Alternative investments are simply investment products designed to differ from stocks, bonds and cash. They were developed decades ago and have long been used by institutional and high-net-worth investors to diversify existing portfolio holdings.
Today’s alternative strategies are offered in more easily accessible structures, making them available to many more investors.
An Evolved Asset Class
The pioneers of the asset class were institutions and then ultra-high net-worth individuals. As the asset class has changed and grown, it has become more mainstream. Strategies today are available in more transparent, liquid wrappers. Some are publicly listed, and in recent years, the asset class has been restructured to welcome a broad range of investors. The reasons investors access alternatives have also increased. While portfolio diversification, access to niche strategies, and alpha generation remain constants, today’s investors also seek alternatives for downside risk protection and the benefits of lower correlation to traditional investments.
Why Is Correlation Important?
Correlation is the relationship of one asset class to another. Given a specific set of economic or market conditions, an asset class may move up or down in value. Correlation measures how two asset classes perform in relation to each other.
The classic correlation relationship is that of stocks and bonds. Because stocks are generally riskier assets than bonds, when economic conditions are positive, investors tend to move investments to equities to reap the potential benefits. When economic conditions look more difficult, investors may shift their allocations to bonds, which have less risk.
This usually results in stocks and bonds having low correlations with each other. When one is experiencing positive performance, the other may decline in value. Diversifying a portfolio is the process of determining an asset allocation that spreads assets over asset classes with low or no (called “negative” correlation to each other.
This lowers the volatility of the portfolio and helps protect against downturns. This is the theory behind the 60/40 portfolio, and for decades it worked well.
The problem has been that over the last several years, equities and bonds have become more correlated to each other, making creating a well-diversified portfolio more challenging.
Alternatives May Offer More Diversification Benefits
Traditional investments like stocks and bonds are accessible through the public markets. While holding them long-term is often an investment strategy, it isn’t required. These assets are traded on public exchanges or markets and are considered liquid.
Alternatives generally are not publicly traded. This means these assets have limited liquidity or are illiquid.
But because they don’t trade on public exchanges, they have low correlations to stocks and bonds. This is one reason investors use them to help diversify traditional portfolios. They may also help achieve other portfolio goals.
Types of Alternative Assets
There are many different types of alternative investments. Some of the most common types include:
Private equity: These are ownership investments made in a company that is not publicly listed. These investments attempt to capitalize on rapid growth or restructuring and also may create more value by playing an active role in streamlining operations or providing other expertise.
Private debt: These are loans made to private companies. These are bi-lateral transactions between the company and the investor and are governed by specific covenants on the deal to allow the investor and company interests to remain aligned. They provide capital to private companies that cannot access the capital markets in order to fund operations or grow.
Hedge funds: These are illiquid products that may encompass many different types of investments and strategies. A common one is long/short equity or derivative instruments.
Real assets: These include real estate, infrastructure, natural resources, agricultural land, and commodities.
The Goal of Alternative Investing
In general, alternatives may help to lower portfolio volatility by adding diversification to an asset allocation. Specific goals will often be related to the type of strategy or asset chosen. For example, a private equity investment may provide the potential for higher returns, while a private credit strategy may be chosen for enhanced income potential.
For an investor, alternatives may offer the ability to create a portfolio that is more customizable to their goals. For younger investors, retiring early or creating a “work-optional” financial plan may mean building more options into a financial plan. For retirees, alternatives may provide more stable income.
These strategies are often illiquid, so it’s important to understand how much of the portfolio is dedicated to long-term investing and how much may need to be accessible for use. Having a clear understanding of the illiquid nature of these strategies is critical.
The Bottom Line
Alternative investments have become much more mainstream in recent years. They are more accessible for today’s investors and may be helpful in creating a portfolio strategy that can meet financial goals.
If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER™ and owner of True Equity Wealth Management LLC. Email him at email@example.com or fill out a contact form.
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