By Kevin R. Mirabile, CPA, DPS
The current rationale for investing in exotic alternative investments is based on a combination of stand-alone returns, risks and portfolio effects. Today, exotic alternative investments offer investors an opportunity to achieve many of the stand-alone and portfolio benefits that hedge funds and other types of more traditional alternatives often struggle to achieve. These benefits include the chance to benefit from high absolute returns, low correlation to stocks and bonds, attractive risk-adjusted returns and yield premiums, inflation protection, and acting as a potential hedge against a recession. Some exotic alternative investments also offer the potential for significant upside to business disruption, deregulation and changes in consumer behavior, wealth distribution, and population growth. While the case for investing in new and exotic types of alternative investments is not without issues, it certainly seems to be strong.
In my most recent book, I researched a wide spectrum of attractive exotic investments ranging from artwork and collectibles to those based on financial contracts, such as litigation funding and life settlements. Other types of exotic investments discussed in the book include hybrids, such as farmland and genomic medicines, and those based on innovation and technology, such as eSports, gaming and Bitcoin. The book is intended to provide readers with a better understanding of the return drivers and value propositions, risks, and issues with this class of investment, as well as the impact of adding exotic investments to traditional stock and bond portfolios.
Historically, a collector might purchase a piece of artwork by Picasso, a financial investor might buy tax liens and trade claims, or a speculator might buy bitcoin or crypto currency in order to invest in exotics by direct transaction. In each such case, the amount of any investment would be a function of the time, expertise, and research skills that a particular investor was willing to commit, as well as the access to investment opportunities available to any one individual. This paradigm, however, limits the allocation of capital to categories of investment where the need for available capital is far greater than the supply. It constrains growth in many of these markets and leads to inefficiencies in pricing.
This, of course, is good for investors. For example, the demand for capital to fund litigation and commercial disputes of class action lawsuits far exceeds the amount of investor funds allocated to this space. The same could also be said for art finance, litigation funding, tax liens, trade claims, crypto asset infrastructure, and many emerging eSports and gaming ventures. This imbalance between the demand for capital in the form of direct investment of loans and the supply of capital can produce higher returns in many of these asset classes, relative to their risk. Consider life insurance contracts, which when purchased for a large group of individuals with predictable life expectancies can have a far greater yield than one might expect from what is otherwise, essentially, a portfolio of receivables from AAA insurance companies. For its part, art-based lending offers excess collateral, independent appraisals, and insurance, yet can also generate 8-12% yields, despite loan-to-value ratios of 50% or less.
More recently there has been an explosion of niche-oriented private funds, mutual funds, public companies, exchange-traded funds, and robust trading and research platforms to facilitate a combination of direct and commingled investments, along with lending and funding opportunities for many exotic alternative investment asset classes. In fact, today, individuals can obtain fractional ownership in items including baseball cards, comic books, farmland, contractual disputes, or bitcoin. They can also gather interest in loans to finance shipping containers, litigation, vintage automobiles or motorcycles, and more. These opportunities have opened up the market and allowed for the utilization of a new combination of structures and investors to gain exposure.
In the book, I present original research on exotic alternatives that focuses on the period between January 2016 and March 2020. The research shows that exotic alternatives can be valuable both as stand-alone investments and as part of a diversified portfolio. One of the most salient research observations is that a composite of many exotics exhibits a higher Sharpe ratio than traditional stocks and bonds (or even traditional alternatives like hedge funds). This is because many exotics - such as litigation finance, life settlements, cannabis, homeopathic and genomic medicines, and eSports - offered the opportunity for higher returns than traditional stocks, bonds and hedge funds, while also having a low correlation to these markets and to each other. Table 1 shows the stand-alone returns, risk, and correlation of some individual exotic alternative investments, as well as a composite constructed using a sample of private and public investments from a wide range of exotic asset classes.
eSports and Gaming
|Cannabis and Alternative Medicines||
Exotic Alternatives Composite
|Hedge Funds, Private Equity and Real Estate composite||
|Correlation to S&P 500||0.12||-0.13||.66||0.03||0.44||.88||1.0|
Source: Author’s calculations
Moreover, the research showed that a portfolio of exotic alternative investments also had some very attractive risk parameters compared to traditional alternatives and the S&P 500. For example, Table 2 shows that an exotic alternatives composite had a worst case month of negative 8%, a positive skew of 1.89, a best case month of 26% and 37 positive months out of the 48 months considered in the research sample.
|Worst case month||-8%||-6%||-9%|
|Best case month||26%||8%||9%|
|% positive months||77%||73%||75%|
Source: Author’s calculations
Despite the seemingly clear-cut conclusion that there are benefits to adding exotic alternatives to traditional portfolios, there are still skeptics. Some stay away from certain asset classes on social or ethical grounds. They may be uncomfortable investing in instruments that generate windfall returns based on increased mortality, such as with life settlement contracts. Perhaps they feel that funding litigation promotes frivolous lawsuits and a more litigious society, or that decriminalization of cannabis will have adverse health effects on individuals or lead to greater societal drug use.
On the other hand, certain investors have determined that there are alternative investments that improve society by providing capital to issuers at a time when they most need it, as is the case with particular pandemic and catastrophic loss bonds. There are also investors that may recognize the social justice arguments for the legalization of cannabis, or who believe that investing in intellectual property will fund research and development leading to scientific breakthroughs (such as advancing homeopathic and genomic medicines that can save or extend lives).
In today’s environment, investors in search of new ways to diversify their portfolio have an opportunity to benefit from exotic alternatives. The market is growing, and there are now more vehicles, indices to track investments, and exchanges to trade this asset class than ever before. In recent years, individuals, family offices and a few institutions have begun to take notice. Still, more research and better infrastructure is needed to expand access to many of these opportunities. In addition, every investor will need to balance the risks, rewards and the potential legal or ethical issues evoked if they buy into the rationale for this asset class. My hope is that the more people are open to taking a thorough look, the more attractive some of these opportunities become.
Kevin R. Mirabile, C.P.A, D.P.S. Mirabile is a Clinical Associate Professor of Finance at Fordham University. He teaches courses on the principles of finance, investment analysis, derivatives and alternative investing. Prior to becoming an academic, he held several senior executive positions at Morgan Stanley, Barclays Capital and Larch Lane Advisors in banking, sales and trading and asset management. Responsibilities included securities operations and financing, electronic trading, derivatives and hedge fund investing. Mr. Mirabile received his B.S. in Accounting from S.U.N.Y Albany in 1983, M.S. in Banking and Finance from Boston University in 2008 and doctorate in Finance and Economics from PACE University in 2013. He is an author of several articles and books on alternative investments and hedge funds. In January of 2021, he published his most recent book on the subject of “exotic alternative investments.”