Alternatives are flourishing in an environment where traditional stocks and bonds may not be delivering an acceptable risk profile and return.

Personal finance

Alternative Investments: Diversification and (Potentially) Higher Returns

  • Julian Einfrank
  • 9/29/2017

Many investors are probably familiar with the concept of alternatives in the context of rock music or energy, but not so much in the large universe of investments. The Chartered Alternative Investment Analyst Association (CAIA) defines an alternative investment as one that does not have a strong correlation with a traditional investment, such as stocks (equities) and fixed income bonds.

Once considered a difficult asset class to access, alternative investments (or simply alternatives) have become an important part of the modern investment landscape for individuals, pension funds, and institutions. Depending on an investor’s objectives and risk tolerance, alternatives can add impactful diversification to an overall portfolio strategy.

Types of alternative investments

CAIA puts alternatives into four major categories: real assets, hedge funds, private equity, and structured products. Within these main types there are structures and strategies that provide uncorrelated returns when combined with or compared to the most common traditional assets. Hedge funds and private equity investments (also known as private investments) — more prevalent among ultra-high-net-worth investors — are inaccessible to most investors; most are high-minimum investments with specific net worth and/or income requirements.

Caution is warranted in selecting investments that meet an individual’s investment objectives, risk tolerance, and overall portfolio strategy.

The array of these investments is immense, and yet the category as a whole makes up only a tiny percentage of the total investments of retail investors. Stone Ridge Asset Management conducted an in-depth review of research and concluded that the total aggregate value of the investable market stands at approximately $450 trillion in assets. This includes all investable real estate, stocks, bonds, derivatives, reinsurance, commodities, royalties, and other investments. However, many individuals are invested heavily in the two major asset classes (stocks and bonds) that make up just under one-third of that entire investable universe.

Given the diversification benefits and potential to provide a higher risk-adjusted return, the other two-thirds of the investable market is worth a closer look.

The Investable Universe

The original alternative investments

A look back at the long history of alternatives can put them in context. For much of the modern investment era, alternatives — owned primarily by institutions, wealthy investors, and some businesses — allowed for the hedging of specific risks and diversifying of other return streams. However, many investment concepts and vehicles predate the modern era by thousands of years.

Hedging is an age-old concept where a business will purchase contracts to reduce business-related risks they cannot afford to take. Ancient Greeks wrote about a form of structured product in which an individual is paid for the right to use olive presses at a fixed price. Today this would be called an “option” contract.

Options are commonplace in farming, where corn farmers (and other farmers) purchase options to guarantee a specific price for this year’s crop to protect against a downward or unexpected move in prices. The seller of that corn option contract receives a payment, or “premium,” for providing the guaranteed price to the farmer, and helps to transfer the risk of commodity price fluctuations. Over time, the option seller aims to sell enough contracts to offset any losses and make a healthy profit.

This need for a risk transfer mechanism is common, which means there is always a need for an investor on the other side of the contract. The seller of the option contract is engaged in a form of alternative investment, since the price of commodities like corn have negative correlation to the equity or fixed-income marketplaces.

Hedging trade exists in nearly every marketplace and across many types of risks all over the world. The Chicago Board of Trade opened in 1848, allowing buyers and sellers to meet to conduct business. Many years later the Chicago Board of Options Exchange opened in 1973, ushering in the dawn of modern day options and computerized trading. Most individual investors do not participate in the option marketplace today.

However, investment firms, including Stone Ridge Asset Management, have begun to offer alternative funds that buy and/or sell options across many different markets (e.g., interest rates, commodities, currencies, equities) in order to capture the profit or “premium.” This type of strategy used to be available mainly to savvy hedge funds investors or their advisors. Option contracts are an example of an alternative investment that has a lengthy history, but low adoption by retail investors.

Private real estate investments

Another example dating back many hundreds of years is ownership of land or buildings, in which the owner leases the property to an individual in exchange for rent or lease payments. Of the $450 trillion in investable assets worldwide, nearly half is real estate. Real assets are one of the most commonly held alternatives because they encompass commodities, natural resources, and property ownership. The purchase of buildings, apartments, or land for investment is fairly common, if not at least relatable to most investors.

