Alternative investments are generally considered assets that are not traditional stocks, bonds, or cash investments. They are classified as alternative because they often require more sophisticated investment strategies, may have less liquidity, and typically have less regulation than traditional investments.
There are a wide range of assets that are grouped as Alternatives, but whilst they all fall under this banner they are, in fact, very diverse in what they look like and what they can provide for an investors’ portfolios. Read here about why they shouldn’t be a homogenous asset class (in our opinion).
Examples of Alternatives:
1. Real estate: can include rental properties, commercial buildings, and land. Real estate investment trusts (REITs) are also a popular way to invest in real estate without owning physical property.
2. Private equity: PE involves investing in privately held companies or acquiring them outright. This is often done through funds or partnerships.
3. Hedge funds: these are private investment funds that use complex investment strategies to generate returns for their investors. These are generally inaccessible unless you are a significantly large investor.
4. Commodities: This includes investing in physical goods such as gold, silver, oil, or agricultural products.
5. Real Assets: investing in items such as fine art, antiques, and rare collectibles.
BlackRock give a very good distinction that looks deeper into how you can classify Alternatives and understand how to incorporate them into your portfolio for different reasons:
‘Contents can be either the assets themselves (e.g. currency or real estate) or the investment strategy employed (e.g. long/short strategy or event driven strategy). Either way, the contents determine how individual investments might be expected to perform relative to traditional investments.
Containers define the vehicles in which investments might be found, such as hedge funds, private equity funds and mutual funds, all of which are structured differently for a variety of management, liquidity, legal and regulatory reasons. Hedge funds, for example, are categorized together because their goal is to mitigate (“hedge out") certain risks inherent in other asset classes, not because their contents are all the same.’
Although some of the benefits of investing in alternatives have been touched on already, it’s important to look deeper into why many successful investors incorporate this asset class into their portfolios.
Diversification - a portfolio may not be suitably diversified if the underlying assets derive their returns from the same sources of risk. In early 2022, with the pandemic still very much ravaging the globe and Russia Ukraine on the cusp of open warfare, both equities and bonds, which traditionally have an inverse correlation with each other, were both negative for the first four months of the year. In this situation, if an investor had exposure to Alternatives as well as a traditional equity / bond mix, they could have offset some of the losses they experienced.
Less Volatile - traditional, liquid asset classes become highly correlated in times of market stress. Alternatives rely less on broad market trends and more on the strength of each specific investment; hence, adding alternatives can potentially reduce the overall volatility and therefore risk of a portfolio.
Improve returns - For long term investors able to sacrifice some liquidity, investing in alternatives assets can help to improve the overall risk/return profile of their portfolio through access to a broader universe of investments and strategies.
As with any asset class, there are some factors to be considered before blindly throwing money at certain investments. Alternatives tend to be less liquid than traditional asset classes. They cannot be traded on a public exchange and the 'hold period' of the investment is normally longer than traditional assets. Additionally, the exact weight of the alternatives in a portfolio will depend on individual return objectives, investment horizons and liquidity constraints.
There is also sometimes a lack of transparency with the particular vehicles investors put their money in. With Hedge Funds especially, they can be highly leveraged, speculative and volatile. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Alternative investment managers also typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, ultimately resulting in less diversification (which is a purported benefit).
One final consideration is the higher fees that are normally attached to these types of investments. As the money is being more actively managed, there are larger fees for good performance, total AUM and to withdraw funds.
In short, alternative investments can generally offer a multitude of benefits to investors, but as with any asset class they come with risks such as lack of liquidity, transparency issues and higher fees. It is important for investors to carefully evaluate the risks and potential returns for the individual types of alternative investments (or contents), and the investment vehicles (or containers) they are trusting their money with. As always, horses for courses.
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