While traditional investments (such as stocks and bonds) serve as an investment portfolio’s core components, a more sophisticated “alternative” range of investments has evolved over the years. Alternative investment strategies were developed through academic and practical advances as a means for institutional investors to address increased market volatility and help achieve their investment objectives with the potential for more precision and accuracy.
Alternative investments, also called non-traditional investments, are investment strategies that utilize trading techniques generally unavailable through public markets. They can encompass a broad variety of investments – including but not limited to, hedge funds, private equity, real estate, natural resources/commodities and managed futures.
Alternative investment managers have a greater range of strategies available, but what does that ultimately mean for our clients? Why have colleges, institutions, and high net worth investors chosen to allocate assets to these strategies? The basic answer is that adding alternatives to a portfolio of traditional assets can lower risk while increasing returns. More specifically, alternative investments offer the following goals and objectives:
- Increased Diversification
- Lower Correlations
- Lower Portfolio Volatility
- Enhanced Portfolio Performance
Some alternative investments, particularly hedge funds, have become more accessible over the last couple of years. Investment minimums (some were $1 million per account), have become much less onerous. Therefore, alternative products have become a viable option to incorporate into our portfolios.
Increased Diversification
By combining assets that vary in response to forces that drive markets, more efficient portfolios provide higher returns than less well diversified portfolios. Conversely, through appropriate diversification, a given level of returns can be achieved at lower risk.
Lower Correlations
In order for diversification to realize its benefits, a portfolio’s underlying asset classes must behave differently in varying market conditions. The measurement of this historical relationship, whether different or similar behavior, is called correlation. Adding alternative investments to a portfolio increases diversification because, for the most part, alternative strategies are not highly correlated to one another or to traditional asset classes. Many alternative investment strategies are designed to minimize, or even eliminate, the role of overall market direction in determining returns. The lack of correlation between alternative investment strategies offers the opportunity to create a truly diversified portfolio.
Lower Portfolio Volatility
By adding alternative investments to traditional portfolios, we can reduce portfolio volatility (as measured by standard deviation) and improve the opportunity to experience increased returns over the long term. How does reduced volatility help improve portfolio returns? Reducing the frequency and severity of losses in a portfolio creates an environment in which the portfolio may compound return more efficiently. When an investor experiences negative returns in a volatile portfolio, subsequent monthly returns must first “catch up” for those prior losses before the investor can begin to enjoy growth on their overall portfolio.
Enhanced Portfolio Performance
When an investor experiences consistently positive returns in a low volatility portfolio, each month’s returns compound upon prior positive returns to offer growth and help preserve capital. The true power of compounding has its greatest impact when negative months are eliminated or reduced.
Conclusion
Considered in isolation, alternative investment strategies are attractive because they are designed to produce positive returns, with low standard deviation. When considered as a complement to traditional assets, prudently selected alternative investment strategies can reduce risk and increase returns for the overall portfolio. Adding alternative investment strategies to a portfolio of traditional assets increases diversification and helps lower volatility, offering an opportunity to compound positive returns and avoid significant periods of loss. The result: an optimized portfolio with the potential to increase returns over time while reducing risk.
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