Alternative Assets
This learning series on Modern Commercial Real Estate Investing first appeared on the EquityMultiple blog. Please check in there for updates and additions to this series.
The Modern Alternative Assets Landscape
A growing body of evidence suggests that greater exposure to alternative assets can boost portfolio returns and offer downside protection alongside a portfolio of traditional assets. At a basic level, alternative assets are defined as those offered outside of public markets and are less liquid than traditional assets like stocks and bonds. Traditional assets provide passive shareholders with efficient exposure to “beta” or “the market”, whereas alternative investments are associated with private markets and less correlation with publicly-traded assets, and derive yield potential from the skill of individual managers, operators and/or quality of distinct underlying assets.
The general case for greater exposure to alternative assets is simple: due to their lower correlation with public markets, diversifying into alternatives can reduce a portfolio’s overall exposure to risk. This was supported empirically by a recent Blackstone study¹:
A Blackstone study shows empirically that for a fixed portfolio volatility, adding alternative assets would boost overall average returns, i.e. the application of modern portfolio theory to alternative asset holdings.
While some alternative assets — like hedge funds or gold — have been explored extensively, there is growing enthusiasm for passive alternatives available through online platforms. Let’s take a look at three kinds of modern, online investments typically referred to as “alternative assets”.
Equity Crowdfunding and Pre-IPO Startup Investing
While the real estate crowdfunding paradigm has introduced greater access to individual investors, “equity crowdfunding” — the purchase of shares in pre-ipo startups by individuals for relatively small amounts — is perhaps an even more radical sea change, allowing individuals to operate as small-scale venture capitalists. While real estate is tangible and makes conceptual sense to even inexperienced investors, though, equity crowdfunding often presents a more opaque investment thesis, and correspondingly more risk.
Equity crowdfunding presents an obvious challenge: individuals who invest in exotic or niche startups assume similar risks to venture capitalists, but without the analysis firepower, capital reserves, or negotiating leverage that VC firms wield. What’s more, few of the platforms in the equity crowdfunding space even pretend to offer in-house diligence and underwriting for the benefit of individual investors, often creating additional risk, as noted in a New York Times article from early 2017.
The bottom line: equity investing in pre-IPO startups can yield outsized returns for individual investors, but carries tremendous risk. As of this writing, the underwriting standards in equity crowdfunding are spotty, even by admission of leaders in the nascent space. To a greater extent than real estate investing, each potential investment in a pre-IPO startup requires in-depth knowledge of the company’s leadership and
Cryptocurrency Investing
Unless you’ve been living in a crypt, you’re probably well-aware that it’s been a very good year for cryptocurrencies. While doubters have been proclaiming cryptocurrency investing the latest incarnation of Dutch tulip mania for some time now, the value of leading cryptos has been climbing steadily: Bitcoin rose from $738 a year ago to $8220 as of this year (in other words an investment of just $7000 in Nov. of 2016 would be worth six figures today), while Ethereum has skyrocketed from just $9 to $350, per coindesk.
While no one can predict the future for cryptocurrencies, here are some points to keep in mind:
Bitcoin is not synonymous with the shadowy underbelly of the web. It really wasn’t that long ago that public perception of bitcoin was as mysterious faux-currency used only to buy opiates and hit jobs on the dark web. This seems to still taint most people’s understanding of blockchain-based currencies, and dampen enthusiasm for cryptocurrency investing. At this point, this association is somewhat unfair — while blockchain currencies have a long way to go to earning legitimacy, there are indicators that bitcoin and its ilk will become more integrated in the mainstream economy. For example, Amex and Santander are partnering with Ripple² — a blockchain payments startup — to offer real-time transatlantic non-card payments. If household name companies in personal finance, capital markets, and payments adopt blockchain technology, cryptocurrency investing will become a more stable alternative asset class in the long run.
This could still be a bubble. Despite encouraging developments like the Amex partnership, and persistent enthusiasm among some very smart people, the fact remains that cryptocurrency has no inherent worth and, as of now, does not have the backing of any government; its value is part and parcel of people agreeing that it is valuable. While government-issued fiat money is also (mostly) without material worth, the vastly interconnected global economy and hard currency holdings of central banks ensure a degree of stability for major fiat currencies that cryptocurrencies may not enjoy for a long time, if ever.
Don’t sell the farm and dump the proceeds into cryptocurrency investing, but some exposure to cryptos is probably worthwhile. We won’t pretend to know what the future holds for blockchain-based currencies, but it’s reasonable to assume that cryptocurrencies have at least the potential to become more prominent in global capital markets and payments infrastructure, and to continue climbing in value. At the same time, it remains an unproven and risky alternative asset. As such, it makes sense for many investors to devote a small portion of their overall portfolios to major cryptocurrencies.
Initial Coin Offerings
Initial Coin Offerings (ICOs), while relatively new have taken the alternative investing world by storm. Companies have raised as much as $230M in a short amount of time. This dwarves traditional venture-backed fundraising in early rounds.
ICOs are not cryptocurrency investing. Though they are based on the same technology, most ICOs are not synonymous with cryptocurrency investing. They are investments into the company doing the fundraise, and thereby less secure, potentially illiquid, and extremely high risk. Therefore, while potentially lucrative, investors must be fully aware of all the terms of the offering. Much like equity/startup crowdfunding investments, ICOs are risky, and the risk and return potential depend entirely on the specifics of the company conducting the ICO.
Historical allocation to alternatives by different classes of investor. This shows the immense room for growth among individual investors with respect to alternative asset holdings.
Does Cryptocurrency Investing Actually Qualify as Alternative Investing?
You would be correct in noting that, though they are new and certainly alternative to traditional government-backed currency, cryptocurrencies do not meet the typical definition of low liquidity; exchanges for buying and selling cryptocurrencies have skyrocketed in popularity (coinbase, for example, has eclipsed 7 million users), creating more and more opportunity to quickly buy and sell cryptocurrencies. One might suggest that cryptocurrencies are not correlated with public markets, but really there’s not enough historical data to make a claim either way: the ascent of cryptocurrency investing has taken place entirely within the current bull market.
Though cryptocurrency investing is still certainly alternative and may provide welcome diversification in a portfolio, cryptocurrencies should not be considered “alternative assets” in the same way as private real estate, equity crowdfunding, or commodity holdings.
Passive, Private Real Estate Investing
Private real estate investing is an established alternative asset. As we’ve explored at length, online passive real estate investing (often referred to as “real estate crowdfunding”) presents an alternative to traditional modes of real estate investing, with lower barriers to entry.
Though we can’t claim to be totally unbiased, our belief that online passive real estate investing provides downside protection, and better portfolio diversification, has been well-supported by the literature³. Relative to equity crowdfunding and cryptocurrency investing, private real estate investing (via a platform like EQUITYMULTIPLE) provides more historical precedent for consistent yield, the backing of a tangible asset with inherent worth, and low correlations with public markets.
All three asset classes discussed above may be worth at least some small exposure for investors who are not overly risk-averse, and seek greater portfolio diversification. With its historical precedent for low volatility, stable cash flows and relatively strong performance during downturns, private real estate should factor much more into most investor’s portfolios than the other alternative investments discussed here. Fore more on modern portfolio theory and asset allocation in the context of modern alternative asset investing, please review this article.
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¹https://www.blackstone.com/docs/default-source/black-papers/seeking-an-alternative.pdf?sfvrsn=2
²https://www.reuters.com/article/us-blockchain-amex-ripple/amex-launches-blockchain-based-business-payments-using-ripple-idUSKBN1DG1SX
³https://www.investopedia.com/articles/mortgages-real-estate/09/real-estate-portfolio.asp
