Explaining the basics of alternative strategies
Alternative investments (alts) were first embraced by institutions, and some people still view them as a complex solution for complex needs. However, a growing number of alternative strategies are now available via mutual funds. This allows alts to be used by everyday investors to help meet three of their most common investment objectives: building wealth, preserving wealth and providing income.
Why use alternatives?
Like stocks and bonds, alts are simply tools that investors can use in an effort to help achieve their financial goals. With some unique characteristics, alternatives have the potential to help investors:
- Build wealth. The primary reason people invest is to build wealth, whether to provide for a comfortable retirement, buy a home or pay for a college education. Alternatives offer opportunities to profit outside of stocks and bonds through asset classes such as currencies, commodities, real estate, master limited partnerships (MLPs) and infrastructure. Additionally, some alternatives are designed to generate positive returns during both rising and falling market environments.
- Preserve wealth. Alternatives can be incorporated into strategies designed to help investors preserve wealth.
- Alt investment strategies that have the ability to take short positions in securities (which are designed to profit from a decline in the value of those securities) offer investors the potential to generate positive returns in a falling market environment (offsetting losses incurred by traditional assets in the portfolio).
- Over the past 20 years, a portfolio consisting of alternatives generated a slightly higher return than traditional stocks and bonds with reduced volatility and a lower maximum drawdown (please see the chart following section #3).
- Additionally, investments in certain alternative asset classes (like commodities or real estate) may help investors preserve their purchasing power during inflationary periods, while other types of alternatives (such as leveraged loans, also known as bank loans) may help mitigate the effects of rising interest rates on a bond portfolio.
- Enhance current income. Historically, government bonds were the preferred investment for many investors. For decades, these provided an attractive level of current income with very low risk. For example, during the 1980s and 1990s the yield on 10-year US government bonds ranged between approximately 5% and 10%.1 Since 2000, however, rates have fallen sharply, and 10-year US government bonds currently yield only 2.88%.2 With many investors searching for better-yielding investments, attention has turned to a number of alternatives that can generate attractive levels of current income, albeit with greater risk than government bonds. Alternatives which may offer attractive yields include leveraged loans, real estate income funds, MLPs and infrastructure funds.
The ability of alternatives to help build and preserve wealth is best demonstrated by comparing the historical performance of alts3 to that of equities, fixed income and the traditional 60% stock/40% bond portfolio. This comparison is illustrated in the chart below.4
On a historical basis, alternatives have generated a compound annual return slightly above that of equities with much less volatility. Furthermore, the maximum decline for alternatives was less than half that of equities. To me, the biggest takeaway from the above chart is while alternatives may enhance return, their greatest potential benefit is reducing risk within a portfolio by dampening volatility and decreasing maximum decline.
About the series
As highlighted in my previous blog, this summer I am writing a series covering the basics of alternatives, with an emphasis on those available via mutual funds. This is the second installment in the series. My next blog will focus on how to incorporate alternatives into a portfolio. In the meantime, to learn more about Invesco and its alternative products please visit our website at www.invesco.com/alternatives.
1 Source: Bloomberg L.P., data as of May 31, 2018
2 Source: Bloomberg L.P., data as of June 25, 2018
3 For purposes of this analysis, only the performance of liquid alternatives is included. The reason for this is that liquid alternatives are widely available to all investor types. In contrast, illiquid alternatives (e.g., private equity, venture capital, direct real estate, etc.) are only available to high net worth and institutional investors, and are not available to retail investors.
4 Source: Invesco, August 1998 to March 2018. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Alternatives portfolio is represented by a portfolio consisting of: 20% inflation-hedging assets, 20% principal-preservation strategies, 20% portfolio-diversification strategies; 20% equity-diversification strategies and 20% fixed income-diversification strategies. Traditional 60/40 portfolio is represented by 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index. Equities are represented by the S&P 500. Fixed income is represented by the Bloomberg Barclays US Aggregate Bond Index. 20% inflation-hedging assets are represented by 15% FTSE NAREIT US Real Estate Index Series, All Equity REITs and 5% Bloomberg Commodity Index. The 15%/5% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. 20% principal-preservation strategies are represented by the BarclayHedge Equity Market Neutral Index. 20% portfolio-diversification strategies are represented by 12% BarclayHedge Global Macro Index and 8% BarclayHedge Multi-Strategy Index. Multi strategy is underweighted in this example due to its potential overlap with global macro. 20 % equity-diversification strategies are represented by the BarclayHedge Long/Short Index. 20 % fixed income-diversification strategies are represented by the 20 % BarclayHedge Fixed Income Arbitrage Index; N/A% S&P/LSTA US Leveraged Loan Index. Data for the Leveraged Loan index became available on Aug. 20, 2001, and is not included.
Walter Davis
Alternatives Investment Strategist
As Alternatives Investment Strategist, Walter Davis serves as Invesco’s primary alternatives representative to retail, high net worth and institutional clients across the major broker dealers, wirehouses and RIAs. He is responsible for collaborating across Invesco’s alternative strategies to develop a cohesive alternatives education program for financial advisors and investors.
Prior to joining Invesco in 2014, Mr. Davis served as a managing director in Morgan Stanley’s Alternative Investments Department, and earlier as director of High Net Worth and Institutional Sales. Prior to Morgan Stanley, he worked at Chase Manhattan Bank in the Alternative Investments Department. He has worked in the industry since 1991.
Mr. Davis graduated cum laude with a BA in economics from the University of the South. He earned an MBA in finance and international business from Columbia Business School. He holds the Series 3, 7, 24 and 63 registrations.
Important information
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The Bloomberg Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment grade, fixed-rate bond market.
The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.
The Bloomberg Commodity Index is a broadly diversified commodity price index.
The BarclayHedge Equity Market Neutral Index includes funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country.
The BarclayHedge Global Macro Index includes funds that carry long and short positions in any of the world’s major capital or derivative markets.
The BarclayHedge Multi-Strategy Index includes funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines.
The BarclayHedge Long/Short Index includes funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market.
The BarclayHedge Fixed Income Arbitrage Index includes funds that aim to profit from price anomalies between related interest rate securities.
The S&P/LSTA Leveraged Loan Index is a weekly total return index that tracks the current outstanding balance and spread over LIBOR for fully funded term loans.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.
Alternative investments can be less liquid and more volatile than traditional investments such as stocks and bonds, and often lack longer-term track records.
Alternative products typically hold more nontraditional 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.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. 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.
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. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (PowerShares) and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.
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Why should investors consider alternatives? by Invesco