Today, real estate investment might take the form of value-add apartments, wherein a manager such as Bascom Group buys, renovates, and sells apartment communities across the United States. Another example could be a fund dedicated to purchasing cash-flowing office and industrial buildings. Other types of investments in the real asset category are commodity funds, private debt, public infrastructure-focused funds, and real estate investment trusts (REITs).

Alternative Investment Growth Since 2005

Availability and use of alternatives is growing

Today, there are many opportunities for investors to gain exposure to asset classes exhibiting uncorrelated returns to stocks and bonds. According to CAIA, both the availability and use have increased precipitously in recent years. Funds of alternative investment strategies, characterized by the ability to buy or sell daily (known as liquid alternatives), totaled less than $100 billion prior to the financial crisis. This is a small dollar amount in comparison to the U.S. bond market at an estimated $25 ‒ $30 trillion during that time frame (Securities Industry and Financial Markets Association).

Several factors have contributed to the continued rise of this asset class, allowing alternatives to go from an obscure part of the investment marketplace to a much more accessible and viable option. Investment firms have created mutual funds and limited partnerships that invest in different types of alternatives and private investments. Mutual funds, ETFs, and exchange-traded notes (ETNs) holding alternatives can be purchased by individual investors through a brokerage account or by working directly with a forward-thinking registered investment advisor experienced with nontraditional investments.

As of 2015, the liquid alternatives market has grown to $500 billion and is expected to expand at 20 percent per year for the foreseeable future (CAIA). This reflects just one type of fund but can be viewed as a proxy to illustrate how quickly individual investors are adopting exposure to a particular segment of the investable universe.

This influx is due in large part to the desire of individual investors and institutions to diversify out of traditional investments due to low-interest rates and elevated equity prices. Many on Wall Street and elsewhere have lowered forward-looking return expectations, while at the same time seeking out other ways to meet investment return goals.

The belief is that historically low interest rates since the financial crisis and high equity prices are likely to result in significantly lower-than-average returns, catching many unassuming investors off guard. Investors may still expect an average of 8 percent annualized from a traditional balanced 60 percent stock/40 percent fixed income portfolio.

With many analysts, investment officers, and forecasters proclaiming the 60/40 as “dead” or no longer providing sufficient return, a large opening exists for alternative investments to enter the traditional portfolio mix. Another contributing factor is a large shift away from defined benefit plans (traditional pensions) to defined contribution plans (such as 401(k)s) that give individual investors greater control over investment and fund selection.

Diversification: how correlation can show benefit

One important characteristic in evaluating the potential for an alternative or private investment to add value to a portfolio is the correlation between one asset and another. For example, if an investor holds two stocks that move together in tandem at all times, that “portfolio” would be said to have a correlation of 1.0, meaning the price movements in each stock are identical. Conversely, if those two stock prices moved in the exact opposite direction, the correlation would be -1.0.

Precise correlation, either positive or negative, isn’t particularly common across different types of assets. However, the constituent parts of an asset class are correlated, which at a basic level is what makes up the class. Think of large and small publicly traded companies in the United States (Amazon or Disney versus Dunkin Brands or Domino’s Pizza).

They will have some correlation, which can be explained by their shared traits: ownership of a public business and some geographic overlap. Diversification is the process of reducing risk through combining uncorrelated assets. A portfolio of stocks and bonds contains less risk than a pure stock portfolio; not simply because bonds exhibit less risk than stocks overall, but due to different correlations inside the portfolio.

What happens if another asset class is added to the portfolio of stocks and bonds? If this new asset class exhibits zero or negative correlation to stocks or bonds, additional diversification can result in a higher level of return for the amount of risk taken in the portfolio. Most alternative strategies exhibit little correlation to bonds and fixed income, which is yet another reason many investors have begun adopting these strategies.

How we can help

Historically, the investment minimums were unattainable for most individual investors and the cost of investing made alternatives unsavory for financial firms to package inside of a mutual fund. Recent developments are beneficial for investors, but caution is warranted in selecting investments that meet an individual’s investment objectives, risk tolerance, and overall portfolio strategy.

An uncorrelated alternative investment does not make it the right investment for every portfolio. Consultation with an investment advisor regarding your own particular circumstances is always a good idea when evaluating any type of investment, alternative, private, or otherwise.