The old curse: “may you live in interesting times” seems to have been bestowed upon us lately.  In the ever so global village that we live in, it is amazing to notice how quickly and profoundly financial markets have been reacting to significant political uncertainties such as the “Pax Populi” movements and the rising isolationist sentiment across both America and Europe. 

There have been steady declines noticed in certain main equity markets (e.g. FTSE All share index as well as Nikkei 225 have noted decreases in the first months of 2016; and although the NYSE and NASDAQ indices have been increasing, S&P 500 earnings yield announcements show consecutive declines over the past year).  Governments’ monetary policy moves such as increasing the US fed funds rate to 0.5% in December 2015, or the "currency wars" taking place with certain Asian countries building reserves of US Dollars earlier this year... Connecting these global dots, it would be fair to conclude that we are experiencing uncertainty in financial markets and a resulting adverse effect on the global economy, with arguably the greatest negative impact on Europe.  Are we at a "watershed" moment with relation to big questions that urgently need to be answered (Brexit, Grexit and the future of the EU, the US elections, Putin, the Syria crisis and immigration)?  

What are alternative investments?

In “interesting” times like these, economists notice that investors turn their attention to “alternative investments”.  Let’s first agree on a definition as the term appears to be used differently across varying contexts. Defined loosely, alternative investments include any type of investment that is not cash, exchange traded equities, derivatives or fixed income.  A more strict definition would limit the term to products that aren’t readily traded, but rather kept for longer periods such as antiques, rare books, wines, and artwork.  I take a blended approach to the term, opting to include these more "unusual" investments listed above as well as property.

Why do alternative assets show negative correlation with the main financial exchanges? 

Because they hedge against inflation.  They maintain their value through the decades, the centuries.  Because they aren’t prone to losing value if, say, Donald Trump becomes president of the United States, or if the Euro ceases to exist. In other words, they aren’t “event driven”.  In our lifetime we may see the collapse of the European Union, we may even live through a Third World War; we don’t know what the future holds, but whatever happens, there will always be someone willing to pay a lot of money for a 15^th century manuscript copy of Dante’s Divine Comedy.

The number of ways to invest in alternatives has been growing as investment vehicles such as the Real Estate Investment Trusts ("REITs") (see our earlier blog with relation to REITS called "UK Real Estate Investment Trusts 101 - what you need to know"), or other Collective Investment Schemes (“CIS”) have been introduced.  Investors now have the option of either making a direct placement or investing through trusts or funds.  Below we highlight the pros and cons in opting to make a placement in an alternative investment vehicle such as a trust or a fund:

Pros and cons of investing in alternative investment vehicles

Advantages:

1. Risk diversification – alternative investment vehicles spread the investment risk across a number of different assets.
2. Hedge against inflation – alternative investments in general provide an inflation hedge due to the asset class being invested into.
3. An underlying value is preserved – because they aren’t actively traded, these assets will have a level of unquestionable value. For example, land won’t fall below a certain base value; and if it does fall, it would be for a short term period, and investors that could afford to do so, will typically hold on to the asset until the value recovers.

 Disadvantages:

1. Illiquid – the assets aren’t frequently traded and as such any placement made will be locked in for a period of time.
2. Concentration in one asset class – typically alternative investment funds are in one area – such as property, art, or antiques. Thus, although the risk is diversified across a number of assets, they are all in one asset class therefore carrying an element of concentration risk, whereby investors aren't able to avail of short term up-sides that an equities portfolio would provide.
3. Susceptible to tax changes over a longer term period – as the investment can be held for a number of years, the placement may be susceptible to changes in tax legislation, which may be favourable or unfavourable to the holder of the investment.

Are Alternative Investments eligible for SEIS or EIS status?

Generally no. As alternative investment funds make investment placements, the underlying asset is not a trading asset and as such neither the asset nor the fund would typically qualify for the Seed Enterprise Investment Scheme or the Enterprise Investment Scheme.

Political uncertainty's profound impact on financial markets arises from many issues that, once decided upon, will materially impact life in our global village.  Until decisions are made and implemented, investors' attention most likely may be diverted to seeking value through the ages.

Note: Sapphire Capital Partners LLP is not promoting any product for investment or providing any form of investment advice.