Alternative investments, once an option reserved for institutional investors and the uber-wealthy, are now gaining traction with investors wishing to enhance overall returns, diversify their portfolios and curtail volatility.
More than just hedge funds and private equity, alternatives can be pretty much any investment that isn’t a stock or bond.
Liquid alts, the type of alternatives most individual investors would have access to, package alternative investments into tradable funds or units, which helps reduce some of the risks associated with traditional alternatives.
Liquid alts become more attractive when bond yields fall and investors move further out the risk spectrum while chasing yield. For years, bond returns had come in well below historical averages and future equity returns were uncertain following a decades-long bull market, which meant investors couldn’t count on traditional 60/40 balanced portfolios to generate adequate returns.
In these circumstances, lower correlations to the traditional asset classes in a balanced portfolio make alternatives a powerful diversification tool that can boost returns and also reduce portfolio risk.
Portfolio risk vs. single-asset risk
While alternatives are riskier than stocks or bonds on a standalone basis, the measure inventors need to pay attention to and manage is overall portfolio risk.
Lower investment requirements for liquid alts enable investors with modest portfolios to access multiple types of alternative investments for much less than the minimum needed for most traditional alternative opportunities. The ability to diversify within the alts component of a portfolio allows for some risk mitigation while still maximizing potential returns.
Risk is an inherent part of investing, and the potential for higher returns always translates to higher risk. Investors need to determine how much risk they’re comfortable taking on and structure their portfolios with this threshold in mind.
Liquidity less constrained
Liquidity is extremely important when it comes to evaluating alternative investments. Traditional alternative assets such as infrastructure and private equity are usually quite illiquid, which makes them unsuitable for anyone who plans to draw income from their portfolio. It’s also a concern because it means investors will be unable to exit the investment if their financial situation or the prospects for the investment change.
The advent of liquid alts means that investors can now access alternatives with the ability to exit the investment. Liquidity options are laid out in the offering documents and will vary, but many now permit daily or quarterly redemptions. And these can usually only be altered with unitholder approval.
Alternative investments are more complex than most other investments, which means higher fees. There are also performance fees associated with some alternative investments. But, fees for liquid alts are lower than those for traditional alternatives. So, while investors might pay more to gain exposure to alts, these investments are excellent diversifiers and have the potential to earn outsized long-term returns.
The time horizon for alternatives is longer than for stocks and bonds, which means they can take years to produce any sort of payout. Investors in traditional alternatives will have to be patient if they want the big payout.
Keeping volatility in check
Since alternatives are riskier than traditional asset classes, they tend to be more volatile as well. But if they can reduce overall portfolio risk, investors will have a better chance of staying invested during all phases of a market cycle. This is because their portfolios are better positioned to withstand market turbulence. Smoothing out that volatility could prove immensely beneficial since participation in market upturns hinges on being able to stay invested during the downturns.
Alternatives are definitely not suitable for everyone, but they do have the potential to achieve two things that virtually every investor strives for with their portfolio: enhanced returns and lower risk. These are by no means guaranteed with every investment and it will take time to achieve those objectives.
The numerous options out there each have their own unique risk/return profile as well, so investors who choose to add alts to their portfolio should customize this allocation to best match their risk tolerance, time horizon, return expectations, and liquidity needs.