Increased competition in the wealth management industry, the high fees on traditional asset classes, and the decreased valuation of bonds and stocks have encouraged investors to seek innovative ways to maximise their returns. Alternative holdings, such as gold and art, outside of the traditional asset classes of equities and debt offer investors a dynamic approach to asset allocation, enabling an efficient diversification of their portfolios. The ability to diversify risks, in the case of strong market extremes or extreme volatility, make these investments more attractive. Assets such as Art and Gold, provide returns that are less correlated with returns from traditional asset classes, due to their exposure to non-traditional cash flow.
Key alternative assets such as Gold, are considered safe assets, especially during economic downturns, as they tend to store value for a long period. The large reputation of gold as a safe haven asset is also due to its lack of positive correlation with another asset in times of market turmoil, thus, providing a sense of safety. The graph below shows the extreme volatility and market turmoil caused by the current Coronavirus Pandemic. As gold is a hedge for stocks, we can see a negative correlation with the MSCI China TR and the MSCI Emerging Markets TR. If the price of one asset increases the price of the hedged asset falls, as seen as a reduction in gold.
Source: Financial Times, (Lipper & Tilney, 2020)
This confirms that Gold is a good diversifier and a safe haven asset, providing cumulative returns in the case of market turmoil, and portfolio stability. However, given the properties of gold as a hedge, it may only function as a safe haven asset for a limited time, of around 15 trading days (Baur and Lucey, The Financial Review, 2010), and then the investor may experience losses in the long run. As seen in the graph, the return of gold is positive on the day of an extreme negative shock in the stock market, and then the price declines reducing potential returns from larger than 4% to 2%. To reduce losses, it is advised to allocate approximately 10% of the portfolio to gold (Hillier et al, Financial Analyst Journal, 2006).
Investing in Art, as an alternative holding has continued to increase these past years, especially with the increase of High Net worth individuals (HNWI). Art offers unique advantages for investors, specifically, it is inflation-protected, provides a hedge against currency devaluation, and it is not subject to geographical risk like gold. If the investor is part of an Art fund there is the additional advantage of generating cash inflows by lending the artwork.
Even though alternative assets offer large benefits to investors they possess a large degree of complications and risk exposures that can affect a stable portfolio’s returns.
Gold has been perceived as a hedge against inflation, however, this is not reliable. Studies by Wright & Macmillan (2001) on ‘Gold as an Inflation Hedge’, conducted on five countries (UK, USA Germany, Japan and France) over a short term period demonstrate that gold was not an effective short-run inflation hedge, as the price of gold is in dollars, and both the movements in the dollar price of gold and the exchange rate will affect the price of gold in any individual country, as the value of gold is tied with the according to inflation. This creates currency risks, as gold is affected by demographics (Baur & McDermott, Journal of Banking and Finance, 2010)
Art as an alternative investment it carries an important caveat specifically its illiquidity. Generally, art has to be held for a long period before the investment turns profitable. The time it takes for the investment to appreciate may make it less attractive for investors with lower capital reserves. High due diligence costs are associated with owning it. The risk of authenticity arises in the regards that it is difficult to discern the authentic artwork from a counterfeit one, and the transaction is strongly dependent on trust on that specific seller. Furthermore, the unregulated art market is often filled with a problematic lack of transparency. The risk of encountering a counterfeit piece may be small, but not impossible. Also, high transaction costs, of around 10-25% for the buyer and 10% for the seller, need to be considered.
When incorporating illiquid alternative assets in their portfolios, such as art, investors are faced with a difficult choice. How much should they invest? According to modern portfolio theory, the proportion invested in an any given asset should be such that it minimizes the portfolio variance while maximizing the portfolio expected return. However, the illiquid and informational inefficient nature of assets such as art creates an obstacle as the expected portfolio return and variance cannot be calculated as easily compared to widely traded assets such as stocks. As such determining the exact amount of funds to invest in art to arrive at a mean-variance optimal portfolio is more intricate and requires more sophisticated modelling.
In conclusion, alternative assets provide a means for diversification. Furthermore, gold has proved during market downturns, that it can serve as a safe- haven asset. Holding a percentage of gold, offers some benefit and diversification, allowing for better risk-adjusted returns than portfolios comprised of only traditional assets. Art may not be a good choice of investment for some individuals, given their high transaction costs, their illiquidity, the lack of transparency and complications to measure return. Taking into account the risks associated with alternative assets, and different components in assessing returns are key for a balanced and stable portfolio.