Should you invest in alternative investments?

Sir, off late I keep hearing about alternate debt instruments, especially investing on "invoice discounting" platforms. Is that proven? Is that something Value Research would suggest to try with some surplus debt investment cash? Is there a risk? They are promising about 10 to 11 per cent IRR, as the company has to pay an interest of 12 per cent or so for discounting. - Sriram Ramanathan

Equities are for wealth creation. Fixed income for capital preservation and regular cash flows while keeping up with inflation.

Now what are alternative investments?

Alternative investments are supplemental strategies to your traditional long-only positions in equities, fixed income and cash. They include investment in five main categories, viz., hedge funds, private capital, natural resources, real estate and infrastructure. The common characteristics of such investments are: low liquidity, less regulation, low transparency, higher costs and limited historical risk and return data.

All of this makes this asset class not advisable, at least for retail investors.

Invoice discounting
Invoice discounting is a form of short-term financing for businesses which is usually financed by banks. It would fall under the category of private capital, specifically private debt. This is a rather age-old product which has been in existence for over a century. Banks have been at the helm of it. Here, the risk-return trade off is highly skewed, i.e., the upside is limited and the downside is a 100 per cent loss of investment. In addition, the diversification effect is simply not sufficient to justify the added risk to your portfolio.

And how does this work?

Suppose you supply goods to a company on credit. You draw a bill of exchange, the buyer accepts the bill and agrees to pay at the end of the credit period, say 30-90 days. Now your money is blocked for this period and if you need funds, you can approach a bank and give them this bill in exchange for receiving the money. Banks would take their cut and pay you the rest. This is where the term 'invoice discounting' comes from. You exchange an invoice at a discount. Banks have been doing this for over a century in some form or the other.

Recently, this has taken a new form where retail investors can fund business and play the role of a bank through the emergence of various fintech platforms. While such entities have been subject to regulations over time by RBI and SEBI, this is a rather niche product. Your biggest concern should be 'what happens in the event of default?'. These platforms lure you in with attractive marketing ploys while the relevant information such as risk disclosures are hard to find or even absent. As an investor, understanding the risk of an investment is more important than simply looking at the returns. In the event of a default, banks have separate departments to take care of that.

What about you as a retail investor? Are you willing to wait for however long it takes to see if you can recover the money? Are you willing to risk 100 per cent of your investment for a mere few extra percentage of returns?

We don't think so.

These are illiquid instruments and you are not likely to find a buyer for it if you wish to sell it. If the goal is diversification, then think about it - you are lending to a small business in exchange for receiving payment from a bigger business, and in case of an economic downturn, all businesses are affected alike, some more than others.

So what should you do?
Stick to equities.

Equities provide better returns when taking on similar risk. Mid-cap and small-cap funds have given better returns for lower risk. So if you have an appetite for such high risk, then we recommend you invest in mid-cap and small-cap funds instead. Debt is supposed to be an asset class to preserve your capital and keep up with inflation.

Choose from funds handpicked by our team of analysts.

Suggested read: Alternative investment funds vs mutual funds

This article was originally published on January 20, 2023.