The alternative investment segment of the market has undergone dramatic change over the last 5 – 10 years. Historically, these investments have been primarily accessible only to high net worth “Accredited Investors” and “Qualified Purchasers” through limited partnerships which often come with high minimum investments, limited liquidity and K-1 tax reporting. Now, access to alternative investments is going mainstream. Managers are creating mutual funds and other “liquid” alternatives utilizing the same underlying strategies of alternative investment partnerships without the high minimums or liquidity restrictions. According to a recent Morningstar report, between 2008 and 2014 the number of alternative mutual funds and ETFs has grown from 482 to 1,569, while net assets have grown from $42.6 billion to $309 billion. So what are alternative investments and should they be included in your portfolio?
The term “alternative investment” encompasses many types of strategies but at their core they are investments designed to perform differently from traditional equities, fixed income and cash. These strategies include private equity, real estate, commodities, managed futures, multi-strategy hedge funds and absolute return funds, among others. While the common feature and key benefit of alternatives is a low level of correlation with fixed income or equity markets, each strategy has a unique objective and risk/return profile. In today’s low interest rate environment, one might use a low volatility vehicle such as a multi-strategy hedge fund, market neutral fund or absolute return fund to complement the traditional fixed income portion of a portfolio, as these investment vehicles can enhance the total return of a portfolio without, in many cases, substantially changing its risk profile. Managed futures and publicly traded real estate investment trusts (REITs) tend to have higher levels of volatility and higher long-term returns. These particular investments can complement the equity portion of the portfolio as they provide a return stream that is independent of the equity markets.
Having a clear understanding of the role that alternative investments play in your portfolio is important, especially when you are evaluating performance. For example, you shouldn’t expect a multi-strategy hedge fund to produce the same return in the short term as the S&P 500 in a bull market. The strategic choice to use a multi-strategy hedge fund is for downside protection (i.e., holding “dry powder”) for when the equity markets pull back, which makes the market at large an ill-fitting benchmark. If you have a portfolio where every investment is rising at the same time, you may be assuming more risk than necessary. Over longer periods of time (e.g., 5- to 10-year rolling periods), alternatives should improve and smooth overall returns in your portfolio while reducing risk.
Alternative investments can play an important role in many portfolios by diversifying exposure away from traditional fixed income and equity assets, with the goal of creating consistent portfolio returns while reducing the volatility of the portfolio. However, alternative investments are not without their own risks (including, in many cases, liquidity limitations) and an individual should consult with their advisor for guidance on how to best utilize these types of investments and whether they are suitable for your particular portfolio. Each individual’s specific situation and risk tolerance will determine the level of allocation, the form of investment (partnership or mutual fund), and the underlying strategies employed (hedge fund, real estate, manage futures, private equity, etc.). At Moneta Group, we work closely with our clients to understand their unique circumstances when constructing an investment portfolio so that it is properly aligned with our clients’ overall goals, risk tolerances, and investment objectives.