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According to a leading barometer of global investment trends, the world’s wealthy held 14% of their assets in alternative investments in 2014, increasing their allocation from 10% the year before.

A variety of factors suggests an appetite for alternatives will keep on rising as more affluent investors come to appreciate the important part they can play in intelligently managing their wealth.

In the past it used to be the case that a rough 60/40 split between fixed income (bonds) and equities was the template for constructing a portfolio for what you might call a typical investor looking for a balance of income and growth. Things have moved on significantly now, however. Savvy investors subscribe to the tenets of modern portfolio theory, which emphasises the importance of diversifying holdings among asset classes, sub-asset classes, markets and instruments in a bid to generate superior returns and minimise risk. While traditional assets (bonds and equities) may still comprise the bulk of most investors’ portfolios, the complementary role a (relatively small) allocation to alternatives can play in properly diversifying a portfolio and therefore mitigating against risk should not be ignored. Nor should the superior returns and attractive tax benefits alternatives can hold out. There are subsequently a range of opportunities that you might like to explore with a wealth manager. An in-depth discussion of the alternatives “universe” available for your portfolio size and risk tolerance may uncover lots of attractive options.

The alternatives universe

The term “alternative investments” is in fact incredibly broad in terms of how many types of investment come under this umbrella. Each has its own distinct characteristics and risk/return profile, and therefore pros and cons for achieving your own investment objectives. At the most familiar end of the alternatives spectrum is property (both commercial and residential) which, as one might expect, is a perennially popular type of investment among affluent individuals the world over – both directly and through vehicles like property investment funds.

Slightly more complex, because of the investment instruments typically used, but with the same kind of real world tangibility as property, are commodities, which in turn can be broken into two categories: hard and soft. The former covers those which are mined or extracted (precious metals, diamonds and oil) and the latter those which are grown (coffee, wheat, cotton). Of course, commodities investors generally don’t take physical delivery of the asset they have put their money into and may not be investing directly, so collectives (and some pretty complex investment instruments like futures contracts) figure highly here.

Readers with a keen eye on investment risk may well be thinking about the vagaries of geopolitical strife or adverse weather conditions at this point, and they are right to. Commodities, and indeed alternatives in general, can represent significantly more risk than traditional assets, but this naturally means that they can often hold out far greater rewards too. If one backs a privately-held company there is a risk that the company fails, yet on the flipside, it may be a huge success which rewards grass-roots investors handsomely.

Likewise, trading in hedge funds or the fast-moving foreign currency or derivatives markets can see fortunes fall – but also rise – dramatically. Some alternatives, like hedge funds and derivatives tend, therefore, to be the preserve of the more sophisticated investor, who is more sanguine about risk and feels confident enough in their financial knowledge that they feel able to “look under the bonnet” of these types of investments. While having a granular understanding of how every asset class and instrument behaves is the business of the professional investment managers who advise wealth management clients, you should certainly never invest in anything you don’t understand.

Arguably at the most esoteric extreme of the alternatives spectrum are tangible investments or investments of passion, which include items such as prestigious cars, art, jewellery, watches, fine wine, stamps and collectibles. But while investing in these kinds of assets is doubtlessly highly arcane when it comes to having the knowledge required to be able to identify good opportunities and make healthy returns consistently, they are perhaps the easiest to understand from a psychological perspective.

Attractive returns

There is an increasingly strong case for passion investing on the returns front. In its research, private bank Coutts has found that a basket of 15 types of tangible asset delivered significantly stronger returns than equities over a seven-year period, for example. With some passion investments there may also be attractive tax-efficiencies on offer, such as with fine wine that has a drinkability horizon of less than 50 years and is therefore classed as a wasting asset for Capital Gains Tax purposes. Yet it is perhaps the non-financial returns – the pleasure of driving that car or wearing that timepiece – that ensures that passion assets are becoming increasingly popular, even at the more modest ends of the wealth scale.

For some individuals, the enjoyment factor may more than make up for a lack of stellar returns from a passion asset; equally, the financial objectives of others may not provide scope for this. Similarly, others looking to aggressively grow their wealth may be prepared to take on the additional risk represented by hedge fund investing in a bid to garner impressive gains, while the more cautious investor may feel uncomfortable with such an approach.

It may be that you have different pots of money in mind when it comes to the management of your wealth and so you may feel comfortable with taking on more risk through gaining exposure to alternatives with a portion of your portfolio (sometimes referred to as a core-satellite approach). Nevertheless, alternatives will usually account for only a small proportion of most investors’ assets overall – usually no more than 10%, the received wisdom would seem to be. Where the wealth manager really adds value is to discern what type and level of alternatives investing (if any) is appropriate for your objectives, risk appetite and time horizon, in light of your other holdings. As their name suggests, alternatives really are one area where specialist knowledge is called for, along with a holistic overview of your entire exposures. The rewards of investing in alternative assets can be great, but so too can be the risks for the unaware.

*The 2014 RBC/Capgemini World Wealth Report