Recent events have created an enhanced need for investors to diversify their portfolios. This is due to things such as the economic downturn, stock market volatility, a low-interest rate environment, the potential for rising inflation, and a possible tax code change, to name a few.
Alternative investments — essentially anything that is not a stock or bond — offer portfolio diversification, as well as the potential of downside protection and greater returns. The important question for investors, however, becomes whether they should include alternative investments and if they are appropriate based on individual goals, risk tolerance, and time horizon.
Examples of alternative investments include real estate, private equity, hedge funds, commodities (including precious metals and natural resources), managed derivative funds (including future and option contracts), foreign and cryptocurrencies, and even tangible assets such as art and collectibles.
Some of the above examples are very complex and should only be used by investors with a sound understanding of how they work. Because of this, some strategies may not be available to the general investing public, and are instead only available to “accredited investors.” Private equity and hedge fund investments are two types of investments that should not be used by someone who does not understand how these investments work. An easier way to add real estate exposure to your portfolio is to invest in a publicly traded real estate investment trust (REIT), which trades like a stock.
Alternative investments can be purchased directly, such as buying gold bars or real estate property. For purposes of diversification and liquidity, however, they usually work best when purchased via a mutual fund. Most of these funds are actively managed. Yet, some index funds do exist for investors who want exposure to alternative investments but prefer owning an index (i.e., a commodity index rather than owning a mutual fund that purchases companies that produce those commodities).
Advantages of Having Alternative Investments in Your Portfolio
As Miguel de Cervantes penned in his novel, Don Quixote, “It is part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”
Ultimately, investors wish to generate returns commensurate with the level of risk they are willing to accept in their portfolio. To do that, you must diversify your portfolio with investments that do not always all go up at the same time and do not all go down at the same time. If we have portfolios A and B, both with the same level of risk (standard deviation), yet portfolio A has generated higher returns, then portfolio A is a better portfolio to invest in since it’s risk-adjusted rate of return is greater than portfolio B.
Alternative assets tend not to move in the same direction as stocks and bonds, which make them good assets to add to a portfolio to achieve better risk-adjusted returns. This could potentially lessen losses during market downturns or periods of economic recession.
Disadvantages to Alternative Investments
A significant disadvantage of owning alternative investments is that owning them via direct ownership may not be as liquid as owning them via a mutual fund, where gaining access to those funds is easier (if needed). Additionally, the complexity of certain types of alternative investments may make it difficult to evaluate whether they are appropriate for inclusion in your portfolio. Certain types of alternative investments are harder to value due to their illiquidity and may also involve higher fees.
While alternative investments have underperformed the stock market recently, we believe there is a place for these types of uncorrelated investments in most portfolios. For example, here at Access Wealth, some client portfolios do include a mutual fund that invests in global real estate as well as a mutual fund that invests in mergers and acquisitions, both of which are considered alternative investments. The inclusion of these funds in a portfolio requires significant analysis and research to be sure they fit well with the other pieces of the portfolio.
If you decide that alternative investments should be part of your portfolio, we caution you to not invest more than 10% of your total portfolio into these types of investments.
If you have any questions about alternative investments or specifically about the alternative investments we are using, please contact us, and we would be happy to discuss it further with you.