How to Build a Diversified Portfolio Using Alternative Investments

Alternatives come in various forms and can serve as powerful tools for achieving growth, reducing volatility, and enhancing portfolio diversification.

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In recent years, there’s been a growing shift towards alternative investments in the financial world. Yet, despite this trend, many investors still perceive alternatives as an exclusive, narrowly defined investment category reserved for a select few.

This perception, however, is far from accurate. Alternative investments are a diverse and expansive field, offering a wide array of assets and strategies that can potentially benefit a broad range of investors.

These non-traditional investment options come in various forms and can serve as powerful tools for achieving growth, reducing volatility, and enhancing portfolio diversification.

As we delve into the world of alternative investments, we’ll explore how these assets are breaking out of their niche status and becoming increasingly accessible to a wider audience of investors.

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What Are Alternative Investments?

Alternative investments are financial assets that fall outside the conventional investment categories of stocks, bonds, and cash. These non-traditional investments can include private equity, venture capital, hedge funds, real estate, commodities, and even tangible assets like art or collectibles.

Key Features of Alternative Investments:

Low correlation with traditional markets: Alternative investments often don’t move in tandem with stocks and bonds, providing diversification benefits.

Potential for higher returns: Many alternative investments offer the possibility of above-average returns, though often with higher risk.

Less liquidity: Alternative assets are typically harder to buy and sell quickly compared to stocks or bonds.

Limited regulation: Many alternative investments face less regulatory oversight than traditional securities.

Higher fees: Alternative investments often come with higher management and performance fees.

Complexity: These investments can be more complex and may require specialized knowledge to understand and manage effectively.

Alternatives vs. Traditional Assets

Traditional investments like stocks and bonds are typically highly liquid, traded on public markets, and have a high correlation to overall market movements. They’re also generally more transparent and subject to stricter regulations.

In contrast, alternative investments may be less liquid, often involve both public and private markets, and have a lower correlation to broad market trends. They frequently require more active management and can offer the potential for higher returns, albeit with potentially higher risk.

Types of Alternative Investments

Private Equity: This involves investing in private companies or buyouts of public companies. In Africa, private equity has played a crucial role in sectors like telecommunications, with firms like Helios Investment Partners making significant investments in companies like Helios Towers.

Hedge Funds: These are actively managed funds that use advanced investment strategies. While less common in Africa, some hedge funds focus on African markets, like Steyn Capital Management in South Africa.

Real Estate: This can include direct property investments or real estate investment trusts (REITs). The African real estate market offers significant opportunities, with rapid urbanization driving demand in countries like Kenya and Nigeria.

Commodities: These include investments in raw materials like gold, oil, or agricultural products. Africa is rich in natural resources, making commodity investments particularly relevant. For example, investing in companies involved in gold mining in Ghana or cocoa production in Côte d’Ivoire.

Infrastructure: Investments in physical systems like transportation networks, energy, or water systems. Africa has a significant infrastructure gap, presenting numerous investment opportunities, such as renewable energy projects in countries like Morocco or Kenya.

Venture Capital: This involves investing in early-stage companies with high growth potential. Africa’s tech startup ecosystem is booming, with startups attracting significant venture capital. Investors can participate in this space through venture funds, which pool capital from multiple investors to back a portfolio of startups. For example, funds like Future Africa are actively investing in promising African tech companies.

Myths About Alternative Investments

Myth: Alternatives are only for the ultra-wealthy.
Reality: While some alternative investments have high minimum investments, many are now accessible to a broader range of investors through mutual funds and ETFs.

Myth: Alternatives are always high-risk.
Reality: While some alternative investments carry high risk, others can actually help reduce overall portfolio risk through diversification.

Myth: Alternatives always outperform traditional investments.
Reality: Performance varies widely among alternative investments, and they don’t always outperform stocks and bonds.

Myth: Alternatives are too complex for average investors.
Reality: While some alternatives are complex, others, like real estate or commodity investments, can be quite straightforward.

Myth: Alternatives are completely illiquid.
Reality: Liquidity varies widely among alternative investments. Some, like certain hedge funds, offer regular redemption opportunities.

Pros and Cons of Alternative Investments

Pros:

Diversification: Alternatives can help spread risk in a portfolio.

Potential for higher returns: Some alternatives offer the possibility of above-average returns.

Inflation hedge: Certain alternatives, like real estate and commodities, can provide protection against inflation.

Access to unique opportunities: Alternatives can provide exposure to investments not available in public markets.

Cons:

Higher fees: Many alternative investments come with significant management and performance fees.

Less liquidity: It can be harder to sell alternative investments quickly.

Complexity: Some alternatives require specialized knowledge to understand and manage effectively.

Less transparency: Many alternative investments provide less frequent and detailed reporting than traditional investments.

Higher risk: Some alternative investments carry a higher risk of loss.

