Alternative investments have begun to gain traction in the past couple of years due to its different approach for investors. Acting as a defense rather than an offense investment, long-term investors are grasping the importance of including alternative investments into the diversification of their portfolios. They also give the investors a risk/return profile that is different from that of equities, bonds or cash.
Most alternative strategies fall between stocks and bonds in overall risk profile that they bring to the portfolio. Alternative investments include real estate investment trusts, hedge funds, private equity, venture capital, commodities, MLPS, REITs, trust deeds and real assets such as rare coins, art, wine and precious metals. They have a low correlation to stocks and bonds and reap in benefits and are less volatile.
MLPs are publicly traded partnerships that constitute a large part of a nation’s energy infrastructure. They make quarterly distributions to limited partners and create a more attractive steady income stream. REITs, as discussed above are real estate investment trusts in that you are investing in, for example, an apartment complex that is generating income from rent. Trust deeds offer investments in collateral-backed property loans in the United States.
It is important to have a diversified portfolio because different investments can be affected differently throughout the year due to economic and market factors. To reduce the risk of your portfolio, owning different types of investments can help minimize unsystematic risk. With alternative investments, one invests with a mindset of a conservative return but with the benefit of continuing to gain through economic and market hardships. For example, if one were to invest in gold stocks with a 3% return and the stock market tanks, your gold position would then increase to more than 3%. At this point, you would be able to sell your gold shares and use the proceeds to invest in the stock market while it was down.
Using alternative investments as a hedging tool can encourage long-term investing, eliminate the need to time investment decisions, reduce the risk in your portfolio, allow you to adjust your portfolio’s risk over time and help you focus on the big picture. Some also use it to leverage their portfolio. With bull markets having longer cycles, alternative investments allow for a more conservative approach to playing with and reduce volatility during these trying times.
The four distinct benefits that alternative investments bring to a portfolio include diversification potential, inflation hedge, new exposures and opportunities and higher returns over the long-run. Alternative investments help diversify both return and growth streams and help increase the income. They have less interest risk as well as minimize drawdown risk.
The alternative investments have low liquidity and longer holding periods while a small percentage of a portfolio invested in illiquid alternatives doesn’t create problems in down markets. These asset classes are less regulated and often offer limited transparency and are often difficult to measure and evaluate. Most alternative products are not designed to minimize taxes, and some have huge fees like Fund of funds.
As said initially, returns of alternative investments show low correlations to traditional asset classes like stocks and bonds and therefore by adding them to a portfolio one can reduce volatility without sacrificing a part of the return. Secondly, alternative asset classes are a good inflation hedge as their returns are highly correlated to inflation. Again, a low return but a stable long-term real return. Some alternative investments are very risky on a standalone basis, but investing in these can lead to a higher return on your investments.
Baby boomers are currently seeing the disadvantages of not having diversified their portfolio further with investments such as alternative investments. Investing solely in stocks and bonds led them to have to endure the bear markets and financial crises of 2000 and 2008. Had they invested in alternative investments during this time, their return would have been greater over time and they would not have felt the downs of these years. Even when the equity market is up, it helps in boosting returns and help diversification. Periodic review and rebalancing of the portfolio is the key to success in an asset allocation. Some advisors allocate 5% or 10% of their portfolio to alternative investments while few invest 45% of their portfolio to the alternative investments.
The key takeaway is to diversify and be knowledgeable in all aspects of your investing! Happy investing!