The world of alternative investments includes a range of hedge fund-like strategies that typically consist of publicly traded equity and fixed income investments, but are unconventionally managed using a variety of exposures (long, short, market neutral) and financial instruments. These strategies have gained acceptance in recent years, and have become more widely available to individual investors through vehicles such as mutual funds. However, questions still remain about the best ways to incorporate them into an asset allocation strategy.
We believe the true benefit of these strategies is how they perform in combination with an investor’s entire portfolio, including how they balance risk and return. However, because they are a disparate collection of strategies with different return streams that vary over time, it is difficult to bind them together as one asset class, comparable to fixed income or equities. While frequently discussed, there still is not a consensus among asset allocation practitioners on what the optimal asset allocation to these alternatives should be.
To help assess these alternative strategies, I believe investors should talk to their advisors about risk, including these three questions.
- What is the strategy’s directionality? One key risk measure to consider is directionality — the degree of exposure the strategy has to movements in the equity and fixed income markets. Whether a strategy has a high or a low degree of market exposure will impact how it’s used in a portfolio.
- How has the strategy performed in different market cycles? Another way to look at risk is to analyze a strategy’s performance during different economic regimes or market cycles — such as growth, recession and inflation, for example — paying particular attention to strategies that performed well when the equity markets overall were not.
- Has the strategy experienced extreme outcomes, and when? In addition to standard risk measures, it is also important to investigate a strategy’s historical pattern of major losses or extreme outcomes, as event risk can be high.
Once these risk measures are assessed, investors may have a better idea of which alternative strategies may be better used as complements or surrogates for traditional equity and fixed income allocations, and which may be used more tactically, based on varying economic circumstances related to growth and inflation.
Asset allocation/diversification does not guarantee a profit or eliminate the risk of loss.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
All data provided by Invesco unless otherwise noted.
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