IN recent years, alternative investments – such as private equity (PE) and hedge funds – have surged into the mainstream financial landscape. Traditionally preferred by large endowments and sovereign funds, these asset classes are increasingly accessible to individual or retail investors. This democratisation promises enhanced diversification, attractive return potential, and risk reduction.

In Asia and Singapore specifically, we have seen a series of new digital offerings putting pressure on banks, which have rushed to embrace this asset class. However, the rapid push to make alternatives widely available to individual investors raises significant concerns about due diligence, risk perception, and investor education.

As the industry embraces innovation, it must balance growth with responsibility to ensure that the benefits do not come at the expense of investor security.

Rise of alternative investments

The famed “Yale model” of asset allocation employs risk seeking and diversification strategies for a long horizon. This allocation approach has been increasingly adopted by institutions and family offices for its ability to offer returns uncorrelated with traditional markets. Singapore’s own GIC has been a pioneer of the “total portfolio approach”, which leans more towards alternative assets.

Among alternative assets, PE enables investors to participate in private companies’ growth; venture capital gives access to investments in early-stage companies; while hedge funds employ diverse strategies including long/short equity and global macro to generate alpha. Over the past decade, these asset classes have seen exponential growth, fuelled by strong performance in periods of market volatility and low interest rates.

The mainstreaming of alternatives is driven by several factors. More companies are choosing to remain private to avoid regulatory burden. This has coincided with advances in technology and financial platforms, which have lowered barriers to entry, enabling individual investors to access products which were, until now, exclusive to a select group of ultra-high-net-worth individuals and institutions.

Additionally, regulatory changes have broadened the definition of accredited investors, expanding the pool of potential participants. Fund managers, financial advisers and robo-advisers are increasingly incorporating alternative strategies into their offerings, driven by demand for more sophisticated investment options among retail clients.

Benefits of alternative investments

The attraction of alternative investments lies in their potential to enhance portfolio performance. Unlike traditional stocks and bonds, alternatives often exhibit lower correlation with traditional asset classes, providing significant diversification. This can lead to smoother returns and reduced volatility, particularly in turbulent market conditions.

PE and venture capital, for instance, can generate substantial returns through active management and strategic growth initiatives for portfolio companies. Hedge funds, with their varied strategies, can capitalise on market inefficiencies and generate alpha regardless of market direction. Alternative investments also require longer investment horizons.

Rush to mainstream

While the mainstreaming of alternatives opens doors for individual investors, it also introduces significant risks. The rapid expansion of these asset classes has outpaced the development of robust due diligence frameworks, leaving both institutional and individual investors vulnerable to poor investment choices. The complexity and diversity of alternative strategies make it challenging to evaluate performance and assess the competence of fund managers.

One of the primary drivers of higher returns in the alternatives space is the ability to select the right manager and the right fund. This places immense pressure on investors to conduct thorough due diligence, a task that requires expertise and resources often beyond their reach. Even institutional players, with dedicated research teams, may struggle to navigate this landscape.

Challenges in price discovery and liquidity

Alternative investments often suffer from poor price discovery and limited liquidity. Unlike publicly traded securities, alternatives are valued infrequently and assessments may be subjective. A lack of transparency can obscure the true performance and risk exposure of the investments, making it difficult for investors to make informed decisions.

The lack of liquidity means investors may find it challenging to exit their positions. PE investments, for example, typically have lock-in periods spanning several years, during which it is very difficult to sell and get back the invested capital. Hedge funds may also impose redemption restrictions. Investors will demand higher returns to compensate for the additional risk and reduced flexibility.

Some investors may be enticed by the potential for outsized gains without fully appreciating the underlying complexities and unique risks. This misperception can lead to overexposure and inadequate risk management within portfolios.

The imperative of investor education

Educating investors on the inherent risks of alternatives is paramount. Both accredited and retail investors must understand the unique characteristics of the asset classes, including their liquidity profiles, valuation methods, historical performance, and manager selection. Transparent communication about the potential for losses and the illiquid nature of the investments can help set realistic expectations and foster more informed decision-making.

The wealth management industry bears a significant responsibility to provide comprehensive information and support to investors. Financial advisers, fund managers, and platform providers should prioritise transparency and education, offering clear explanations of investment strategies, risk factors, and historical performance. Tools and resources that simplify complex concepts can empower investors to make choices aligned with their financial goals and risk tolerance.

Historical lessons: Cautionary tales

History is replete with instances where inadequate understanding of complex financial instruments led to substantial investor losses. The Asian financial crisis of the late 1990s, the collapse of Lehman Brothers during the global financial crisis and the more recent turmoil in digital assets – all underscore the dangers of insufficient due diligence and risk management.

As Singaporeans we have made a competitive sport of FOLO (Fear of Losing Out), or as we call it colloquially, “kiasu”, which sometimes makes us rush into the newest and latest things. Investors must guard against the pitfalls of overconfidence, overallocation (putting too many eggs in one basket) and inadequate risk assessment. The lessons from past crises are a stark reminder that financial innovation must be accompanied by robust safeguards and investor education.

Balancing innovation with responsibility

Innovation in financial markets is beneficial, driving efficiency, accessibility, and new investment opportunities. The democratisation of alternative investments aligns with broader trends towards financial inclusion. However, this progress must be matched with a commitment to responsible growth.

The industry must adopt best practices for transparency, due diligence, and investor education to mitigate the risks of alternative investments. Industry bodies and societies must play their part to instil standards for investor protection without stifling innovation. By fostering an environment where alternatives are accessible and well understood, the financial ecosystem can harness the benefits of these asset classes while guarding against their inherent risks.

A responsible path forward

As alternative investments go mainstream, there are opportunities and challenges. The potential for enhanced portfolio performance and diversification is attractive, but the complexities and risks necessitate a cautious approach. Investors must remain vigilant, and seek out education and guidance to navigate this evolving landscape effectively.

By fostering transparency, enhancing due diligence processes, and committing to comprehensive investor education, alternative investments can grow sustainably.

The collective effort of industry stakeholders, regulators, and investors will determine whether the democratisation of alternatives leads to broader financial empowerment or unforeseen vulnerabilities. The 60/40 portfolio (60 per cent equities, 40 per cent bonds) needs to be bolstered by asset classes with different return profiles and whose correlations support wider diversification.

By learning from the past and committing to a future of informed and cautious growth, alternative investments can indeed become a cornerstone of diversified and resilient investment portfolios.

The writer, CFA Charterholder, is a member of the CFA Society Singapore advocacy committee