Alternative investments can provide an interesting opportunity for investors to diversify their portfolios, dampen the impact of market volatility and help them achieve their long-term investment objectives, even during times of market uncertainty.
Of course, along with these potential benefits come additional complexities and risks. That is why it is imperative that investors understand the various strategies available to make more-informed decisions regarding the role of alternatives in their portfolios.
The definition of alternative investments
With traditional investments forecasted to deliver modest returns of approximately 4% per year over the next 10 years1, both institutional and individual investors are increasingly looking to alternative investments to try to meet their diversification and return objectives.
But what are alternatives? Simply put, they are any investment that falls beyond traditional long-only investments, such as stock and bonds. Because alternatives tend to have lower correlations to traditional investments, they are primarily used to diversify an investment portfolio and provide return profiles that may differ from those of traditional investments.
For large institutional investors with a tolerance for illiquidity, alternative investments could include a combination of hedge funds, private equity, alternative credit, and real estate. For individual investors, the alternative investment universe may include all of these and even vintage cars, rare wines, or fine art.
With such a broad range of investments in the category, it’s important to fully understand the unique risks and benefits of alternatives before incorporating them into a portfolio.
The key characteristics of alternative investments
Alternative investments cover a wide range of assets and strategies. Generally speaking, however, they are characterized by:
- Low correlation to traditional investments like stocks and bonds
- Higher return potential than traditional investments
- More esoteric and oftentimes illiquid assets
- Longer lock-up of periods, meaning shares or interests may not be able to be redeemed/sold on a daily basis. This helps allow for exposure to less liquid assets
- Often complex investment structures and risk-return profiles
- Typically, higher minimum investment requirements
- Unique risk profile that should be understood prior to investing
The types of investors who may be suited to alternative investments
Alternatives are not suitable for every investor. Given their unique risk-return profile and complex investment characteristics, they often are most attractive and more suitable for more sophisticated and higher-net-worth investors.
In addition to meeting minimum investment and suitability requirements, investors should also consider their time horizon, investment objectives and their ability to withstand periods of volatility before considering an allocation to alternatives.
Some popular alternative investment strategies
Alternative investments have grown in popularity over time. Today, alternatives include a spectrum of strategies, each designed to support a unique objective and with a different risk-return profile. Below are some of the most common.
Alternative credit investments refer to illiquid financing provided to borrowers that cannot access public credit markets or require non-standard, customized terms. Categories of lending within alternative credit include direct lending, mezzanine, distressed debt, and specialty financing.
Private equity investments (typically accessed through a limited partnership) take an ownership position in companies or securities that typically are not listed on a public stock exchange. The goal is to add value by providing capital to help new businesses grow and by restructuring existing businesses with operational inefficiencies that offer the potential to generate significant long-term gains.
In exchange for an equity ownership stake, venture capital investors provide funding to early-stage start-ups they expect to grow substantially. The goal is to guide the firm with the intent of selling it either through acquisition or an initial public offering.
Real estate has evolved into a multi-faceted asset class that includes publicly-listed and private real estate investment trusts (REITs) and private commercial real estate debt. Real estate not only has a low correlation with equities, but is often viewed as a hedge against inflation.
Hedge funds are investment vehicles that use a range of non-traditional strategies (e.g., pairs trading and long-short strategies) in an effort to maximize the overall return potential and diversification of a portfolio. Some of these non-traditional strategies include:
- Alternative risk premia
Alternative risk premia strategies seek to deliver attractive returns by earning a “premium” through exposure to recognizable and exploitable risk factors. These strategies generally leverage long and short positions within traditional asset classes.
- Managed Futures
Managed futures is a trend following investment strategy that uses quantitative signals to define when securities are trending. Often, these signals compare the current (spot) price of an asset to the trailing (historical) moving average of the price and then make investments based on those trends. If the spot price is above the moving averages, then the security is in an uptrend, and vice versa.
- Global Macro
Global macro strategies invest across asset classes and markets globally, taking both relative value and directional positions based primarily on broad economic and political analysis. Systematic global macro strategies employ computer models to evaluate and predict market movements, while portfolio managers make buy and sell decisions within discretionary strategies.
Return targets and risk levels differ across alternative strategies and vehicle types:
1 Source: PIMCO as of 31 December 2019. Return reflects a 60/40 portfolio represented by 60% U.S. equities and 40% U.S. core fixed income