Risk Management for Alternative Investments
The risk spectrum in alternative investments is broad. Venture capital is one of the riskiest alternative investments, where the business model is such that venture capitalists expect the majority of early-stage investments to fail, and about three quarters of venture-backed startups in the U.S. don’t return investors’ capital, according to research by Harvard Business School’s Shikhar Ghosh. On the other hand investing in fine art can be less risky as there’s less volatility in prices.
But there are also risks that are inherent to alternatives, including the risk related to illiquidity in private equity, real estate, and some hedge funds. The money in such alternative investments is locked in for the long term and secondary markets aren’t as efficient as with stocks or bonds. With buyouts, there can also be risk associated with the use of leverage.
Emerging alternative investments including cryptocurrencies or cannabis, present regulatory risk. The Securities & Exchange Commission typically scrutinizes more closely nascent unregulated markets and the chance that they may eventually impose rules can be high.
So where to start?
The first step in managing risk with alternative investments is to measure the standalone risk of an investment. It’s essential to understand the product you’re investing in and the risks that are intrinsic to the investment. That can be done during initial due diligence.
There are some technical tools to measure risk. The annual standard deviation can be used to measure the volatility of historical returns for an investment. Meanwhile, value at risk tools calculate the maximum dollar amount that can be expected to be lost over a given time horizon, or in other words, the worst-case scenario.
But often, simply understanding how a company is structured or how an asset is managed through due diligence is just as important. Is the asset leveraged? Is the management team known for success or failure when investing in this asset class? Is the team transparent enough and does it have the skills required to manage the asset successfully?
Investors always need to understand the operations of their management team, including how they charge fees and how the team is organized. Do they have a legal and compliance department? Do they understand the legal and regulatory issues attached to the asset class they focus on? How does the organization value assets? Asking a manager and understanding how they manage risk internally and whether they conduct stress test scenarios can be extremely useful.
Investors should also assess the risk of an investment in the context of their own portfolio. Whether the alternative investment exposure represents a small or a large portion of their overall portfolio makes a huge difference in terms of risk. To minimize risk, it’s important to make sure the portfolio isn’t concentrated in one alternative investment or even one asset class, and that there’s diversification with safer and more liquid assets such as stocks and bonds.
While there are many ways to manage risks when investing in alternatives, the flipside is that alternatives also offer boons and rewards for taking that additional risk. These are often lower correlation to equities, tax advantages and the potential for higher returns. These things and more all make alternatives an attractive asset class for future investments.