Alternative investments are everywhere. You see them advertised on TV and frequently discussed in the financial media. Advisors use the term freely to mean any number of things. We find that all the recent exposure to the term “alternative investments” has created lots of confusion, so we have put together this piece to help answer some basic questions.
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?
Alternative asset classes include real estate and commodities (such as gold). Each of these asset classes offer 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 from a portfolio of traditional asset classes like stocks and bonds. And of course, more diversification may help control volatility, or simply provide a different set of returns.
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. Instead, they may use active management of existing asset classes, including non-traditional ways to manage the asset classes. The goal of the management philosophy is to have the return stream less dependent on the equity and fixed income markets for generating results.
Alternative strategies are generally attractive to investors who find themselves uncomfortable with the traditional passive strategies of holding stocks and/or the low expected returns from bonds. SWP utilizes 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 (6% to 9% standard deviation) with reasonable returns (5% to 9%).
WHAT ARE TYPES OF ALTERNATIVE STRATEGIES?
- Mix of Different Asset Classes: One type of alternative strategy is when a manager mixes different classes of investments such as stocks, bonds, commodities, currencies and real estate. The manager reviews the asset allocations regularly and can change the allocation based on a variety of factors selected by a manager. The objective of this strategy may be to try to maximize returns or to control risk, as measured by volatility, inherent with specific asset classes.
- Shorting: Shorting involves selling something today and then buying it at a later date, presumably at a lower price. We are conditioned to “buy low, sell high” to make a profit. Shorting reverses the order of the transactions with the same desired outcome. There are many reasons to short a security. Different investment managers develop concepts where shorting is an integral part of their strategy. Shorting is a very common strategy used by hedge funds. Hedge funds are a type of investment strategy that we classify as an alternative strategy. They are not an asset class. Hedge funds come in many different flavors designed to do many different things.
- Downside Risk Control: At SWP, we also utilize other types of investments where downside risk control is integrated into the investment vehicle itself. Structured notes are one such example.
Frequently, alternatives are private investments that result in liquidity constraints as opposed to traditional long only investments that can be bought or sold on a daily basis. These constraints may be due to the underlying investment being illiquid, like real estate, or because the investment is not actively traded on an exchange, such as private loans and private equity. Sometimes investment managers prefer a private investment structure to control inflows and outflows of capital to avoid interrupting their investment strategy.
Risk control is typically one of the key factors we use in our selection of alternative strategies. 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.