Alternative investments as an asset class or investment category have been viewed by many investors with confusion. Many describe alternative investments as the “alternative” to traditional investment strategies in a portfolio of “long” positions in stocks or bonds, allocated in an optimized fashion reducing risk while maximizing returns. The securities industry has created a wide variety of proprietary alternative investments to sell to investors. Alternative investments are complex and are frequently sold by investment banks as an alternative to investing in the stock market with complex hedging strategy which allows an investor to hedge his risks against the stock market. Alternative investments have significant fees and costs which need to be understood. Alternative investments are now considered a core product by most financial institutions.
Alternative Investments have emerged as its own asset classification as a result of investor disappointment in returns realized from portfolios holding traditional investments alone. Traditional investing is considered to be any investment strategy which involves maintaining “long” positions in stocks, bonds and cash. Traditional investment portfolios hold varying proportions in these asset classes in accordance with an asset allocation strategy that is based on historical returns and volatility designed to maximize returns for a specified level of risk. This type of portfolio construction method across the traditional asset classes of stock, bonds and cash result in investment returns “relative” to the overall securities markets. Whereas, alternative investments are intended to provide “absolute” investment returns over time which allow investors to avoid extended periods of low nominal investment returns.
Alternative investments have long been available to sophisticated investors, such as large pension funds, foundations and trusts. Retail investors have become targeted by Wall Street firms with alternative investments packaged in familiar investment vehicles, including private placements, mutual funds and ETFs. The alternative investment universe is comprised of investments in:
- Real Estate;
- Infrastructure;
- Private Equity/Venture Capital;
- Commodities; and
- Hedge Funds.
Alternative investments can have certain investment characteristics, including:
- low correlation with traditional investments;
- greater diversification;
- potential for greater returns over time;
- limited performance histories;
- long term investment time horizon;
- non-traded, limited liquidity; and
- limited downside in volatile markets.
The primary rationale for investing a portion of an investor’s portfolio in alternative investments is to generate portfolio returns with greater returns on a risk-adjusted basis. The low to negative correlation of alternative investments to traditional investments provides superior results for an investment portfolio during “down markets” which smooth portfolio returns over time. Professional money managers caution investors cannot “market-time” when to invest in alternative investments which many financial advisors contend makes alternative investments a permanent part of an asset allocation strategy. Alternative Investments are frequently complex and multi-faceted which can provide greater investment however, investors must weigh the potential benefits against the obstacles and uncertainties to investing, including:
- lack of transparency;
- lack of suitable performance benchmarks;
- inherent conflicts of interest;
- higher fees and commissions;
- illiquid, non-traded investments;
- less securities industry regulation;
- non-transferable interests; and
- long term, investment time horizon.
Alternative investments benefits can be described technically in statistical terms, but there are concerns about the implementation and performance measurement to determine how best to assure these investment strategies are suitable for retail investors. Retail investor liquidity concerns make investments suitable only when there is a long enough investment time horizon over multiple market cycles. In many instances, alternative investments are not traded or uncertain pricing makes it difficult to ascertain actual performance measurements. In addition, portfolio construction methods used by traditional asset allocation models are unable to accurately predict portfolio returns when alternative investments are added because their prices are not measurable with limited price histories making risk/return assumptions tenuous leaving financial advisor unable conduct adequate due diligence required for making suitable investment recommendations.
A financial advisor can review your current holdings and determine the appropriate investment allocations in alternative investments based on an investment policy statement designed to reach your True North.
