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A beginner's guide to alternative investments

07 January 2016

While the traditional cornerstones of any diversified portfolio typically include equities, bonds and cash, these days many investors are increasingly looking to ‘alternative’ investments to bolster their asset allocation.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • What alternative investments are.
  • Why these investments can help you diversify.
  • How some of the main types of alternative investment work.

Alternatives can include specialist funds, which focus on more unusual investments such as infrastructure, commercial property, commodities and even solar power. The alternatives space is also home to funds that look to deliver positive returns even if markets are falling.

Why alternatives?

The main reason for using alternative investments is to help spread out your risk by giving your portfolio an extra layer of diversification, as generally speaking, they tend to have a low correlation to other asset classes such as shares, cash and bonds, although this isn’t always the case. It’s worth bearing in mind too that alternatives tend to be considered far higher-risk than more conventional asset classes and should only form a small part of a diversified portfolio. We take a look at some of the main alternative type funds on offer and explain how they work.

Targeted absolute return funds

Targeted absolute return funds have enjoyed something of a surge in popularity over recent years, which should come as no surprise, since their main aim is to deliver positive performance regardless of market conditions. But this isn’t guaranteed and you may get back less than you put in.

In a bid to deliver consistent positive returns, these funds can employ a number of different investing techniques, and at times complex financial instruments, to help them to profit from the markets’ ups and downs. They can invest in equities, bonds and even currencies as well as a mixture of all of these and more. One of the more common tactics they use to enable them to potentially make money even if markets are sliding is known as ‘short selling’ where the aim is to profit from falling share prices. But while demand for these funds tends to increase during periods of volatility, it’s vital to remember that there’s no guarantee that they can protect your capital – you may well lose money.

Alternative’ investment trusts

Many closed-ended funds or investment trusts already have a strong foothold in the mainstream space, with many global vehicles popular with retail investors. But it’s worth noting that the sector also houses many more esoteric funds that invest in a wide variety of alternative assets including, for example, forestry and timber, biotechnology, infrastructure and solar energy.

As with all alternatives, these funds aren’t for the risk-averse and it’s also important to understand exactly how investment trusts work before you invest. The major difference between investment trusts and others funds such as unit trusts and OEICs is that they’re stock market listed and therefore closed-ended, in other words they issue a fixed number of shares. If you want to invest in an open-ended fund, its manager simply creates new units, while shares in investment trusts are generally fixed in number and can be bought and sold like other shares.

Market demand dictates a trust's share price, which, unlike open ended funds, can move either above or below the value of the assets that it holds – called the Net Asset Value (NAV) – and alternative funds in the space can potentially endure heavy periods of volatility.

Find out more about investment trusts

Property

Commercial property funds, which invest directly in bricks and mortar, tend to be one of the more popular alternative investments. These funds buy commercial real estate such as industrial and retail parks as well as office blocks. The aim here is that the rent from these properties should provide a steady income for investors, who can also potentially benefit from any capital appreciation.

Money invested in this type of fund is spread across a range of different properties, which helps with diversification and ensures that if one or more properties are unoccupied for a period of time, the others can still generate income. Investors must remember, however, that property is an illiquid asset, meaning it can’t be sold quickly and values can also be highly volatile.

Following the referendum vote to decide whether Britain should exit the European Union, many investors started withdrawing their money from property funds over fears that a departure from the EU could have a negative impact on commercial property prices.

Subsequently, a number of open-ended funds were temporarily suspended to stop investors from selling and buying units. This is to ensure a fund manager has adequate time to sell buildings to repay investors, because if they’re forced to sell assets too quickly, they risk getting a lower price. Property funds can also be closed-ended, such as property trusts or real estate investment trusts (REITs). As a result, they don’t face the same liquidity issues, as they’re traded as shares but equally, their values can be very volatile.

Commodities

Commodities are essentially tangible goods and can be divided into four main groups – energy, precious metals, industrial metals and agricultural. Like other alternatives, the main attraction is they generally have little correlation with other asset classes, although commodity prices can be highly volatile. When a particular resource is in short supply, its price typically rises and falls back if it’s in abundance.

But political factors and the overall state of the global economy can have a very significant impact on prices too. For example, after Britain voted in favour of Brexit, investors piled into gold, as the yellow metal is often viewed as a safe haven during periods of market uncertainty. However generally speaking, commodities have traditionally given some inflation protection to investors, as they tend to rise in line with the overall costs of living. For example, if petrol and diesel prices are rising on the UK’s forecourts, it’s typically a reflection of higher oil costs.

In the main, investors gain access to the asset class through a specialist fund or exchange traded fund (ETF). ETFs are a type of passive investment that mimics the performance of a particular market. They’re traded on the stock exchange and can be traded in ‘real time’ like shares. Some ETFs have a specific commodity focus and are known as exchange traded commodities (ETCs). Generally, these track the price of a particular resource so, for example, you can invest in a physical gold ETC, which will provide you with exposure to the metal. But there are a wide number of actively managed funds that focus on the sector too. Some will invest in physical commodities as well as mining firms and companies involved in the commodities industry. Both commodity ETFs and funds come with a number of risks that need to be carefully considered by would-be investors. In addition, if income is your main goal, commodities may not be for you as on their own, they offer no yield. However some portfolios, which invest in commodities and commodity related firms, aim to pay investors an income stream.

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