Introduction
We’ve all heard the financial success stories that make alternative investments sound like the golden goose of the financial world.
But are they really 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 fail.
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 & many 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 and the owners become greedy. 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 they need capital, often hundreds of millions in order to grow to the next stage. Hundreds of millions sounds like a lot of money, but in the investment world, this is a tiny amount, too small! In order for retail funds to be successful they will have billions invested in them.
Forestry and Plantations
Let’s look at forestry, agriculture and plantations. These are capital-intensive businesses. You need to purchase or rent huge areas of land. You also need to buy and grow the product, manage the space, employ a large workforce and 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 they then look 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, it wants $100 million more to really propel it into a big successful business.
If the business manages to find a single, understanding and incredibly rich 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 then the business may be able to produce an income in order to pay investors their return. If you do not cash out and stay invested, then your growth is what is known as a “paper return“, which is 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 do want to cash out, then the fund has to find the money from anywhere possible in order to keep public investor confidence in the fund, this money may now come from new money flowing into the fund and if this happens then the fund has now become a “Ponzi scheme” but it still can survive and grow at this point.
The real problem occurs when you have a financial downturn, bad news resulting in a lack of confidence in the sector, or a large investment house that has many millions invested changes its investment strategy and want to sell its sizable holding.
This is when we have a liquidity problem and 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 too.
If you invest in an “HSBC Large Cap Fund“, then HSBC buys and sells shares in enormous companies on the stock exchange every day in order 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 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 now it can no longer function as a fund.
This is the point where the fund becomes “Gated”, stopping all new money coming in and old money going out, this is usually imposed by the regulator. Here is a link to BlackRock warning their customers that at some point they might need to gate their funds. (Blackrock is one of the biggest investment companies in the world and they struggle with this problem. Blackrock manages Trillions of dollars and they can cope with these problems if they foresee and predict them and put measures in place).
Forestry & plantation companies have little understanding of financial instruments and do not plan for this eventuality, nor have the ability to do so. When the fund becomes gated, every investor loses their confidence and tries to redeem their money and the inevitable happens….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% pa. The allure of owning casks of whisky in Scotland or owning an expensive wine that will be enjoyed by many is very 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 just simply 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 not priced correctly. The price that is given to you is always a guess by one of the Directors who will more often than not overprice the valuation in order to keep you satisfied, the fund stable and 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 own 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 in fact 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.”
Litigation Funding, Student Accommodation, Guaranteed Returns
We have seen many of these types of funds come and go over the years. If you implement an investment strategy of a fund needing a minimum of $1 billion of assets under management and a ten-year track record of delivering 7-10% a year on an average rolling basis, then this is a good starting point.
I will cover other alternative investments in a later blog. But, if we work on the fundamentals of investment that I continually write about; paying attention to liquidity, stability, longevity, underlying assets and business nouse and choosing the right fund manager & management company then you shouldn’t find yourself reading this blog with your head in your hands.
Unfortunately, we can not cover every section of alternative investments in this blog due to the size of the industry, but I hope we have shed some light on how businesses cannot just be turned into investment funds for retail investors no matter how sound the business model is.
Why Alternative Investments Are Not for Everyone
While alternative investments may suit high-risk, high-capital investors, or the naive, they are not suitable for the average investor unless you are prepared to lose all of your money.
Please speak to us before you consider any investment of this nature.
Where Should I Invest my money: Simple Solutions
I have written many blog and articles about keeping investment simple. You need to be involved in the financial markets under the guidance of a good, reputable, experienced advisor.
Here is a blog about choosing the right advisor.
I have also written many. other blogs about offshore investing, Index tracking, offshore banking, ETFs, Mutual Funds, investment platforms, retirement planning and the list goes on.
Please read about them all here.
I cannot stress the importance of choosing the right advisor, 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 have a good ending.
Always my advice is to keep things simple, always fully understand what 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 collectibles.
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.