How to Diversify Your Portfolio with Alternative Investments

As established, alternative investments can be a powerful tool for portfolio diversification, offering unique benefits that complement traditional assets like stocks and bonds. Here’s how you can use alternatives to create a more robust and diversified investment portfolio:

Understand the Concept of Complementarity: The key to effective diversification with alternatives lies in the concept of complementarity. This refers to how different assets move in relation to each other under various market conditions. By selecting investments that don’t always move in the same direction, you can reduce overall portfolio risk. For example, while stocks might struggle during an economic downturn, certain alternative investments like gold or hedge funds might perform well, balancing out your portfolio’s performance.

Consider Different Time Horizons and Liquidity: Alternative investments often have longer time horizons and lower liquidity compared to traditional assets. This can actually be beneficial for portfolio diversification. By including investments with varying time horizons, you create a portfolio that balances short-term flexibility with long-term stability.

Diversify Across Markets and Industries: When incorporating alternatives, look beyond just asset classes. Diversify across different markets and industries. For instance, in private equity or debt investments, choose companies from complementary industries. For real estate, spread investments across different types of properties or geographic locations. With commodities, consider a mix of different resources like metals, energy, and agricultural products. This approach helps protect your portfolio from sector-specific downturns.

Balance Risk Levels: Different alternative investments come with varying levels of risk. Consider how these risks complement the existing risk profile of your portfolio. For example, longer-term investments like private equity might offer lower market risk due to their extended time horizons. Physical assets like real estate or collectibles might have lower market risk but higher physical risk (damage, theft). The goal is to select alternatives that help balance out the overall risk of your portfolio.

Use Alternative Investment Funds: For many investors, especially those just starting with alternatives, using alternative investment funds can be a good strategy. These funds, which can include hedge funds, private equity funds, or real estate investment trusts (REITs), offer professional management and built-in diversification within the alternative space.

Consider International Alternatives: Looking beyond your home market can provide additional diversification benefits. International alternative investments can help protect against country-specific economic issues and provide exposure to different growth opportunities.

Start Small and Gradually Increase Exposure: If you’re new to alternative investments, it’s wise to start with a small allocation and gradually increase your exposure as you become more comfortable with how these assets behave in your portfolio.

Regular Rebalancing: As with any investment strategy, regular rebalancing is key. Because alternative investments can be less liquid, it’s important to regularly review your portfolio and make adjustments to maintain your desired asset allocation.

By thoughtfully incorporating alternative investments into your portfolio, you can potentially enhance returns while reducing overall risk. However, it’s important to remember that alternatives come with their own unique sets of risks and challenges.

How to Invest in Alternatives

Direct Investment: For those with significant capital, directly investing in private companies, real estate, or commodities is an option.

Funds: Mutual funds and exchange-traded funds (ETFs) focused on alternative assets provide a more accessible entry point for many investors.

Investment Platforms: Digital platforms are making alternative investments more accessible. For example, Daba is a platform that allows investors to access African startup and venture fund investments, traditionally a difficult market for individual investors to enter.

Real Estate Investment Trusts (REITs): These provide a way to invest in real estate without directly owning property.

Crowdfunding: Some platforms allow investors to pool money to invest in alternatives like real estate or startups.

Commodity ETFs: These provide exposure to commodities without the need to directly own the physical asset.

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Investment platforms like Daba are particularly interesting for those looking to invest in African alternatives. The platform allows investors to back promising African startups, providing exposure to the continent’s rapidly growing tech ecosystem. This type of platform democratizes access to venture capital investments, which were traditionally only available to institutional investors or high-net-worth individuals.

When considering alternative investments, it’s crucial to do thorough research and understand the risks involved. While alternatives can offer significant benefits, they also come with unique challenges. It’s often wise to start small and gradually increase exposure as you become more comfortable with these investment types.

For African investors, or those interested in African markets, alternatives present unique opportunities. The continent’s rapid economic growth, young population, and developing financial markets create a fertile ground for alternative investments. From tech startups in Lagos to solar farms in Morocco, from infrastructure projects in Kenya to commodity investments across the continent, Africa offers a diverse range of alternative investment options.

However, it’s important to note that investing in African alternatives also comes with unique risks, including political instability, currency volatility, and less developed regulatory frameworks in some countries. As with any investment, thorough due diligence and a clear understanding of the risks and potential rewards are essential.

In conclusion, while alternative investments were once seen as a niche area for sophisticated investors, they are increasingly becoming a mainstream consideration for portfolio diversification.

As the investment landscape evolves, particularly in dynamic markets like Africa, alternatives offer exciting opportunities for those willing to venture beyond traditional assets. Whether through established alternative asset classes or innovative platforms like Daba, investors now have more options than ever to diversify their portfolios and tap into unique investment opportunities.