Consider Alternative Investments in Your Portfolio
Today’s economic landscape is forcing us to reconsider what we thought we knew about diversification. We’ve discovered that traditional asset classes can behave similarly in periods of economic volatility, which is bad when they’re trending downward. But alternative asset classes frequently behave differently from traditional assets under the same market conditions. That means adding alternatives could help you diversify to manage portfolio risk. As a result of being subject to a variety of different factors, the return patterns associated with alternative markets can differ significantly from those of traditional investments.
What are Alternative Investments
The term “alternatives” can be applied to a wide range of investments, each with different characteristics and roles in a well-diversified portfolio. Prior to an in-depth discussion on specific alternatives, it is helpful to put some structure around a definition for alternatives. At the highest level, alternative investments can be viewed as exposures or strategies that provide different and unique return streams from those offered by traditional equity and fixed-income investments. These different return streams are generally the result of unique characteristics relative to traditional equities and bonds, such as lower correlations, unique volatility patterns or unique up/down capture ratios. Generally, alternative investments can be broken out into three categories: Alternative Markets; Alternative Investment Approaches; and Absolute Return Strategies.
|ALTERNATIVE MARKETS||ALTERNATIVE INVESTMENT APPROACHES||ABSOLUTE RETURN STRATEGIES|
|Provide exposure beyond the traditional markets of U.S. stocks and bonds to “niche” or “non-mainstream” markets. Typically, investors have little or no exposure to these markets. Because the performance factors of alternative markets are often unrelated to those of traditional markets, they tend to have different return patterns and also offer the potential for increased returns while mitigating portfolio risk, often defined as Standard Deviation.||Utilize unconstrained and opportunistic investment strategies. The flexibility these managers have allows them to be opportunistic in increasing or reducing market exposures. Additionally, these managers sometimes employ non-traditional investment vehicles and techniques. This flexible “go anywhere” approach results in a unique return pattern that can provide further diversification benefits.||Designed to generate a positive return in various market conditions over a full market cycle, absolute return strategies often hold long and short positions and have minimal or no correlation to traditional markets. They offer the potential for consistent returns with lower volatility than the traditional equity market. Most Absolute Return strategies provide some yield without sensitivity to changes in interest rates.|
|Emerging-market equity||Global tactical asset allocation||Equity market neutral|
|Global real estate||Multi-sector strategies||Global macro|
|Commodities||Long and short-selling strategies||Currencies|
Advantages of Using Alternatives
To understand how alternatives can improve the risk/return profile of traditional portfolios, it helps to understand how they produce a different return pattern than that of traditional investments. As an example, let’s compare the return pattern of a traditional portfolio with that of a more diversified portfolio implementing alternative investments.
The graph above provides us with an example of how the risk and return characteristics of a portfolio can be enhanced by adding alternative investments. By investing 20% of the portfolio in alternatives the average annual return increased 0.49% but the risk on this portfolio has been reduced by 1.98% standard deviations. The return is increased while the overall risk is reduced almost 20%.
Diversification Potential of Alternative Investments
The popular belief that hedge funds and private equity funds are extremely risky investments on a standalone basis is justified to a great extent. However, when you think about these investments in the context of total portfolio, you will find that many types of alternative assets have great diversification potential. Their returns show low correlations to traditional asset classes like stocks and bonds and therefore adding alternative investments to a portfolio can reduce volatility without sacrificing part of return. Diversification is among the strongest reasons why we invest in alternative assets.
Alternative Investments as a Hedge against Inflation
Some alternative asset classes are a good inflation hedge (their returns are highly correlated to inflation). Infrastructure investments provide a low, yet stable long-term real return. Commodities are also believed to be a good inflation hedge, though you must be ready to accept much higher volatility with commodities.
New Exposures and Opportunities
Because alternative investments are so diverse, you have plenty of opportunities to find new exposures, which are not accessible with traditional investments. Besides stocks and bonds, you can invest in commodities, infrastructure, real estate projects, or start-up business ideas.
Higher Returns on Alternative Investments
Some kinds of alternative investments are very risky on a standalone basis, but investors are rewarded for this risk by higher returns. Like all the other above listed benefits, this only applies to some types alternative investments (e.g. some hedge fund strategies or venture capital investments). Like those of traditional investments, returns of alternative investments vary over time depending on market conditions and economic cycle.
Alternative investments have not been readily accessible to a large segment of individual investors due to high minimum investment limits and restrictive investor requirements. Private institutions, such as Pension funds, and Ivy League school Endowment funds have had access to alternatives for decades – marrying them with traditional investments. Consider this: Over the last decade, endowments with assets of more than $1 billion that invested in alternatives gained a respectable 6.9% average annual return, while the S&P 500® returned 2.7% in that time period.1
In the last decade several alternative investments have become available to the average investor. This is primarily due to changes in the regulatory environment as regulators understand and accept the positive attributes alternatives bring to asset allocation, when properly implemented. This is not to indicate that all alternatives are appropriate for all portfolios. As with any investment, proper due diligence and objectivity must be applied when selecting alternatives.2
Presented by Matthew T. Prifti, ChFC®, CASL®, CLTC, CRPC®, CRPS®, a financial advisor located at Summit Financial Strategies, Inc. 7 New England Executive Park #220 Burlington, MA 01803. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser and can be reached at 781-860-0999 or email@example.com © 2013 Commonwealth Financial Network®
1Source: 2011 NACUBO-Commonfund Study of Endowment Results. Period ending June 30, 2011. An equal-weighted average of 472 University Endowments returned 6.9% compared to the S&P 500® Index average return of 2.7%. The S&P 500 Index is unmanaged and not available for direct investment. Performance represents past performance, which is not a guarantee of future results. 2011 NACUBO Endowment Study, Annual Report of the National Association of College and University Business Officers of Endowment Performance and Management in Higher Education, 2012.
2Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, adverse market forces, regulatory changes, and illiquidity. There is no assurance that the investment objective will be attained.