Despite what their name suggests, “alternative investments” have become an increasingly mainstream part of the investment world over the past decade. Most investors have some knowledge of alternative investments as an asset class, but there is still quite a bit of confusion about this eclectic collection of investment types.
While there is no official comprehensive list of alternative investments (also referred to as “alternatives” or “alts”), the common thread is that they fall outside of the traditional public equity and fixed income arenas. We provide an overview of the major types of alternative investments and the various roles they can play in a portfolio. We also describe some of the key risks and misperceptions associated with alternatives and our approach to using them in clients’ portfolios.
Alternative investments comprise a diverse set of assets and investment strategies. Some of the most commonly used alternatives include:
For most investors, the primary motivation for including alternatives in a portfolio should be diversification. The returns of alternatives are driven by different factors than what determines the performance of public equity and fixed income markets. As a result, alternatives offer risk/return profiles and return streams that have a fairly low correlation with traditional asset classes.
This diversification can improve risk-adjusted returns at the portfolio level, which can be particularly appealing in a low-interest-rate environment like we have today. Traditionally, investors have looked to publicly traded fixed income to provide diversification from their equity exposures. However, today’s low yields mean that most bonds are very sensitive to rising interest rates; this reduces bonds’ ability to play their traditional risk-reducing role in a portfolio. Alternatives can be very effective in providing this valuable diversification from the equity market.
The most notable risk with alternatives compared to public equities and fixed income is illiquidity. Most alternatives require investors to lock up their invested capital for several years, and investors typically are paid a premium as compensation for leaving their capital in place long enough to allow a process to play out. For example, with distressed investing, an extended time horizon is often required for a manager to work through bankruptcies and turnaround situations. Similarly with private equity, funds need time to source, invest in and develop portfolio companies before selling them. At a high level, investors in alternatives essentially plant seeds by committing their capital and expect those seeds to bear fruit some years down the road.
Liquidity, or the ability to sell assets and turn them into cash, is an important concept for investors to understand. The amount of illiquid assets that an investor can afford to own is a function of the investor’s cash flow needs as well as the composition of the rest of the portfolio.
Many investors view alternatives as exotic, “swing-for-the fences” strategies that add risk to a portfolio in exchange for the chance of high returns. While some alternatives can indeed be volatile, we believe that alternatives are best viewed as a tool for reducing portfolio risk and smoothing out returns.
Investors also tend to underappreciate how varied the strategies and potential outcomes are within alternatives. Alternatives are in no way a stand-alone investment. This is true both across the various types of alternatives as well as within those asset classes. As a result, manager selection is paramount with alternatives. In other words, you do not simply decide to invest in private equity and then allocate capital to any available manager. It is imperative to carefully vet a manager’s unique skills and focus areas.