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Alternative assets

Alternative assets is the name given to an asset class that includes everything except cash, fixed interest, equities, and property (although property is sometimes considered as an alternative asset). The main alternative investment areas are private equity, venture capital, commodities, and hedge funds. We would also include collectibles which, although not usually of interest to mainstream investors, might appeal to private investors who have a special interest in and knowledge of the subject.

In general, all alternative assets demand a level of knowledge and perhaps involvement that makes them unsuitable for many private investors. Detailed discussion of each type of asset is beyond the scope of this site and you should do your own research and seek appropriate advice before making any investment. All we can do here is take a brief look at some of the more important ones.

Private equity

Private equity now accounts for a very significant part of the total corporate sector in the US and UK, and is increasingly important in the rest of Europe. Although up until recently it has been exclusively the preserve of large institutional investors (and a handful of very wealthy private investors), managed funds are beginning to take an active interest.

Private equity ‘houses’ raise money from pension funds and insurance companies, typically in the form of closed-end funds. In effect, the institutional investors and private equity house become partners in a defined fund, with which the private equity house buys what may be quite large businesses. The objective is to improve the profits of the business and sell it on, typically within three to five years. The fund will have a target life of, say, ten years, by the end of which the money in the fund should have been returned to the original investors.

Many private equity funds made extremely good returns for their investors (and themselves) during the 1990s. Although things have been tougher in the last few years, there have still been some very successful deals. As a rule, private equity houses are highly professional and highly motivated business owners. The management teams in the companies they own are very well rewarded in return for meeting tough performance targets. It will be interesting to see how the industry develops and whether there will be worthwhile opportunities for smaller private investors to benefit from this alternative to public equities. The private equity industry in the UK is represented by the British Venture Capital Association (BVCA).

Venture capital

The boundary between private equity and venture capital is blurred. Essentially venture capital refers to early stage investment in smaller companies. Because of the perceived importance in generating future industries, private investors have been encouraged to put money into venture capital by various tax incentives. Venture Capital Trusts (VCTs) are often managed by private equity houses and take stakes in unquoted (and some AIM listed) UK companies. As a private investor, you can subscribe for shares in a VCT and obtain tax relief at 20% for an investment of up to £100,000. There is scope for deferring capital gains tax on realisations of investments in VCTs. There is a booklet (IR196) available from the Inland Revenue.

Enterprise investment scheme

Whilst VCTs offer a spread of risk, you can invest in single enterprises under the Enterprise Investment Scheme (EIS). As with the VCT, there are attractive tax benefits to offset what is essentially a very high-risk investment. Not surprisingly, the rules that enable you to qualify for tax relief are quite complex and you should study them carefully and take appropriate advice if this is of interest. Any investment in a small, private company is very risky and fraught with difficulty, but the potential rewards can be exceptional. As a general rule, you should look firstly at the business and the people involved in it before ever considering the possible tax benefits. If the business isn't viable or you can’t trust the integrity or ability of those involved, don’t do it. No amount of tax relief will restore the money you will lose if it goes wrong.

We will be looking further at starting or investing in a business later: mail us if you would like details. Meanwhile, information on the tax aspects of the EIS is available here.

Commodities

Commodities themselves (as opposed to an index or derivative) are unsuitable for private investors simply because of the delivery problem. You really don’t want to have to store even precious metals let alone tonnes of grain or aluminium or cocoa. Futures contracts are intended to help commodity traders reduce their risks by buying or selling future production, although increasingly these and other derivatives have become popular with some of the more adventurous investors. (We will be looking at derivatives on the next few pages).

Commodities as a whole have not been good long-term investments. The Economist commodities index has fallen in real terms from a level of 100 in 1850 to 30 by 2004, although there has been a strong rise in the past year or so fuelled by strong demand from China. Gold and silver can be a useful hedge against financial assets. For example, the price of gold rose from $300 to $400 per ounce between 2000 and 2004, a period during which equity prices were falling for much of the time.

Investors interested in commodities need to study the subject in far more detail than we can cover here, and take appropriate advice. It is worth bearing in mind that equities include the shares of major companies that are engaged in commodity trades and extraction, and these give investors some exposure to commodity markets.

Hedge funds

Hedge funds are special types of managed funds that have much broader (and possibly riskier) investment strategies. Normal managed funds (units trusts for example) buy equities or bonds and tend to hold on to them. They are said to be ‘long’ in the assets they deal in, and rarely if ever go ‘short’ (which means selling shares or market indices that they don’t own). As a consequence, managed funds lose money when markets fall, because the value of the shares they own has fallen.

Hedge funds may not own any shares at all, but in effect take bets on the price movements of individual shares or market indices using derivatives. For example, if equity markets are falling, a hedge fund can decide to ‘short’ an index or share and make money from the fall in price because it could potentially buy the share for less than it sold it for in advance. Generally, the more volatile the market, the more scope there is for a hedge fund to make money, and arguably activities such as short selling increase volatility.

To the extent that hedge fund operations can provide some degree of risk reduction for funds that are ‘long’ they are adding value to markets. However, given the scale of their operations in recent years you have to ask where their supposedly high returns are coming from. If hedge funds as a whole are making money then who is losing it? Unless you are ‘long’ in equities you can’t benefit from the cash that is generated by the businesses whose shares you own. If you don’t hold the shares you can only get a return by exploiting mistakes that the markets make in pricing, and that means you are gaining at the expense of other market agents.

Of course, it is often difficult to get a ‘fix’ on fair value and prices vary accordingly. If you can pick the right shares and buy (and sometimes sell) at the right time then you have an opportunity of beating the market – which means beating other investors. Given the size of securities markets, as a private investor you can make an awful lot of money without making much of an impact and anyway everyone is free to deal at the same prices and the same times as you. There isn't any virtue in not taking advantage of any opportunities that other investors, via Mr Market, are offering you.

It’s like betting on horses: if you win then whatever money you win will have come from other punters. The bookies only lose if they get their sums wrong. The world doesn't get any wealthier from betting (apart from the small amount that is siphoned off by the bookies and tax): the world gets wealthier from economic growth. All betting does is shift wealth from one pocket to another. The question for hedge funds is whether they are simply shifting money between their own pockets, or whether someone in the outside world is paying for the cars and yachts and expensive houses that hedge fund managers are reputed to enjoy.

Until recently, hedge funds were only available to very wealthy private investors and institutions. However, there are managed funds that invest in a selection of individual hedge funds, and smaller private investors now have the opportunity of entering the game. Most hedge funds are based offshore and are unregulated. Whilst it’s not difficult to lose money in regulated funds, regulation does provide some degree of investor protection and make it easier to compare fund performance. That isn't necessarily true of hedge funds.

Let’s take a closer look at some of the derivatives that hedge funds – and other investors – might deal in.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page