Looking for an Alternative: A Guide to Alternative Investments
Historically, traditional asset classes such as stocks (equity), bonds (fixed income), and cash have been the primary tools used to build a diversified portfolio. Stocks provide the opportunity for long-term growth, while bonds have typically preserved investor capital and provided current income in the form of regular interest payments. As we have highlighted in previous Beaumont Quarterly Market Insights, after a 38-year bull market for bonds and a multi-year bull market in equities, we believe that future investment returns over the next several years may be lower than the historical average. Therefore, we think it may be prudent to incorporate “alternative investments” in portfolios (for qualified clients) in an effort to further increase diversification and enhance expected returns for given levels of risk.
What are Alternative Investments
Alternative Investments (or “alternatives”) are classified as financial instruments that expose investors to risk factors other than traditional stock and bonds. Alternatives include an array of assets, strategies and structures and are typically used as a complement to traditional asset classes. Examples of alternatives include venture capital, hedge funds, private credit, private direct lending, managed futures, life settlements, and private real estate (i.e. multi-family housing, commercial office, industrial, senior living facilities, farmland, etc.). Most alternatives have investment minimums and fee structures that can be higher than those of traditional asset classes. In addition, many do not price regularly making it difficult to determine an accurate fair market value, and they are often much less liquid than stocks and bonds as most alternatives do not actively trade in public markets.
Alternatives are also subject to less regulation than traditional investments. While alternatives fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, most are not required to register with the Securities and Exchange Commission (SEC). As such, they are not overseen or regulated by the SEC or the Financial Services Regulatory Commission. Therefore, alternative offerings are often only available to those investors who meet certain eligibility requirements. In most cases, investors must be deemed to be an “accredited investor”, which requires the investor to have a net worth exceeding $1 million (excluding the value of their primary residence), or an income of $200,000 on an individual basis or $300,000 when combined with a spouse, during the previous two calendar years (and a reasonable expectation of the same for the current year). As a result of these limitations and risks, a rigorous due diligence process is necessary when determining which alternatives are appropriate to add to a portfolio.
Benefits of Utilizing Alternative Investments
Alternatives can provide exposure to sources of risk and returns that are uncorrelated with traditional asset classes, giving them the potential to enhance portfolio returns and reduce overall portfolio risk with the increased diversification. For example, when you own a diversified portfolio of U.S. equities, you are subject to market risk, and the value of your portfolio would typically rise and fall with the U.S. stock market. The same goes for a diversified portfolio of U.S. domiciled bonds. While you can use diversification to reduce much of the associated bond credit risk, you are still subject to interest rate risk. Together these risks are known as systematic risks; they cannot be diversified away from overall financial market movements. Markets reward and penalize investors for taking on these systematic risk factors via investment returns over time. However, if you were to add an alternative investment which has exposure to a different set of risks (for example, life settlements – an investment in which the return is dependent upon the predictability of mortality rates), theoretically you can further reduce the systematic risk in the portfolio. This is because the returns generated by the life settlement investment have minimal correlation to stock market returns, thereby reducing overall portfolio investment risk.
The following chart offers a generalized view of the potential impact of adding a diversified mix of alternatives to different traditional portfolios comprised of just equity and fixed income investments. The blue line represents the efficient frontier for a set of portfolios using only stocks and bonds, while the orange line denotes the efficient frontier for a set of portfolios using stocks, bonds as well as a 10% allocation to alternatives. For those of you who are not familiar with the efficient frontier, the efficient frontier is a set of optimal portfolios that offer the highest expected return for a defined level of risk (where risk is defined as volatility). Starting from the bottom left, on the blue line, we plot a “low risk” portfolio of 100% bonds and 0% stocks. On the upper right, we illustrate the inverse of that portfolio, 80% stocks and 20% bonds (an example of an investor with a higher risk tolerance). The orange line illustrates the same portfolio with a 10% allocation to alternatives broken up by real estate and hedge funds with different underlying strategies. As you can see there is a reduction in risk and an increase in return for the portfolios for both lower-risk and higher-risk investors.
