Considering the Risks of Alternative Investments

What is leverage?

Leverage refers to the practice of borrowing money to fund a purchase. This process can increase the potential for returns, but also potential for greater volatility and losses. If an asset or investor is highly leveraged, it indicates that there is a higher proportion of debt than equity.

When investing in alternatives, it is especially important to consider and understand the type of leverage being used by the investment manager. Often, some form of leverage is required in order to deliver the sought-after enhanced returns.

Why do investors use leverage?

The key reason investors use leverage is to increase their buying power and improve investment returns. For example, if an investor invests $10,000 in an asset that they later sell for $15,000, they have earned a 50% return on investment.

However, if they had invested only $2,000 of their money and borrowed the other $8,000, the $5,000 profit would represent a return of 250%, less borrowing costs. This gets particularly interesting if the investor makes multiple investments using the same amount of capital. Say they use $10,000 of personal capital combined with $40,000 of borrowed capital to make five investments totaling $50,000. If the same return of $5,000 is made on each investment, they would earn a return of $25,000. Like all investment strategies, higher potential returns come with higher potential risks. When it comes to leveraged investments, an unexpected drop in the value of the asset could leave an investor holding an asset that is worth less than the leveraged amount, meaning they may be unable to repay their loan.

Additionally, leveraging investments can be expensive. Due to the higher risks involved for the lender, leveraged finance products generally come with the requirement to pay higher interest rates.

Why should investors consider illiquidity?

For the average investor, illiquidity is one of the key barriers to investing in certain alternative strategies. Liquidity refers to how easily or quickly it is for investors to sell shares or interests in an investment. Assets that are illiquid generally cannot be sold for an extended period and/or without a potentially significant impact on price.

Due to this increased risk, investors understandably look to achieve an illiquidity premium for these types of investments relative to liquid assets. However, it can be difficult to determine exactly what level of illiquidity premium an investor should demand. Investors need to understand the implications and trade-offs of illiquidity and decide how important it is, given their individual circumstances, and balance that against the return expectations and volatility profile of the investment.

Getting comfortable with volatility

The term volatility refers to the potential variation of an asset’s value. When an asset’s value has the potential to move drastically in either direction, it is considered highly volatile and, therefore, riskier.

While volatility can be cyclical in nature, negative cycles of volatility can be exacerbated by human emotions such as fear, anxiety, and stress. These natural human responses can cause negative volatility cycles to last longer and have more impact than positive ones.¹

Volatility is a factor in any investment, whether it is traditional stocks, bonds or alternatives.

In order to get comfortable with the potential volatility of an alternative investment strategy, investors should:

• Ensure they understand the impact volatility will have on returns (in some cases volatility may have a positive impact on returns)
• Be comfortable with the long-term or historical standard deviation of the investment
• Be aware that during periods of high volatility it may be sensible to hold the investment to avoid selling during a falling market
• Ensure that they have a diversified portfolio and are not allocating an excessive amount of their portfolio to one investment or strategy.

How can managed futures act as a buffer against market volatility?

Some alternative investment strategies offer an additional hedge against volatility. Managed futures, which are trend-following investments across asset classes, are one such example.

Managed futures have a unique profile relative to other investments, including:

• Long-term positive returns historically, similar to those achieved in equities
• Low correlation to equities and other global asset classes
• Strong historical performance during equity bear markets.

As a standalone investment, managed futures are relatively volatile. However, this volatility can reduce risk in a broader portfolio context – but not in every circumstance. While managed futures tend to perform well in extended periods of volatility, they may not provide sufficient downside risk mitigation in times of sudden, short-lived volatility.

Understanding valuation

Accurately valuing unlisted assets can be a challenge when it comes to alternative investments. Increased regulations and investor pressure for more transparency around valuations has, in some cases, resulted in more complexity rather than less.

Unlike listed equities, which are reviewed regularly by a large community of financial analysts that challenge and test valuations, there is no clear source of “truth” when determining values for unlisted or non-publicly traded investments. Even finding prices of comparable assets can be a challenge, making the process of determining the fair value of non-listed assets an often complex undertaking.

As a result, auditors must consider a range of other factors including current market conditions and the asset’s risk exposure, capital structure, liquidity levels and volatility. To gain insight around valuations, investors can request information from the investment manager regarding their valuation practices, policies and procedures.

Other key risks to consider

As with any other investment type, alternative investment strategies present a significant number of risks. Throughout this series we have outlined some of the key risks, including illiquidity, volatility, and complexity. However, investors should conduct independent research into other risks to determine if an investment strategy is appropriate for their circumstances. Some risks to consider carefully include:

• Manager risk: the risk associated with ineffective, destructive or underperforming investment management.
• Currency risk: arises from the change in price of one currency in relation to another.
• Systemic risk: the possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy.
• Counterparty risk: the risk to each party of a contract that the counterparty will not fulfil its contractual obligations.
• Regulatory and legal risk: The risk that a change in laws and regulations will materially impact a security, business, sector or market.
• Taxation risk: the risk that a taxing authority will levy or impose a tax.
• Operational risk: the risk of failed internal processes or systems.

¹ Managing Futures and Volatility: Decoupling and “Convex” Relationship with Volatility Cycles, Kathryn M. Kaminski, PhD., CIO and Founder, Alpha K Capital LLC ↩