the line shows the portfolio growth if that money is invested 100% in IWDA, an index ETF tracking the MSCI World. Final value is €10,543.14
- In blue, the line shows the portfolio growth if that money is invested 90% in IWDA, and 10% in the OSOM Crypto Autopilot basket. Final value is €13,592.69
As you can see, putting just 10% into a well-curated portfolio of crypto assets over that time period allows you to see 28.92% more returns as opposed to using just traditional assets. While it is true, this comes at a cost of increased exposure to risk, but the absolute worst that could happen to the crypto part of your portfolio is that it would go to 0. Even in this unlikely event, it would still only affect 10% of your overall holdings. Considering an expected return on equity investment of 8% – 10% p.a., you’d make up for that loss in about a year using your traditional asset portfolio.
The Benefits Are Clear
While there are many, many strategies out there for diversification, it cannot be overlooked how useful alternative assets can be in mitigating overall risk. Of all alternative assets out there, cryptocurrencies stand somewhat unique in their liquidity, accessibility and diversification inside of their own class. While going “all in” on crypto is a much more dangerous game, we have shown how allocating a modest 10%, or whatever makes sense for your investment goals, can have notable positive effects on your portfolio valuation over time.
About The Author
Anton Altement is CEO of Polybius and OSOM Finance. Prior to starting OSOM, Altement spent close to a decade with Credit Suisse as an investment banker in London and Zurich. He is focused on building a currency-agnostic ecosystem to facilitate the convergence of fiat and crypto.