The other way to make good money

By Radhika Gupta 

With increasing income, investments other than equity, fixed income and gold are gaining popularity, especially with high net worth individuals. The reason they look at alternative and exotic investments is diversification and increasing returns. While alternative investments also have the potential for substantial capital appreciation, often in excess of traditional investments, they have a larger probability of collapsing too, increasing the risk. However, some alternatives, such as commodities can hedge your portfolio in a market crisis.

ALTERNATIVE OPTIONS

While almost anything that has tangible value can qualify for an alternative investment, a couple of ideas have become very popular among investors in the last 10 years.
Private equity funds are one of the most popular alternatives in India, with hundreds of domestic and foreign funds available to the Indian investor. PE funds are essentially a pooled vehicle for investing in unlisted emerging companies that have substantial growth potential, as opposed to mutual funds that invested in listed and more mature companies. PE funds take large stakes in their companies and often play an operational role and bear higher risk than equity mutual funds. Because of the additional risk, they should provide substantial additional return, 25-30 per cent a year, where listed equities return 15-20 per cent. Among financial assets, hedge funds—alternative strategies that use instruments such as commodities, currencies and equity derivatives to generate returns uncorrelated to the market—are also now finding favour in India. Film funds are also another unique asset class—pooled vehicles investing in selected film projects—and a number have already been launched and gained investor traction.

Among physical assets, wine is an asset that has been recognised as an asset class of its own, with the London International Viners Exchange setting up a benchmark for wine that tracks the top 100 wines. Wine, either bought as individual bottles and stored in cellars, or in the form of wine funds managed by a professional (available in the US and UK), has typically returned 10-15 per cent annually over the years, comparable to the performance of global equities. The return of course has varied greatly by fund and bottle vintage. A broader asset class of collectibles, such as stamps and coins, has also found favour with investors. Coin investing—picking up rare coins from around the world that have unique aesthetic value and will appreciate—is popular as investors look at coins in gold, silver, and other precious metals. Stamp collecting—collecting postage stamps that will appreciate over a 15-plus year period, has a 100-plus year history as a collectible asset class, with well-known strategies for stamp investing. Art—whether collected in individual form as unique paintings or sculptures, or in a pooled vehicle as a fund—has also caught on with investors, although the launch of the first art fund in India (Osian's fund by Neville Tuli) had left investors with a bitter taste.

THE RISKS OF ALTERNATIVES

Exotic investing is high on risk. For one, most physical and financial alternative asset classes are illiquid. It is virtually impossible to get your funds if (a) you suddenly need the money, or (b) there is a market crisis and the investment is not performing in the interim. Pooled vehicles have experienced this first hand; Osian's art fund eventually shut down for this reason.

Holding costs are also a challenge for physical assets. Wine, stamps, coins and art when bought in an individual capacity (rather than a fund structure) do not live in demat and fund form, and your inventories can quickly build up. Storage costs are non-trivial, and storage quality is very important. The right storage can make all the price difference for two wine bottles after a 15-year period.
Valuations and the lack of transparency in them is also a difficult issue with exotics. Unlike equities and commodities that have tradable prices, wine bottles, sculptures and two year old tech companies don't list on the NSE and, typically, bias gets in the way of their valuation. Moreover, there are no known benchmark like the Nifty to measure performance.
Finally, what influences the prices of these products is ultimately out of our hands. The coin market, for instance, can be drastically affected by the government's coinage policies—stopping putting silver in coinage or changing mintage policies—which we may have 
no idea about!

REGULATION OR THE LACK OF IT

One of the biggest challenges with alternatives is the lack of regulation around the asset class. Financial investments such as private equity funds, for instance, are regulated under the Sebi Venture Capital Regulations or the Portfolio Manager Regulations, as are some hedge fund-like products, but reporting standards are hazy at best.

The proposed Sebi Alternative Investment Fund regulations is likely to correct many of the problems and create clear structures for PE/VC/Hedge Fund investing.

The situation for physical asset classes is even more complex. Like Osian's now-defunct art fund, wine funds and stamp funds, too, are completely unregulated. Besides the problem with both financial assets, such as PE funds, and physical assets, such as wine, the underlying asset (not the fund) is also not regulated. In these, you are really investing on faith!

SHOULD YOU INVEST?

With all the risks and rewards known, should you invest in exotics? As usual, it depends your investment sophistication. If you have not covered basic asset classes such as equities, debt and commodities, it is too early to start thinking alternatives. However, if you have got the basics in place, you should start, with a couple of caveats in mind.

The most important is start small. Only invest what is purely excess risk capital that can be tied up at least for 5-plus years (don't expect multibaggers in two years) and with which you can take serious risks. Finally, alternatives should be no more than 5-10 per cent of your total portfolio.

INVESTMENT PLANS

As with a traditional investment, it is important to have a strategy and do the right due diligence.

Focus on quality. Wine, art, stamps and unlisted companies are already so exotic that, within this pool, one should focus on quality. Invest in a few quality assets, particularly if you are buying in the physical form as a large numbers of assets add to storage costs and pare returns. Stay clued into the investment market. With physical assets, find the right storage options.

Buy from reputed dealers, agents and distributors. With financial assets, ask the private banker for all the due diligence and with a physical product, do a check on ethics, past history and track record. Beware of large upfront fees, and check the prices and commissions. If it seems too high or too low, there is probably an issue. Portals for wines, stamps and collectibles can give you an idea of prices.

When choosing a fund, look at its track record, particularly during tough times. Check how carefully 
performance is calculated and ask for audited numbers; see if the fund has returned money back to investors on time. With private equity, check the exit track record of the manager because mark-to-market return means little. Check on fund size, and invest in funds that have the right size for an asset class. Assets of `1,000 crore may be too much for a venture fund, while `1 crore too little for a film fund.

Alternatives are definitely a worthwhile space to pursue, when done in the right quantity and with the right approach.

The writer is co-founder, quantitative investment, manager, Forefront Capital Management 
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