Alternative Facts for Unwary Investors
While scrolling through my newsfeed, I noticed this headline from CNBC: “Some advisors are flocking to alternative investments, survey finds. What investors need to know.” My spidey sense for danger tingles anytime I see the term ‘alternative investments’ used in a headline.
That may come as a surprise to people that have known me for a long time. Back in my early days as a financial advisor, I embraced alternative investments as portfolio diversifiers. Other than stocks and bonds, there wasn’t much else an individual investor could buy.
At first, the universe of alternative investments primarily consisted of limited partnerships and mutual funds that owned real estate, commodities, or businesses. It wasn’t the underlying investment that was alternative, but the means by which they could be assessed by investors.
That aspect of alternative investments still holds true today. In addition, in many cases the underlying investments are relatively new asset classes for which there is very little track record to go by.
That’s what makes me nervous. Portfolio diversification is used to mitigate risk. But if the asset class being diversified into has no track record, it is impossible to assess how it is likely to react under a variety of market conditions relative to other asset classes.
In that case, adding an unproven asset class to a portfolio could have the undesirable effect of increasing volatility without improving the long-term return. And when it comes to alternative investments, some of the more recent ones have thus far proven to be anything but an effective portfolio diversifier.
It wasn’t that long ago that non-fungible tokens (NFTs) were all the rage. An NFT is a unique digital representation of an image that is recorded on blockchain, giving the owner proof of authenticity and ownership.
During the height of NFT mania in early 2021, the artist known as Beeple sold an NFT of one of his works of art for $69 million. After that, the NFT floodgates opened.
Two weeks later, Hall of Fame Resort & Entertainment Company (NSDQ: HOFV) announced that it would begin selling NFTs of some of its media properties. In just a few weeks, its share price more than tripled.
That’s the good news. The bad news is that after peaking above $168 in March 2021, HOFV was trading below $25 one year later. During the last week of 2022, it fell below $8.
I don’t think that’s the type of performance that investors want from their portfolio diversifiers. Yes, NFTs are an alternative asset class. But in this case, alternative did not necessarily mean different in any positive way.
The same can be said for cryptocurrencies, which also use blockchain technology. After peaking above $67,000 in April 2021, the price of Bitcoin (BTC) fell below $16,000 one year later.
Turns out, Bitcoin was neither a hedge against rising inflation nor a stock market correction. While both of those things were happening, Bitcoin fell by a larger percentage than did stocks and bonds.
So much for Bitcoin or NFTs being a portfolio diversifier. Turns out, you would have been far better off diversifying your portfolio with hard assets such as commodities that have been around for a long time and have a proven track record.
Given their dubious track record, I was surprised to see CNBC report in October 2022, “Young, wealthy investors are flocking to alternative investments, study shows. What to know before adding to your portfolio.”
The articles cited a Bank of America Private Bank survey of 1,052 investors aged 21 to 42 with a net worth of at least $3 million. Three-quarters of them said they don’t expect above-average returns from stocks and bonds, so they are using alternative assets to improve portfolio performance.
Therein lies the rub. Increasing portfolio returns requires more exposure to risk assets. However, more exposure to risk assets also increases the probability of negative volatility (losses).
That is not how a portfolio diversifier is supposed to work. At least, not in the traditional sense. Ideally, a portfolio diversifier will reduce volatility in the near-term while not detracting from long-term returns.
To my way of thinking, the term ‘alternative assets’ has been hijacked by marketers of risky, unproven assets to make them appear less daunting. If you thought hard about what an NFT or cryptocurrency really is, you probably would want nothing to do with them.
But when they are presented as alternative assets that can diversify your portfolio to reduce risk, they don’t seem so scary. The same can be said for other concepts being hustled as alternative investments these days.
Don’t get me wrong, I’m all for portfolio diversification. And I’m also a fan of alternative investments. That is, provided they are legitimate portfolio diversifiers and not just the latest fad being fobbed off on naïve investors.
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