Alternatives Provide Options to Traditional Investments
The profound effectiveness of portfolio diversification was first recognized by noted economist and Nobel Prize recipient Harry Markowitz in 1952. In today’s global financial markets Markowitz’s theory is as important as ever.
The diverse combination of asset classes can reduce overall portfolio risk while potentially increasing returns. Finding alternative asset classes capable of adding diversification has become increasingly difficult due to the globalization of world markets. Institutional investors have used alternative investments to assist with providing such diversification with abundant success.
As we all know, diversification is the golden rule of investing. The typical approach that most investors are familiar with involves a mix of traditional investments, such as stocks and bonds. However, we can do better with enhancing our returns by employing other asset classes, such as commodities and real estate, or investing in traditional asset classes in nontraditional or “alternative” ways.
Alternative investments might include, but are not limited to: equipment leasing, private equity, long/short equity, merger arbitrage, fixed income arbitrage mezzanine financing, managed futures or energy and natural resources.
The globalization of world markets has led to an increased correlation over the past century, making diversification subsequently more difficult to attain. With the increased challenge in meaningful diversification, investors have turned to alternative strategies to generate returns with a lower correlation to traditional components of their portfolio. Long-term, risk-adjusted returns have typically been associated with utilization of as many low-correlating, high-performing asset classes as possible.
Endowments Are Doing It!
High-net worth and institutional investors have long taken advantage of the increasing benefits of alternative investments. The potential to reduce risk and enhance long-term performance are less complicated today within these asset classes.
To offer some perspective on the utilization of these asset classes by institutions, let us consider some statistics. According to a 1998 report by the National Association of College and University Business Officers (NACUBO), the 31 university endowments in the U.S. managing more than $1 billion allocated an average of 24.5 percent of their portfolios to alternative asset classes at that time. By 2010, that percentage had steadily grown to 60 percent for the 62 endowments managing more than $1 billion.
Those same endowments had an annualized return over the past 10 years of 5 percent as compared to the S&P over that same period of -1.59 percent. Point being, endowments and institutions are reaping the benefits of alternative strategies focused on better managing portfolio risk and enhancing long-term returns.
Endowments typically have longer time horizons, which could exceed that of individual investors with shorter duration requirements. However, liquidity can be adjusted for when considering individual strategies for specified time horizons. Most individual investors would consider less concentration in alternatives, and allow for a substantially smaller piece of the pie than that of an institution.
Where to Begin?
As you might imagine, the world of alternative investments is quite broad. In considering alternatives as a piece of your portfolio puzzle, individual investors should consult with an alternative investment group that specializes in assisting clients in determining which specific investments or combination of investments may be appropriate for their needs.
A. Hedge Funds
These funds typically offer private management of a variety of types of assets. The fund provides managers broad flexibility in executing their mandates. They employ a wide array of strategies that may invest in a myriad of financial instruments across global markets. The strategies of hedge fund managers are further broken down by tactical systems of management.
• Long/Short equity managers can express either a bullish or bearish view of the markets and potentially mitigate risk during difficult times.
• Event-driven managers focus on firm or industry specific events, e.g. mergers and acquisitions, bankruptcies, and spinoffs.
• Fund of Hedge Fund managers incorporate multiple strategies into one fund to gain exposure to multiple hedge fund managers and strategies.
B. Managed Futures
Traded in global markets around the world, managed futures attempt to identify and profit from rising or falling cyclical trends, such as financial markets, currencies and raw commodities.
C. Private Equity
Private equity managers search to identify opportunities for providing capital for startup companies, as well as opportunities for purchasing mature companies with the intent of growing the function and value of the business.
D. Real Estate
It is possible, outside of traditional direct ownership arrangements, to own real estate by means of opportunistically driven managed funds of private real estate and real estate–related securities.
E. Commodities and Tangible Assets
Tangible assets have the potential to generate returns that offer diversification benefits and protection against inflation. Some examples include rail, maritime, industrials and energy.
Consult with an Alternative Investment Group
Certainly, while alternatives provide additional benefits, they are not suitable for everyone. The most commons considerations of suitability are liquidity, transparency, leverage, speculation, taxes and regulation. Many alternatives are illiquid, do not disclose fully their holdings, employ leverage, are speculative in nature, have short-term taxation and might not be required to register with certain financial regulatory organizations such as the Securities and Exchange Commission (SEC).