Alternative investments can be broadly defined as those that are not traditional investments such as stocks, bonds, or cash equivalents like CDs or money markets. Types of investments that fall into the category of alternatives include hedge funds and managed futures — to name just two. These are the focus at Steben & Company.
Alternative investments are not new — some have their roots going back many decades. However, what is new is the heightened awareness of what they can add to an investment portfolio, as well as the increased number of products in the marketplace allowing accessibility among a wider range of investors.
Alternative Investments typically have:
- Return opportunities regardless of overall market direction. Traditional investments like stocks and bonds are generally reliant on rising markets to profit. Alternative investments can pursue returns in both rising and falling markets. The pursuit of returns in both bull and bear markets is commonly referred to as seeking "absolute returns".
- Potential to reduce portfolio volatility via non-correlated returns. The returns of many alternative investments have historically shown little to no correlation to traditional stock and bond investments over the long term. Non-correlated assets may reduce portfolio volatility during difficult market periods
There are many potential reasons an investor may introduce alternative investments into a portfolio. Despite how diverse the various types of alternative investments can seem from one another, many do share common goals:
- To provide added diversification to a traditional portfolio consisting of stocks and bonds.
- To provide the opportunity for absolute returns.
- To decrease the overall volatility of a portfolio.
Although there is a broad range of alternative investments, they tend to fall into one of two common categories: alternative asset classes and alternative investment classes.
Alternative asset classes: These types of alternative investments derive their value from themselves and are sometimes called “hard assets”. Examples include:
• Precious Metals: Gold, Silver, Platinum
• Energy: Oil, Coal, Natural Gas
• Currencies: US Dollar, Euro, Japanese Yen
• Agricultural Commodities: Corn, Wheat, Soybeans
Alternative investment classes: These are investment strategies that use both traditional and alternative asset classes to seek returns. Examples include:
• Hedge Funds
• Managed Futures
Alternative investment products, including hedge funds and managed futures, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not always required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment.
Often, alternative investment fund managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-US exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in US markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss.
Hedge funds and funds of hedge funds involve special risks and considerations. Each fund’s investment program is speculative and involves risks inherent in an investment in securities, as well as specific risks associated with the use of leverage, short sales, options, futures, derivatives, junk bonds, emerging markets, illiquid securities and limited regulatory oversight.
This summary is not a complete list of the risks involved with investing in hedge funds and funds of hedge funds. Before investing, carefully review a fund’s prospectus or offering memorandum.
Some people believe that investing in higher-risk investments leads to higher potential rewards over time. But amid the persistent high-volatility environment of the last decade, investors with traditional portfolios composed primarily of stocks and bonds were not necessarily rewarded for taking on more risk. Selecting from a broader menu of investments including alternative asset classes and strategies—which have different risk and return characteristics from stock and bonds—may help investors improve the risk/return dynamics of their portfolios.
Alternative investments are not for everyone, but they can be a strategic addition to the portfolios of certain qualified investors. Alternative investments can be components of already existing asset class allocations.
For instance, an equity long/short hedge fund could be included within an equity allocation. On the other hand, alternative investments capture different sources of return and could be a separate allocation altogether.
If you think alternative investments might make sense for your portfolio, talk with your financial advisor about what role these strategies might play and where they might fit in your asset allocation strategy.
Historically, access to alternatives was limited to institutional and high-net-worth investors. However as their popularity has increased, they have become more widely available. Talk to your advisor about the possibility of adding alternative investments to your portfolio. Your financial advisor can help you determine if there's a place in your portfolio for these investments, and what asset classes and strategies may be appropriate for you.