You have likely heard of a “60/40 portfolio” — a portfolio that is composed of 60% stocks and 40% bonds. One rationale for the 60/40 portfolio has long been that stocks and bonds are negatively correlated. In simple language, the belief has been that when stocks lose their value, bonds should hold their ground or even appreciate in value, helping stabilize the portfolio during periods of market unrest.
This year has been another proof point that this assumption is flawed.
Year-to-date, the U.S stock market is down 20%[1] while the bond market is off roughly 10%[2]. This means that even the most conservative of traditional investors — with an asset allocation of 10% stocks and 90% bonds — is down double digits in 2022. And while this investor has done very well over the last decade, there is no way around it: the volatility in the public markets this year is uncomfortable, especially so because the stock and bond markets have moved lower in tandem.
So, what is an investor to do?
One solution is to look beyond a traditional mix of stock and bonds when building a diversified portfolio. Specifically, exploring alternative investments that are 1) less interest-rate sensitive than bonds and 2) insulated from some of the volatility found in the public equity markets. This perspective is not new to our team. Alternative investments have been a part of our firm’s DNA from the beginning, and we have been helping clients navigate alternatives, when appropriate, since 2008.
What follows is a discussion of what alternative investments are, how we have used them in client portfolios, and how they may add value to a diversified investment strategy.
What exactly are alternative investments?
Unfortunately, within the investment industry, there is no consistent definition for alternative investments. It is important when discussing alternative investments with an advisor that you get a clear definition of how the advisor views this topic. A common thread with “alternatives” is that they provide something different than a traditional portfolio of cash, bonds, and stocks. Defining what is meant by “different” is where the confusion begins.
At Strategic Wealth Partners (SWP), we view alternatives as a way to create a different return stream than traditional investments. To start, we break alternatives into two general categories: alternative asset classes and alternative strategies. When we use the term “alternatives,” we are more often referring to the latter, although we do have exposure to both categories. So let’s take a look at each.
What is an alternative asset class?
Examples of alternative asset classes include real estate, commodities, and cryptocurrencies. Each of these asset classes offers different ways to invest in the category. For example, one could obtain exposure to real estate through direct ownership, limited partnerships, or real estate investment trusts (REITs). Each has its own benefits and drawbacks. Gold exposure comes from coins, bars, exchange-traded funds (ETFs), or futures contracts. And so on.
The returns from these alternative asset classes can offer diversification beyond that provided by a portfolio of traditional asset classes like stocks and bonds. And, of course, more diversification may help control volatility.
What is an alternative strategy?
The second type of alternative is an area of greater confusion and mystery. “Alternative strategies” are not an asset class. Rather, they offer different approaches to managing traditional asset classes or different investment structures. As a result, alternative strategies are frequently sought after by investors who find themselves uncomfortable with the unpredictable volatility of the stock market and/or the low expected returns from bonds.
We utilize alternative strategies to provide our clients with a different return stream than a strategic mix of traditional asset classes. Generally, we are looking to generate returns that are characterized by modest volatility with reasonable returns and low sensitivity to both the stock and bond markets.
If we dig further into alternative strategies, we see two distinct sub-categories: alternative credit strategies and alternative equity strategies.
Through alternative credit strategies, an investor provides financing to borrowers in exchange for a return on the capital provided. Examples include private lending, private credit, and structured credit.
Many alternative credit strategies have a floating-rate yield associated with the investment. This means that when interest rates rise, you receive a higher yield, and your total return increases. Compare this to traditional fixed income — such as bonds or bond funds — which tend to provide a lower total return as interest rates rise. For this reason, alternative credit strategies are compelling during periods of rising interest rates, as we see today.
The primary threat to the investor is credit risk — or the risk that the borrower receiving the capital won’t make good on the terms of the credit agreement. Accordingly, research is essential when exploring alternative credit strategies, and we focus on opportunities where downside risk control is integrated into the investment vehicle itself.
Alternative equity strategies include hedge funds and private equity. Fund managers may use a variety of tactics to control volatility, such as hedging techniques. This compares to traditional equity investments where there are no controls. In some instances, alternative investments may include multiple alternative strategies within one specific fund.
Year-to-date, and over much longer time horizons, the alternative strategies that we utilize have performed well and have shown resilience relative to the public capital markets.
What are the drawbacks of using alternatives?
One key consideration is liquidity. Most traditional investments can be bought or sold each business day on exchanges like the NYSE or Nasdaq. In contrast, many alternative investments only allow investors to redeem their funds during pre-defined windows. This structure allows alternative managers to pursue investment opportunities that are illiquid but provide compelling returns — such as real estate or private loans. When exploring alternatives, you are often exchanging liquidity for opportunity, so it is critical to understand any liquidity constraints that may be part of the investment.
The second drawback of alternative investments are the fees, which can be many times higher than the fees associated with investing in traditional stocks and bonds. As wealth advisors, one of our jobs is to identify strategies that provide a compelling performance net of all fees for our clients. This is true when looking at traditional strategies, and this mindset is imperative when integrating alternatives into a portfolio.
Closing Thoughts
At SWP, risk control is one of the key factors we use in our selection of alternative investments. Because of the risk control component, alternatives can help investors feel more comfortable with their portfolio. That confidence in the construction of the portfolio can allow investors to ride out possible swings in markets when volatility picks up.
We hope this article has provided a look at what alternative investments are and how we help integrate them into client portfolios. If you would like a personalized consultation covering your investment objectives, we invite you to connect with our team.
[1] As measured by the S&P 500 Index on 7/1/22
[2] As measured by the Barclays U.S. Aggregate Bond Index on 7/1/22
Disclosure:
This article contains general information that is not suitable for everyone. The information contained herein should not be constructed as personalized investment advice. Reading or utilizing this information does not create an advisory relationship. An advisory relationship can be established only after the following two events have been completed (1) our thorough review with you of all the relevant facts pertaining to a potential engagement; and (2) the execution of a Client Advisory Agreement. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.
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