How to Analyze an Alternative Investment
By definition, alternative investments work differently than stocks. As an investor, you have to know how to analyze an alternative investment in order to make the right purchase. Here are a few tools to help.
Once upon a time, alternative investments were the sole purview of the wealthy. These days, though, ordinary investors have a lot more knowledge at their disposal, and more resources to find creative ways to grow their money. Which means there’s considerable new interest in alternative investments.
There’s a good reason for that. Take venture capital firms, for example—the top quartile of professionally-managed VC firms have an average annual return between 15% and 27% over ten years. To put that in perspective, the average annual return since adopting 500 stocks in the S&P 500 Index is 8% from 1957 to 2019.
In short? There’s a lot to take advantage of with alternative investments. But first, you have to know how to analyze an alternative investment. Here’s a quick review of the basics and a few common techniques for investors to know.
What is an Alternative Investment?
Definitions of alternative investments vary widely, but generally, an alternative investment is any financial asset that does not fall into one of the standard asset categories, such as stocks or cash.
Common types of alternative investments include:
- Private equity
- Private debt
- Hedge funds
- Venture capital firms
- Managed futures
- Derivative contracts
- Tangible assets
- Structured products
Typically, alternative investments are often held by high-net-worth individuals or institutional investors, since these types of investments are less regulated, highly complex, and carry more risk than conventional investment assets.
Why Use Alternative Investments?
While alternative investments have long been the domain of high-net-worth individuals, they are becoming more popular with everyday investors. Keep in mind that you don’t need to be a millionaire to afford alternative investments—any investment that doesn’t fall in the category of stock, bond, or cash can technically be considered an alternative investment.
One of the main reasons investors like alternative investment options is that their value does not correlate with the whims of the stock market. This makes them an excellent choice to diversify your portfolio while mitigating volatility you would see in conventional investments like stocks.
This also means that alternative investments tend to be much more illiquid than their conventional counterparts. It’s harder to sell a painting than, say, an IBM stock. There may not even be agreement as to how to value the asset. Even so, transaction costs for alternative investments are often lower than conventional assets, expressly because they have a much lower turnover rate.
Methods to Analyze
Because alternative investments cover a pretty broad collection of investments—anything from a hedge fund to farm land to an 80-year-old bottle of merlot—you have to know how to assess your potential investment before you make the purchase.
Here are a few common techniques to analyze your investment.
The Sharpe ratio is the industry standard for analyzing the risk-adjusted return of an investment. It gauges the performance of an investment by adjusting for its risk.
The ratio is simply the average return earned in excess of the risk-free rate per unit of volatility. Subtract the risk-free rate from the return of the portfolio and divide by the standard deviation of the portfolio’s excess return. The standard deviation shows how much the return deviates from the expected return and the portfolio’s relative volatility.
In simple terms, the higher the ratio, the greater the investment return relative to the amount of risk, and ergo, the more valuable the investment.
The Sharpe ratio has a significant weakness: it can be misleading for portfolios that don’t have a normal distribution of expected returns. For this reason, the Sharpe ratio and Sortino ratio are often used in tandem.
The Sortino return is a risk-adjustment metric determining the additional return for each unit of downside risk. It’s actually a variation of the Sharpe ratio, and it uses the asset’s standard deviation of negative portfolio returns to differentiate harmful volatility from overall volatility.
To calculate it, subtract the expected rate of return from the average realized rate of return and divide that number by the downside risk deviation. The higher the ratio, the higher the portfolio return over the targeted rate of return.
This makes the Sortino ratio highly useful for volatile assets and entire asset classes, since you’re examining whether returns are below a certain threshold.
If you’re interested in hedge funds, you need the Appraisal ratio, which is pretty much exclusively used to evaluate hedge funds. That’s because it measures the quality of an investment manager’s investment-picking ability, which will directly influence your returns from the hedge fund.
Basically, the ratio compares the return of a manager’s stock picks to the specific risk of those selections as a way to assess the manager’s performance. Alpha (the portion of return that active management accounts for) is compared to unsystematic risk.
To calculate it, all you have to do is divide Alpha (the rate of return for a selection of stocks) by the unsystematic risk (the risk for the selection of stocks).
Last but not least is the Treynor ratio, a.k.a. the reward-to-volatility ratio. Like the Sharpe ratio, the Treynor ratio measures the relationship between risks and annualized risk-adjusted returns. It differs from the Sharpe ratio in that it uses beta, or market risk, instead of the standard deviation. Beta refers to the tendency of a portfolio’s return to change in response to the market.
To calculate it, subtract the risk-free rate from the portfolio return and divide by beta of the portfolio. The higher the Treynor ratio, the better the performance of the portfolio.
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