What is The Role of Alternative Investments in Diversified Investment

2 min read

What is The Role of Alternative Investments in Diversified Investment

Alternative investments, which have been used by large institutions and foundations for quite some time, have become more mainstream in the last years. Not only are they more popular among individual investors, but there are also more products available, making investing in alternatives possible for a much broader universe of investors.

Given their non-traditional approach and their ability to invest in areas and ways traditional investments cannot, they have the potential to improve the overall risk-return characteristics of a portfolio. As such, a modest allocation to alternatives may be prudent for more investors than previously was the case.

However, the non-traditional approach and structure of these investments bring with them unique risks of which investors must be aware.

Different approach

Alternative investments use a different approach to investing than do traditional equity or fixed-income investments.

This approach may involve holding both long and short positions in securities and holding private securities instead of publicly traded investments. And there may be derivatives or hedging strategies as well. Investors using alternatives may also have a goal of achieving a particular level of absolute return as opposed to relative performance versus an index. 

Alternative investments have the potential to enhance the risk and/or return characteristics of an investment portfolio. They can potentially enhance diversification and reduce risk; with their ability to be more flexible and invest in a wider opportunity set, they can potentially enhance return.

 

What is The Role of Alternative Investments in Diversified Investment 1

 

Different risk

Alternative investments have different risks and characteristics than do traditional investments. They are less liquid, particularly in periods of stress; they are generally more complex and less transparent.

These characteristics make them difficult for inexperienced investors to understand and they are more subject of investment manager failure.

The successful implementation of an alternative investment strategy relies largely on the investment manager’s experience and skill because of the wide range of investment opportunities.

Satellite asset classes

This is in contrast to managers specializing in specific asset classes such as commodities, real estate, emerging markets equity and high-yield fixed income. These non-traditional, or satellite, asset classes provide portfolio diversification due to low correlation with traditional asset classes. But like traditional investments, performance is primarily driven by asset class exposure as well as manager skill.

Types of Alternatives

We highlight several types of alternative investments but this list is more illustrative than exhaustive because new approaches are constantly being developed.

Private equity. – An investment strategy that seeks to participate in the growth of private companies through long-term investments in private securities globally.

Private equity is an illiquid asset class that offers the potential for greater long-term capital appreciation and diversification away from the public markets.

It is generally available only to higher-net-worth individuals with more investment experience (often referred to as accredited or qualified investors) at high minimums and often has liquidity restrictions.

Hedge funds. Portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating strong returns, reducing volatility or both. They are generally available only to higher-net-worth individuals with more investment experience at high minimums and often have liquidity restrictions.

Managed Futures. An investment strategy that seeks to participate in trends in a large variety of global futures markets. Strategies include the use of the stock index, interest rate, currency, energy and commodity futures. Many managed futures traders apply sophisticated software designed to invest in a disciplined, unemotional fashion, which often results in lower correlation with traditional assets.

Alternative mutual funds. Funds in which the managers are not constrained by traditional portfolio management methods. They have varying approaches, ranging from the absolute return, long/short equity, broad mandate or “go-anywhere” funds and hedge fund-like strategies. Many of these funds also have a total return or absolute return objective. They provide access to non-traditional investment approaches while still providing investors with daily liquidity at reasonable investment minimums.

Despite unique risks and considerations, alternative investments can be useful tools to improve the risk-return characteristics of an investment portfolio. They can increase diversification and reduce volatility, given low correlations to more traditional investments. They can offer the potential for increasing returns due to the wider investment opportunity set.

Risks of Alternative Investments

 

  • Higher fees.  – Alternative investments can have higher fees. Fund of funds may also charge yet another management fee. While higher than traditional investments, these fees may or may not be excused when comparing returns net of fees.

  • More complicated.  – Alternative managers may invest in a wide variety of investments, including derivatives, and utilize short selling. Understanding 
  • Less transparent.  – There can be limited into the underlying holdings of these investments. Many manager evaluation tools are not as well suited for alternative investments. That makes a manager’s investment ability more difficult to assess. Also, some alternative investments are largely unregulated.
  • Less liquid. Limited partnerships may hold illiquid investments and as such restrict an investor’s ability to redeem money. For example, managed futures only offer monthly liquidity; many funds of hedge funds do not allow redemptions in the first year and only annual or quarterly thereafter; and private equity may not allow redemptions for seven or more years. The underlying investments used in an alternative investment strategy may also be exposed to a significant lack of liquidity in stressful trading environments.
  • Less tax-friendly. Most alternative investment strategies have little to no focus on minimizing taxes.
  • May disappoint in strong up markets. Investments that seek to generate an absolute return often use short selling strategies, and as such tend to lag long-only strategies in strong up markets, which may discourage some investors.
  • May not diversify risk in extreme down markets. In periods of dislocation, the correlations of many types of investments, including alternatives, may increase significantly. Often clients and their financial advisors come to the conclusion that the benefits of alternatives warrant the added risk. 

The bottom line

When used appropriately, alternative investments can potentially enhance the overall risk-return profile of an investment portfolio. There are unique benefits but also unique risks associated with these non-traditional investment strategies, and as such it is paramount that investors be comfortable with alternatives when incorporating them into their investment strategy. Therefore, it is important to discuss alternative investments with your financial advisor to determine the suitability of incorporating them into your existing investment approach, as each individual’s circumstances are unique.

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