Traditional Assets comprised of Equity (S&P 500 Total Return Index) and Fixed Income (Barclays Aggregate Total Return Bond Index). These indices were used as a proxy for traditional assets given that these indices are typically used by the market. 10% Alternative Investments comprised of: 2% Credit Suisse Multi-Strategy Index, 4% Credit Suisse Global Macro Index, and 4% Private Real Estate (NCREIF Fund Open End Diversified Core Equity Index). This mix was used to capture alternative investments broadly across major alternative asset classes: diversified private equity and hedge funds as well as private real estate. Past performance is no guarantee of future results. There can be no assurance that any index or fund will achieve comparable results or avoid substantial losses.
Of course, these benefits come with corresponding risks, several of which were alluded to earlier including illiquidity, lack of transparency (due to reduced regulatory requirements), higher fees, tax consequences (including K-1 tax reporting that often is delivered after the April 15th initial tax reporting deadline), and other characteristics that some individual investors would prefer to avoid. Investing in alternatives as part of your overall portfolio allocation is not suitable for everyone. Even if you meet the ownership requirements, alternatives may not be the best approach to help you reach your investment goals. However, many of the features alternatives offer can be very helpful over time. Therefore, it is important to discuss the suitability of adding alternatives to your portfolio with your relationship manager.
Past performance is no guarantee of future results. There can be no assurance that any index or fund will achieve comparable results or avoid substantial losses. Investment returns and principal value will fluctuate, and you may have a gain or loss when positions are sold. The performance information presented is that of the identified market indices and funds, which may not be available for investment to any prospective investor. Investments cannot be made directly in an index.
As with all investments, there are associated inherent risks including loss of principal. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Sector investments concentrate in a particular industry, and the investments’ performance could depend heavily on the performance of that industry and be more volatile than the performance of less concentrated investment options. Fixed Income investments are subject to inflationary, credit, market and interest rate risks. Cash positions are subject to inflation risk. Diversification does not ensure a profit or guarantee against a loss.
Alternative investments come with their own risk characteristics including potential loss of principal. Investors in alternatives should be able to bear a full loss of investment. These are often illiquid investments with no secondary market with many requiring a lock-up period where the principal invested is not retrievable.
The efficiency frontier graph illustrates a 20-year investing period from 12/31/98 through 06/30/19. There can be no assurance that an allocation to alternatives would provide higher real returns. Any points inside the curve indicates less efficient performance based on levels of risk, while no points would be outside the curve as this is a depiction of maximum return at the different risk levels. These are not obtainable by an investor and is shown for illustrative purposes only. Please consult your own third-party advisor before making any investment decisions based on this information. The stated indices are for informational purposes only and not available for investment.
The Credit Suisse Multi-Strategy Hedge Fund Index is a subset of the Credit Suisse Hedge Fund Index that measures the aggregate performance of multi-strategy funds. Multi-strategy funds typically are characterized by their ability to allocate capital based on perceived opportunities among several hedge fund strategies. Through the diversification of capital, managers seek to deliver consistently positive returns regardless of the directional movement in equity, interest rate or currency markets. The added diversification benefits may reduce the risk profile and help to smooth returns, reduce volatility and decrease asset-class and single-strategy risks. Strategies adopted in a multi-strategy fund may include, but are not limited to, convertible bond arbitrage, equity long/short, statistical arbitrage and merger arbitrage. The NFI-ODCE, short for NCREIF Fund Index – Open End Diversified Core Equity, is the first of the NCREIF Fund Database products and is an index of investment returns reporting on both a historical and current basis the results of 38 open-end commingled funds pursuing a core investment strategy, some of which have performance histories dating back to the 1970s. The NFI-ODCE Index is capitalization-weighted and is reported gross of fees. Measurement is time weighted. NCREIF will calculate the overall aggregated Index return.
This material is for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor should it be construed as financial or investment advice. It contains forward or backward-looking statements regarding intent, beliefs or expectations. The views expressed are subject to change based on changing market, political, or other conditions.