Indirect Investing: Lowering Risk Through Diversification

Investing is risky business, but it's a risk that can be managed. One way to do this is through indirect investing, which is when an investor puts their money into a fund or financial instrument that is then used by an intermediary to invest in a desired asset or security. This means that the investor does not directly own the asset but instead owns a share in the fund that owns the asset. This has the advantage of diversification, as well as professional management, and is more accessible to a broader range of investors due to lower entry barriers. By spreading money across different assets, indirect investing minimises the impact of any one investment performing poorly, thus lowering the risk.

Lower barriers to entry

Indirect investing offers a lower barrier to entry for investors who want to build a global real estate portfolio. Direct investment in real estate often requires a large amount of capital, which may not be accessible to all investors. For example, commercial properties such as office buildings can cost nine-figure sums.

With indirect investment, individuals can invest smaller amounts of money by pooling their funds with other investors, thereby reducing the need for a large upfront investment. This makes it possible for investors to gain exposure to a variety of real estate assets without committing a significant amount of capital to a single property.

For example, with Real Estate Investment Trusts (REITs), investors can buy shares in a company that manages a portfolio of real estate assets. This allows them to own a portion of the fund that owns those assets without needing to purchase the properties directly.

Indirect investment options like REITs and mutual funds are also more accessible to investors who want a more hands-off approach and wish to avoid the challenges and responsibilities of property management. These investments are typically passive and are managed by professionals, allowing investors to benefit from their expertise without the same level of involvement required in direct investments.

Additionally, indirect investments may provide greater diversification benefits, as they allow investors to spread their money across different assets and reduce the impact of any single investment performing poorly. This diversification can help to lower the overall risk in an investment portfolio.

Greater diversification potential

Indirect investing allows investors to diversify their portfolios across a range of assets, which can help reduce risk. By investing in a variety of assets, investors can minimise the impact of any one investment performing poorly. This is known as diversification, and it is a key strategy for reducing investment risk.

Indirect investments such as mutual funds, exchange-traded funds (ETFs), and real estate investment trusts (REITs) offer investors exposure to multiple assets or properties within a single investment vehicle. For example, an investor can buy shares of a REIT that owns a portfolio of commercial properties, providing the investor with exposure to the real estate market without having to purchase physical properties directly.

By pooling their money with other investors in an indirect investment vehicle, individuals can spread their capital across different assets and reduce their overall risk exposure. This diversification benefit is particularly attractive for investors who want to avoid putting all their eggs in one basket.

Additionally, indirect investments often have lower entry barriers and allow investors to start with a smaller amount of capital. This enables investors to diversify their portfolios without needing a large amount of money upfront. By investing in a range of assets through indirect investment vehicles, investors can pursue the potential benefits of asset appreciation while minimising their risk exposure.

Indirect investments also provide access to professional management. The funds are typically managed by experienced professionals who make investment decisions on behalf of the investors. This can be advantageous for individuals who do not have the time or expertise to manage their investments actively.

Reduced exit barriers

Exit barriers are lower with indirect investments, such as real estate investment trusts (REITs) or exchange-traded funds (ETFs), compared to direct investments. This is because you can generally liquidate your position much quicker. For example, when you buy a house or a commercial property directly, you're typically tying up your finances for many years. On the other hand, real estate funds and stocks allow you to access your wealth more easily and redirect funds into other investment opportunities that may arise.

The liquidity of indirect investments provides flexibility in emergencies or when you need to access your funds without the hassle of dealing with property sales. Shares in REITs or mutual funds can be bought and sold easily on stock exchanges, giving you quicker access to your money. This is in contrast to direct real estate investments, which are typically less liquid and can take time to sell, making it challenging to free up funds quickly.

Indirect investments also allow you to pursue the potential benefits of real estate appreciation without committing a significant amount of capital to a single property. With a lower entry point, investors can start smaller and spread their capital among multiple funds, reducing the overall risk in their investment portfolio. By not tying up all your capital in a single property, you can more easily exit an investment if needed.

