We’ve all heard the financial success stories that make alternative investments sound like the golden goose of the financial world.
But are they as lucrative and safe as they’re often portrayed? This article aims to shed light on the reasons why alternative investments can be risky and why they usually fall short of what they promise.
We will explore the reasons why everyday investors, mums and dads, might want to think twice before diving into the risky waters of alternative investments.
What Are Alternative Investments?
Alternative investments differ from traditional investment routes such as stocks, bonds, and cash. These investments are often marketed as a means to diversify portfolios and increase returns.
You may come across multiple examples such as Wine, Whisky, Forestry and Plantations, Litigation funding, Student Property, Art, Crypto Currency & and many more.
All of these investments come with their own set of unique risks.
The Inherent Risks in Alternative Investments
Alternative investments are often illiquid and lack transparency. These characteristics can expose investors to an array of risks that are less prevalent in traditional investments.
Liquidity refers to how quickly an asset can be converted into cash without affecting its price. Alternative investments, due to their unique nature, often lack the liquidity of traditional investments, making them difficult to sell without a potential loss.
Often, these investments are built on sound, successful, proven business models, but the problems start when these companies want to expand too fast. The owner’s and director’s lack of knowledge of the financial markets and how they operate becomes all too apparent.
Generally speaking, these successful businesses want to grow fast and need capital, often hundreds of millions, to reach the next stage. Hundreds of millions sounds like a lot of money, but in the investment world, this is a tiny amount, too small! Retail funds will more than often have billions invested in them.
Case Study – Forestry and Plantations
Let’s look at forestry, agriculture and plantations. These are capital-intensive businesses. You need to purchase or rent vast areas of land. You also need to buy and grow the product, manage the space, employ a large workforce, buy and rent all of the machinery connected with this and then market and distribute the product around the world.
This sounds simple and makes sense if you use your own money.
When the business wants to grow bigger, they go to the bank and borrow $10 million over a fixed-year term.
At this point, everything is going well. The business is making money or seeing potential and is making its loan repayments, so it then looks at raising more cash. The bank won’t lend them anymore because they still have outstanding loans, and the business doesn’t want $10 million anymore. The business now needs $100 million more to propel it into a big business.
If the business finds a single, understanding investor who will take a share of the company, then in this scenario, the business model may work. If it can’t, then what sometimes happens is the owners will create an investment fund that acts as a cash-loaning investment instrument that is released on the market for retail investors to buy into.
The fund promises its investors it will pay back a return of 7-15% a year, which, in theory, it can for the first few years because 90% of investors do not redeem in the first few years.
For the 10% of investors that do redeem, the business may be able to produce an income to pay investors their return. If you do not cash out and stay invested, your growth is known as a “paper return“. These are just numbers going on a balance sheet to show you that your investment is growing based on what the owners value the business at.
If more investors want to cash out, the fund has to find the money from anywhere possible to keep public investor confidence in the fund. This money may now come from new money flowing into the fund. If this happens, the fund has become a “Ponzi scheme“. But, it still can survive and grow at this point.
The genuine issue arises in any of these situations: a financial slump, negative news leading to a drop in confidence, or when an investment firm holding investments worth millions decides to alter its investment approach and seeks to offload its substantial stake.
This is when we have a liquidity problem. This spells the start of the end.
Investment funds must have liquidity at all times. This is a core, simple rule that must be adhered to.
If you invest in an “HSBC Large Cap Fund“, then HSBC buys and sells shares in enormous companies on the stock exchange to service their investor demands.
If you own a forestry plantation, this function cannot exist as all of the money is invested in land and all of the business needs to be listed above. The fund cannot just sell off $20 million of farmland overnight to pay redemptions to investors, and the fund/company doesn’t have $20 million in cash, so it can no longer function as a fund.
This is the point where the fund becomes “Gated”. Gated means the fund has to stop all new money from coming in and old money going out. This is usually imposed by the regulator.
Blackrock has the largest AUM of any investment company in the world at the time of writing, and they struggle with this problem.
Forestry & Plantation companies have little understanding of financial instruments and do not plan for this eventuality. When the fund becomes gated, the investors lose confidence and try to redeem their money. The fund and the business crash down to 0.0 value as it can no longer service its debts, pay its staff, rent the land and machinery and service its investors.
This is the end of the business, the fund and your money.
Whisky & Wine
This sector is growing very fast, with the promise of enormous returns of 15-25% annually.
The allure of owning a cask of whisky in Scotland or an expensive barrel of wine is succumbing even to the experienced investor.
But it all might not be what is promised at the outset. The industry is littered with fraudulent companies that may overcharge you for storage or pawn off unwanted table wine as though it is a potential Mouton Rothschild. In the end, you may be sat on hundreds of bottles of poor plonk or scotch that you and your friends will get bored of drinking.
Like forestry and all of the other investments of this nature, you are entering an unregulated market that is in its infancy, and investors are just viewed as an income stream for the growth of the business.
Generally speaking, alternatives are often not priced correctly. The price you are given is often a guess by one of the Directors. The valuation may be overpriced to keep you satisfied, and the fund stable, to entice you and other investors to keep investing.
Here is a link to an article written by Shane Hickey in The Guardian.
Young investors are increasingly being targeted on Instagram with schemes to buy their whisky casks, but the unregulated area has become awash with misunderstanding, misconception and occasionally fraud. “It leaves room for unscrupulous people to take advantage. Some may offer what they claim to be rare and expensive whisky but is nothing of the sort,” says Sarah Coles at investment platform Hargreaves Lansdown.
“Others will claim to be able to offer guaranteed returns in order to get people to part with their cash, but you can never guarantee a sale price upfront. Some will even be offering you the chance to buy casks that don’t exist.”
Why Alternative Investments Are Not for Everyone
Alternative investments may suit high-risk, high-capital investors, but they are not suitable for the average investor unless you are prepared to take the risk.
Please speak to us before you consider any investment of this nature.
Where Should I Invest my money: Simple Solutions
We have written many blogs and articles about keeping investment simple.
Here is a blog about choosing the right advisor.
We have also written many other blogs about offshore investing, and financial advice and we advise that you look here:
Please read about them all here.
We cannot stress the importance of choosing the right advisor and advice company and then the correct investment.
It may seem like a daunting task, and these attractive exotic investments might carry great allure, but rarely do they come with a happy ending.
Always, our advice is to keep things simple, fully understand where you are investing and beware of the smooth-tongued, sharp-shooting salesman!
Frequently Asked Questions
What are some common types of alternative investments?
Alternative investments can encompass a wide range of assets, including but not limited to real estate, commodities, hedge funds, private equity, and collectables.
Why are alternative investments considered risky?
Alternative investments are considered risky due to their inherent complexity, illiquidity, and lack of transparency. These factors can lead to potential investment losses.
Why do student property funds fail?
Student property funds crashed due to a combination of factors, including illiquidity, market volatility, and poor management.
Are alternative investments suitable for the average investor?
While this ultimately depends on the individual investor’s risk tolerance and investment goals, alternative investments, due to their inherent risks, are often not recommended for the average investor.
How can I mitigate the risks associated with alternative investments?
Understanding the unique risks associated with alternative investments, seeking professional financial advice, and maintaining a diversified portfolio can help mitigate the risks associated with alternative investments.
Can alternative investments lead to high returns?
While alternative investments have the potential for high returns, they also come with high risks. It’s crucial to weigh the potential risks against the potential returns before investing.
