How to Beat the Market by Investing in Alternative Assets

The life of an investor is all about alpha and beta.  That is the search for returns while managing risk and given what has been happening in the market lately, then life has been more about beta now.  As such, the impetus to beat the market has never been more important.  With that in mind, here are some tips on how to beat the market by investing in alternative assets.

What separates ‘alternative’ assets from ‘traditional’ assets?  Part of the answer is how they are traded.  Now, we are not talking about over the counter penny stocks; instead, alternative assets are generally recognized investment classes – many of which have been utilized by fund managers for years.

Given that many of these assets are not traded in the same manner as traditional assets, it is incumbent for investors to not only understand how these assets work but also how to properly value them and the options for sale.

If this sounds complicated, the really is that it really isn’t.  Sure, the comparing alpha is not exactly an apples-to-apples affair; but a good proxy is benchmarking to the S&P 500.  At the same time measuring beta is a more straightforward – at least in the macro sense.  This is due to the fact that portfolio beta is more a matter of exposure to an overall asset class.  As such, it’s more a question of diversification than anything else.

This is really where investments in alternative assets are most useful.  Ask any experienced fund manager and they would tell you that they rarely go overweight on one asset class; and even when they do it is only for short periods of time.  Instead, their alternative holdings tend to be as a hedge for something in their basket of more traditional assets.

You see alternatives are about beating beta and this is how you can come out on top against the market.  An example of this can be found in 2008.  When the broader markets were crashing many mutual funds, who bet on alternatives came out on top as their holding had a low correlation to the broader market.

Yes, some alternatives are prone to liquidity issues and this means they can be repriced under opaque conditions but for experienced investors who know how to perform due diligence, they look for assets which can act as a ballast when markets get choppy – like last week.

As most investors want to beat the market, it means they need to rethink the role that alternatives play in their portfolio.  Take,for example, investments in reinsurance.  Sure, no one likes the buy insurance but everyone does it and this opensglobal market estimated to be worth more than $4.5 trillion.

But if everyone is buying insurance, then what do insurance companies do to limit their risk?  They buy reinsurance, this is inter-industry coverage that allows insurers to sell all or part of their portfolio book to a pool of insurers – and this is where you want to consider investing.

If you are not sure then check out this post on car insurance which spells out some of the sins of retail insurance buyers.  What does this mean for an investor?  For starters, there is some risk at the level of the insurers and more importantly, this can be mitigated by selling this to reinsurers.

Now, this is the level of the game where you want to invest as it is an opportunity to buy into something with equity-like returns without a direct correlation to the risks.  Even when there are large scale losses, reinsurers tend to be shielded as they rarely underwrite a complete sector on their own.  The one exception was AIG during the subprime loan crisis and therefore you need to perform your due diligence.

Given this example, how do you approach alternative assets?  Well, the first step is to determine your asset allocation and from there you can identify which classes of alternatives are the best fit for your investment goals.  Keep in mind that you will also want to select a list of ‘next-best options’.  This is useful as it keeps you from becoming married to an investment opportunity and thus skewing the conclusions of your pre-investment analysis.

From there you want to build out your models as you need to not only benchmark the performance of your alternative asset investments while keeping an eye on your performance as compared to the broader market.  At the end of the day, this might mean investment in an alternative asset fund – and this is a good way to dip your toe into the pool – or you could find viable candidates for direct investments.  In the end, it depends on your experience as an investor and the ability of the targets to help you beat the market.


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