Furthermore, indirect investments can provide diversification benefits, which can help reduce the impact of any one investment performing poorly. By spreading your money across different assets, you lower the chances of significant losses and improve the overall stability of your investment portfolio. This diversification can be particularly valuable if you need to sell certain investments to free up cash, as you are not wholly dependent on a single asset.

Lower costs

Indirect investing is a process of investing money in a portfolio of bundled securities through an intermediary, such as a fund or a financial institution. It is a popular choice for investors who want to avoid the high risk and uncertainty associated with direct investment in the stock market. By investing indirectly, individuals can benefit from lower costs, which further reduces their financial risk.

Indirect investment vehicles, such as Exchange-Traded Funds (ETFs) and Mutual Funds, offer lower costs compared to other investment alternatives. These investment options are managed by professionals, who pool money from multiple investors to purchase a diverse range of assets. This diversification helps to reduce the overall risk and provides investors with access to a variety of assets without incurring high costs.

For example, with Mutual Funds, investors can benefit from the expertise of fund managers who select and manage a range of stocks on their behalf, providing maximum diversification. The fees associated with Mutual Funds are typically annual and are offset by the benefits of diversification, professional management, and liquidity.

Similarly, ETFs are traded on major stock exchanges and provide investors with exposure to a variety of assets. The costs of investing in ETFs are generally lower than other options, providing a more affordable way to access the market.

Benefits of Indirect Investing Beyond Lower Costs

In addition to lower costs, indirect investing offers other advantages that contribute to risk reduction. These include:

• Diversification: Indirect investing allows investors to spread their capital across various assets, reducing their overall risk exposure.
• Accessibility: With relatively low investment minimums, indirect investing is accessible to a broader range of investors.
• Liquidity: Indirect investments provide investors with the flexibility to buy and sell their holdings more easily compared to direct investments, such as physical properties.
• Expert Management: Indirect investments are managed by fund managers who have the knowledge and expertise to handle complex portfolios, allowing investors to benefit from their experience.

By choosing indirect investing, individuals can lower their financial risk through reduced costs and other benefits, such as diversification and expert management. This makes indirect investing a popular choice for those seeking a more accessible, flexible, and cost-effective way to invest.

Liquidity

There are two main types of liquidity risk: market liquidity risk and funding liquidity risk. Market liquidity risk occurs when an entity cannot execute transactions at prevailing market prices due to insufficient market depth, a lack of available buyers, or market disruptions. For example, an individual may own real estate but, due to poor market conditions, be forced to sell it immediately at a fire-sale price. The asset has value, but as buyers have temporarily disappeared, the value cannot be realised.

Funding liquidity risk, on the other hand, is the inability to obtain sufficient funding to meet financial obligations. This may be due to the entity's mismanagement of cash, its creditworthiness, or unfavourable market conditions which could deter lenders or investors. For instance, even creditworthy entities might struggle to secure short-term funding on favourable terms during periods of financial turbulence.

In the context of indirect investing, liquidity is improved because shares in investment funds are generally easier to buy and sell compared to direct investments in assets like real estate. This is especially beneficial for investors with shorter investment horizons or those who anticipate needing cash in the near future.

For example, indirect investment in real estate through a Real Estate Investment Trust (REIT) provides better liquidity than direct ownership of property. With direct ownership, converting the investment into cash would be a lengthy process, requiring the property to be prepped for sale, marketed, and put through a negotiation process before finally entering escrow and closing. This could take months. In contrast, shares in REITs are just as liquid as stocks and can be easily sold on the open market in minutes.

Indirect investing also provides the benefit of diversification. Buying shares of REITs, for instance, allows investors to easily invest in multiple REITs with different investment strategies, covering a wide range of asset classes in multiple geographical markets. This reduces the risk of investing by spreading it across a variety of assets and locations.

However, it is important to note that indirect investing may come with fees such as management fees, which can eat into investment returns. Additionally, indirect investments are still subject to market volatility, and there is no guarantee of positive returns.

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