One of the key risks that investors need to focus on when investing into alternative investment is liquidity. Investors may find that less liquid investments become unmarketable during a market downturn. Prior to the GFC, liquidity risk was not a key concern for investors. In fact, some of the financial models even omitted liquidity risk. However, in the post-GFC period, the investment industry is aware of the risks of a liquidity withdrawal and its impact to the system.

In the public market, liquidity risk is less of a concern as investors can easily exit the position at the prevailing market prices. Meanwhile, alternative investment has a high liquidity risk as there is no guarantee that investors could exit and sell their investment.

For example, a private equity fund usually comes with lockup periods. This means that the private equity fund requires investors to commit capital for at least a certain period, making the funds inaccessible during this lockup period. Aside from that, some of these funds require redemptions done by fund managers only. Another common example of alternative investment is real estate. In a bad market condition, the real estate asset can only be sold imminently at a fire sale price. The disposal of the real estate also takes a long time to process.

Most of the alternative investment assets do not have a straightforward net asset value process. This is especially true for those alternative investments that do not have a liquid secondary market. Among some of the assets with the highest valuation risk include venture capital and private equity investments.

While valuation services are available through third-party such as fund managers, there are obvious incentives for the report to be biased in favour of higher valuation. Aside from that, valuation of alternative investment such as art and collectibles is also susceptible to valuation risk. The fluidity in art and collectibles makes it hard to put a value in this asset class. Among some of the most common collectibles are antiques, coins, comic books, baseball cards, figurines, stamps and others. The value of these collectibles depend on several factors such as commercial, social and intrinsic value based on their condition, rarity and original purchase price.

Another example is the latest rage in cryptocurrency and NFT (non-fungible tokens). Value is based on the perceptions of owners and buyers, scarcity, access as well as the distribution channel of the NFTs. The influence on value of these assets could be highly speculative and varies depending on the nature of these NFTs. Some of the NFTs are purely based on artworks while some others even offer smart contract capabilities.

Basically, there is no guarantee that today’s hot hand will be tomorrow’s star.

Market risk is unavoidable for both conventional and alternative investments, but it tends to be much higher for the latter. Generally, market risk refers to the impact of the performance of the entire market due to changes to the interest rate, exchange rates, geopolitical events and other macroeconomic factors. It usually occurs due to sector cyclicality or broad economic downturn.

Given that the underlying assets of alternative investments behave differently to the moving dynamics of the macro environment, this could expose investors to unexpected losses. For example, in the real estate industry, the changes to interest rates and economic growth will have a significant impact to its valuation. It is also worth asking if the changes in the market could pose unforeseen operational risks to the underlying assets of the alternative investment.

In comparison with the conventional investment, most alternative investments carry higher fees. A good example are the private equity funds and hedge funds that have a range of two to three per cent fees on the managed assets value as well as another 20 per cent performance fee.

The fee structure also varies depending on the alternative investment assets. For example, if you were to invest in the cryptocurrency space, the fees could be even lower than the conventional investments. However, if you invest into arts, collectibles and wines, there are additional fees for appraisals and other processes.

Some of these alternative investments are only available through auctions, which take a percentage of each transaction. It is also important to take note of other charges such as maintenance fees. This applies to your investment into real estate.

Given the fragmented structures of the alternative investment and the variation of the fees, investors need to understand the fee structures of the alternative investments based on the platforms that are being used to gain access to such asset

Personally, the lack of regulation in the alternative investment space allows innovation to take place at a faster pace than conventional investment. This is most obvious with the development of blockchain and cryptocurrency over the last 10 years. However, this comes with the regulatory risk that investors have to pay attention to.

In recent years, we have seen the surge in fraudulent cases involving cryptocurrency and NFTs. This is mainly due to the lack of regulation and guidelines for investors. Scams are also becoming more prominent as there are still a lot of investors who do not understand the blockchain ecosystem. It is also difficult to offer investors protection without a proper regulatory system in place. In the long run, this would have a negative impact on investors’ confidence and trust towards the underlying assets.

Other alternative investment such as collectibles, arts and jewellery also come with a higher risk of fraudulent investments. These investments are usually not subjected to the same reporting and disclosure requirements in conventional investment assets. Without some of these requirements in place, this will cause rampant issues when it comes to pricing and price transparency.

Billy Toh is an investment advisor with one of the local brokers in Malaysia. He has a wide array of experience in the investment industry, ranging from asset management, research and financial journalism. A believer of the capital market as capable of doing good, he focuses on reaching out to the next generation of investors.

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