How to Approach the Alternative Investments Puzzle: Putting the Pieces Together

Every summer my family and I go on a vacation to the beach. While there, my wife buys a big jigsaw puzzle for us to work on. Every year, we feel overwhelmed immediately after she dumps out all 1,000 pieces.

That daunting feeling is similar to what many advisors and investors feel when they look at the myriad alternative investment offerings available today: “How am I ever going to figure this out and put all the pieces together?”

When building our puzzle, my family’s first step is to sort and organize all the pieces. Once that’s done, it becomes much easier to identify where each one fits in the bigger picture. I recommend a similar approach toward alternative investments. Specifically, the first step is to organize and align the various alternative strategies with specific investment objectives.

Below, I lay out five common investment objectives and align each one with the different types of alternative investments that can help:

• Objective – Inflation mitigation

With central banks injecting large amounts of money into the markets, many investors are concerned about the emergence of inflation in the future. In order to mitigate against the effects of inflation, investors may consider adding alternative asset classes such as real estate investment trusts (REITs), commodities, master limited partnerships (MLPs) and infrastructure to their portfolio. These investments have tended to increase in value when inflation occurs, and have similar return and risk characteristics as stocks. Several of these strategies also have a history of producing attractive levels of current income for investors.

• Objective – Principal preservation

Given the length of the current bull market and the low level of interest rates, many investors are concerned about the impact that a declining stock and/or bond market would have on their portfolio. To help buffer their portfolios, investors may consider an alternatives strategy known as “relative value.” This strategy has historically generated positive returns regardless of market environment, and has return and risk characteristics similar to that of bonds.

• Objective – Portfolio diversification

One of the benefits of alternative investments is they enable an investor to pursue opportunities that exist outside of the stock and bond markets—which may help cushion a portfolio if stocks and bonds fall at the same time. These “global investing and trading” strategies typically invest on a both a long and short basis across the global financial markets (stocks, bonds, currencies, commodities, etc.). These strategies have historically generated stock-like returns with significantly lower levels of risk than stocks.

• Objective – Equity diversification

For most investors, the largest allocation in their portfolio is to equities. Alternative equities strategies enable investors to diversify this exposure by investing in stocks on a long and short basis, and/or an unconstrained basis, which means the portfolio manager can invest wherever he or she sees an attractive idea. These strategies tend to generate equity-like returns with lower risk than traditional stocks.

• Objective – Fixed Income diversification

Investors have two concerns about fixed income: 1) what happens when interest rates rise from their historic low levels, and 2) how can they generate attractive levels of current income given the low level of interest rates. Some alternative fixed income strategies may help investors enjoy the benefits of rising interest rates (increased current income), while potentially minimizing the downside (declining value). Others are designed to seek positive total returns in both rising and falling rate environments. Furthermore, some of these strategies may help generate attractive levels of current income. In general, alternative fixed income strategies have return and risk characteristics similar to that of bonds.

The table below summarizes this information and can be used as a tool to help advisors and investors organize the universe of alternatives investments. The next step is to start putting the pieces together. In my next blog post, I will discuss different ways to add alternatives to a portfolio using the framework below.

For illustrative purposes only. Not representative of any particular product or strategy. There can be no guarantee the strategies will meet income, performance or volatility objectives. Past performance is no guarantee of future results.

Important Information

Diversification does not guarantee profit or eliminate the risk of loss.

Volatility is the annualized standard deviation of returns.

Downside risk is the maximum decline based on the month end value of the index or portfolio.

Correlation indicates the degree to which two investment have historically moved in the same direction and magnitude.

Relative value strategies seek to provide positive returns above cash in all market environments, typically with lower volatility than the broad market. They generally employ arbitrage techniques to capture pricing anomalies by purchasing undervalued assets and shorting overvalued assets. The success of these strategies is driven by the managers’ security selection and strategy execution, as they seek to profit from the relative value created by the price differentials in the related securities.

Long positions make money when an investment rises in price.

Short positions make money when an investment falls in price.

Unlike most alternative equity strategies, listed private equity ETFs would be expected to have higher returns and higher volatility than equities.

Market neutral strategies use offsetting long and short stock positions in an attempt to limit non-stock-specific risk.

Macro strategies base their investment decisions on macro views of various markets around the world. They may take long and short positions within and across such asset classes as equities, fixed income and currencies.

Also known as risk parity strategies, risk-balanced portfolios are constructed so that each asset contributes a relatively equal amount of risk to the strategic allocation of the portfolio. These portfolios may also include a tactical overlay that allows managers to opportunistically adjust the strategic allocation.

Multi-alternative strategies invest in a number of different types of nontraditional asset classes and strategies.

Long/short strategies (equity or credit) typically take both long and short positions to benefit from rising prices on the long side and declining prices on the short side.

Unconstrained strategies (equity or fixed income) may seek returns in a variety of ways, including the creation of long/short exposures or the implementation of an unconstrained approach that allows the managers to pursue their best ideas across the equity or fixed income markets.

Private equity strategies invest in companies that are not publicly quoted on a stock exchange. Investments in private companies aim to deliver long-term capital gains that are realized when the holding is sold or when the company goes public.

Option overlay strategies are strategies in which a manager uses options in conjunction with a portfolio of equities in an attempt to either boost return and/or reduce risk.

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.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

Investing in infrastructure involves risk, including possible loss of principal. Portfolios concentrated in infrastructure securities and MLPs may experience price volatility and other risks associated with non-diversification. Investment in infrastructure-related companies may be subject to high interest costs in connection with capital construction programs, costs associated with environmental and other regulations, the effects of economic slowdown and surplus capacity, the effects of energy conservation policies, governmental regulation and other factors.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.

There is a risk that the value of the collateral required on investments in senior secured floating rate loans and debt securities may not be sufficient to cover the amount owed, may be found invalid, may be used to pay other outstanding obligations of the borrower or may be difficult to liquidate.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

Before investing, investors should carefully read the prospectus and consider the investment objectives, risks, charges and expenses.

All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.

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