This is the first piece in a series of three short articles that will address investing in non-bankable assets and focus on critical considerations when one’s investment portfolio includes such alternative investment vehicles.
We first introduce investing in non-bankable assets in the article below and then in forthcoming articles we will focus on the use of Machine Learning and Blockchain technologies for improving the risk/return estimation of non-bankable assets on the one hand, and for creating a liquid marketplace to exchange them on the other.
Investing in a new era
Investing nowadays and achieving a good return, without significant risk, is not an easy task. The proliferation of opportunities for potential investors often obscures the complexity inherent in each of them. Many investors find the risks of direct equity investments out of proportion to their potential returns, and so look for alternative sources of alpha. However, the devil lies in the detail. For example, it is possible to invest online using one's own account in the foreign exchange, derivatives or commodities markets (e.g. using eForex trading platforms from providers such as Saxo Bank or Swissquote). These platforms enable retail investors without any previous experience to access such markets by facilitating relatively small initial investments. This possibility can in fact be highly risky for individual investors, despite the prevailing view that FX investments are of a lower risk than investing directly in equity. These platforms frequently offer high leverage and untrained investors can quickly accumulate significant exposures over time as they become emboldened by initial successes.
The hidden dangers of leveraged investments
In the foreign exchange market, investors use leverage to profit from the fluctuations in exchange rates between two different countries. Since currency prices usually change by less than 1% over a trading day, many brokers will offer very high leverage ratios. For example, a $100,000 currency trade could be offered with a margin of 1%; in other words, the investor will only have to deposit $1,000 into her or his margin account with their broker to be allowed to trade on 100 times the amount. The available leverage in the forex market is one of the highest that investors can obtain. It is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage encountered in the futures market.
Yet, the opportunity offered by leveraged trades comes at a price, potentially very high, which must not be neglected. If the currency underlying one of the trades moves in the opposite direction to what the investor expects, the leverage dramatically amplifies the losses. To avoid a fiasco, forex dealers, for the most part, maintain strict trading rules that incorporate the use of stop and limit orders to control potential losses - all of which requiring a certain level of expertise and a time-commitment reserved for more sophisticated investors. By no means easy.
Shouldn’t we stick to more traditional investments?
Investing in the most popular asset classes is simply not as lucrative as it once was. Clearly, in respect to Fixed Income investing, a portfolio of safe government bonds is unlikely to deliver the rates of the previous decades – and in some cases, little more than retail bank deposit rates. The situation has forced even the most risk-averse investors to seek new ways to "buy" risk to finance themselves over the long term. Doing so has led many investors to become even more exposed to the upheavals of the equity markets - a situation that notoriously applies to many pension funds nowadays.
What are non-bankable assets?
Faced with these new difficulties and uncertainties, there is an alternative asset class that is recovering – almost as if arriving after a long desert crossing. Non-bankable assets can include direct investments in companies' own funds, the purchase or co-acquisition of primary or secondary residences, works of art, and rare collectible objects (e.g. luxury cars, boats, high-value jewelry, etc.).
How do these differ from traditional financial assets? Bankable assets are, by definition, collaterals used by banks to guarantee the repayment of a loan. Non-bankable assets do not belong to this category. They are frequently non-liquid assets, which by their specific nature and intrinsic risk/return valuation complexity (e.g. due to the lack of past transaction data) are excluded by most financial institutions as a guarantee for a loan.
Because of this inherent complexity, non-bankable assets are typically excluded or managed independently from other more traditional financial assets in an investor’s portfolio - even for high net-worth individuals under common wealth management conditions. Usually, more holistic portfolio management, which includes non-bankable assets, is only offered to a very wealthy elite in exchange for high management fees (e.g. to family offices).
Why are non-bankable assets a unique opportunity for wealth management?
First and foremost, non-bankable assets have an optimal risk diversification effect on a portfolio of risky financial assets in highly correlated economies, where it has become increasingly costly and complicated to hedge against systemic risk properly.
Since the advent of Distributed Ledger Technology (DLT) and the Blockchain, non-bankable assets have given investors direct access to niche sectors, such as art, classic cars, luxury watches and jewelry, as well as wine and wineries, to name just a few of the markets. These rather uncompetitive markets are arguably less efficient than standard security markets and, therefore, can offer attractive arbitrage opportunities to passionate, or merely knowledgeable, investors.
The boom in DLT has had another very positive impact, which has helped drive the renewed interest in non-bankable assets. DLT allows anyone to quickly set up their marketplace at moderate costs. Virtually anything can be exchanged with minimum friction and without the need for intermediaries. Often referred to as the ‘Uber’-ization of assets, the concept of the shared economy is embodied in these new market places. In essence, investors can share in a part of the value or experience of an asset, without taking responsibility for full ownership and management of the assets. Meanwhile, the asset owner can gain additional returns on their underutilized assets - in a similar way to an Uber driver sharing a car with multiple passengers.
Furthermore, the technological edge of the blockchain enables one to operate within a scalable operational cost structure by limiting the impact of some of the most expensive intermediaries in the non-bankable asset investment chain (notaries, banks, etc.). It is worth noting here the fundamental market transformation that followed the apparition of the Ethereum Blockchain and its flexible smart contract concept.
Democratization of wealth management
These transformational changes are leading to one of the greatest redefinitions of the wealth management landscape. A democratization of wealth management is taking place, whereby non-bankable-assets are no longer the preserve of an elite few but can be brought to the benefit of the broader investment community.
In the next couple of articles of this short series, we will address the following questions:
- What are the main challenges for integrating non-bankable assets into a traditional wealth management scheme?
- How to use advanced machine learning techniques to compensate for data scarcity (too few data points) and data sparsity (data points irregularly spaced over time) in estimating non-bankable assets expected risk and returns?
- How to monetizing the ‘experience’ of non-bankable assets – and how a unique secondary market can be offered to non-bankable asset investors?
- How distributed ledger technology is being used (and abused?) in the value chain?
- How to manage and operate non-bankable assets with Avaloq?