Consider the Alternatives (Part 3)

What are alternative assets?

“Jackalope” Postcard from 1968. Source: Legends of America

Alternative assets are real assets that don’t trade in the public markets. They include natural resources, commodities, real estate, and collectable items. They tend to represent more direct claims on consumption, with less reliance on management. So while a company like IBM owns real estate, patents, and other things, the value of the corporation really depends on management’s ability to turn these assets into a growing stream of cash flow.

Real assets create or add to what people can consume. Financial assets – like stocks and bonds – are the conduits by which we buy and sell things. Real assets are what we use. Naturally, as populations grow, we tend to use more stuff. During times of inflation, with more and more dollars chasing fewer and fewer goods, real assets usually hold – or even expand — their value.

Source: National Museum of American History

Gold is perhaps the most popular alternative investment. People invest in gold because it served as a reliable currency for thousands of years. It was a medium of exchange, a store of value, and a unit of account. During the great inflation of the 70’s and early ‘80s, the price of gold soared from the official price of $35 to over $800 per ounce. Now, gold tends to function as a hedge on the risk of financial collapse. When people worry that our banking system may break down, they tend to buy gold.

But other real assets don’t depend on a financial collapse, like mineral rights or timber. These are attractive because they facilitate growth in the global economy. As long as people need to build houses and drive cars, they will need lumber and fossil fuels. Also, people can invest in collectable items, like stamps or art or vintage wines. The idea is that there will never be another Rembrandt or 1982 Lafite Rothschild.

Rembrandt von Rijn. Source: National Gallery

The investment value of real assets comes from their lack of correlation with stock and bond prices. By zigging when other prices zag, they can reduce the overall volatility of portfolio returns. But it’s important to recognize the difference between a listed price and an executable price. Just because an index has a value doesn’t mean you can buy or sell at that level. And alternative assets have high execution costs. Broker fees, legal costs, and safekeeping all add up. Someone investing in alternative assets may need to have a multi-decade time horizon in order to realize their value.

Alternatives can be attractive. In an era of low interest rates and high stock market valuations, these assets offer another layer of diversification. But there are two important things to remember. First, everything depends on the economy. The financial crisis demonstrated that there are few assets that hold their value in a significant economic downturn. Second, the devil is in the details. Many of those who suggest investing in alternatives make their money from commissions. Read any contracts, disclosures, and agreements closely—with a trusted advisor.

Much the appeal of alternatives comes from a desire to be different. But your investments should be driven by rational calculation, not sentiment. If you’re not careful, alternative investing can turn out to be a very expensive hobby.

Douglas R. Tengdin, CFA

Chief Investment Officer

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