The Pros and Cons of Alternative Investments

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The Pros and Cons of Alternative Investments

Felix Malamud

An alternative investment is an asset that is not among the usual investment types, such as stocks, bonds and cash. Examples of such assets include private equity, hedge funds, real estate, and commodities. Other tangible assets, such as precious metals, art, wine, antiques, coins, or stamps, are also considered alternative investments. There are numerous alternative investment strategies, such as long-short equity and managed futures. Most alternative investment assets are held by institutional investors or high net-worth individuals due to their complex nature and regulation limitations. However, individual investors, primarily retail, have started to incorporate these assets into their portfolios, due to their growing popularity, driven from their ability to reduce risk. Alternative investments have plenty of upside and should be in a portfolio. Despite the important role that alternative investments have in portfolios, there are some risks associated with them, just like any other investment. Advisors approach these types of assets for their clients in a very careful manner, due to the numerous pros and cons associated with these non-traditional investments.

Alternative investments have tremendous benefits, as they play an important role in an individual’s portfolio. Alternatives provide tax benefits that are normally not available in traditional investments. That, however, is not the main virtue. The biggest reason for investing in them is the low correlation to the market. There is little to no correlation between alternative investments and the stock market, which provides several advantages. Since the low correlation is an advantage, it is important to check the actual behavior of the alternative investments that are added to the portfolio. Some alternative investment strategies actually create a high correlation to the market. An example of this is long-short equity, which is a strategy widely used by hedge funds to create positive exposure to the market, which allows them to benefit from a long-term increase in the market. According to BlackRock, there is an approximate correlation of 75% to the market with these funds. However, if the fund is good, it can replace stock exposure. Alternatives immediately add an element of diversification to the portfolio, helping reduce overall risk. Additionally, there is potential for the rate of return for alternative investments to be higher than that of traditional investments (stocks, bonds, cash, mutual funds, ETFs). When the market is volatile, some alternative investments have the ability to generate profit due to its low correlation. This can yield positive returns during a declining market and stable growing periods, something that cash alone cannot offer. Individual investors have access to these higher returns, since they are no longer only available to the wealthy and high net-worth institutions, such as pension funds and foundations. Given all of these positives, it is clear that alternatives should be a part of individual portfolios, as long as they are properly allocated.

Alternative investments also have certain disadvantages. The main drawback is that they are more complex in nature and structure than that of traditional investments. They are very difficult to understand and typically require higher fees. Some alternatives are presumably more volatile than stocks, bonds, cash, and other traditional investments. Most alternatives are hedge funds, which are subject to less regulation than mutual funds, portfolio managers, and ETFs. Less regulation means that alternatives can use higher leverages and higher risks. The performance of the investment cannot be relied on unless the alternative has a reliable trustee. In addition to the complexity, alternative investments are less liquid, meaning they are harder to sell if an investor needs the money back. This makes it harder to exit and price them on a regular basis. There is also the issue of correlation between alternative investments within a portfolio. For example, there could be a case where multiple alternative strategies have high correlation between each other, which will eliminate the possibility to diversify risk. Therefore, it would be necessary to find alternatives with low correlation between them. In order to deal with these disadvantages, one should examine the correlation between various alternatives, the amount of leverage that a hedge fund can reach, liquidity, fees, and regulations associated with these investments. This can help decrease risk and maintain a reasonable risk-return ratio in the overall portfolio.

Some of the disadvantages associated with alternative investments are simply misconceptions or can actually be mitigated. It is commonly believed that alternative investments increase volatility, but the whole nature of these non-traditional investments is to reduce it through diversification. Alternatives have a historically low correlation of returns to traditional investments. Diversifying a traditional investment portfolio with the appropriate alternatives may help reduce overall volatility. Due to low correlation, an investor can replace some of the equity exposure with alternatives and lower risk significantly. One can also decide to increase exposure to dangerous assets, such as stocks and alternatives, to increase the return potential, while maintaining the same risk. The illiquidity issue is one that also adds to the risky nature of alternative investments. But, the varying levels of liquidity are usually balanced by higher returns. This covers the “illiquidity premium”, which investors demand for an asset that cannot easily be converted into cash for its fair market value. Risks associated with alternative investments do indeed exist, but proper allocation and portfolio diversification allows investors to mitigate and overlook them.

The graph below from Morgan Stanley illustrates the effect of alternative investment allocation on risk, return, and volatility over a recent 25-year span.

If an investor wishes to include alternative investments in their portfolio, they should seek a mutual fund or hedge fund manager with a long track record and stellar reputation. Investors working with a financial advisor should understand the reasoning behind adding alternatives to a portfolio. That understanding should connect to the investor's overall goal. There are many questions investors should be asking their advisors. What is the underlying liquidity of the investments? What is the liquidity of the fund? What is the fee structure? In what types of environment does the alternatives manager expect to perform? Advisors should also ask questions regarding the investor’s risk tolerance and long-term investment outlook. They should consider all possible options when building portfolios for their clients, taking into account the client's return objectives, risk tolerance, and liquidity needs. Understanding the advantages, disadvantages, and nature of alternatives is key when it comes to recommending and allocating these investments for a client’s portfolio.

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