Alternative investments (“alternatives”), refers to any asset other than stocks, bonds, or cash. Real estate, private equity, infrastructure, hedge funds, commodities, and venture capital are some of the most well known and invested in alternatives. Many of the largest and most sophisticated investors (i.e. Harvard, Yale) have been taking advantage of the benefits of alternative investing for decades.
Rewind to 2008/2009. Your investment advisor proclaimed that your portfolio was adequately diversified because not only did you have Canadian assets, but you had equity and fixed income exposures to the American and international markets as well. The subprime mortgage bubble burst, correlations to the above-mentioned assets all went to 1, and you saw your portfolio decline by almost half. AI could have helped lower your portfolio’s exposure to this financial crisis. To see why we can examine one of the main differences between a mutual fund (traditional) and a hedge fund (alternative). A mutual fund manager will construct portfolios by purchasing securities that they believe will perform well, while ensuring that there is no deviation from the investment mandate of the fund. On the other hand, a hedge fund manager has much greater flexibility in how they can construct portfolios. They can hedge, short-sell, and use derivatives, which allows them to capitalize on both rising and falling market environments. This flexibility results in hedge fund portfolios that are less correlated, uncorrelated, or even negatively correlated to the stock market.
That same advisor that thought you were properly diversified was also pleased with himself when your portfolio ‘only’ declined 35% vs. the 50% drawdown in the S&P 500. This ‘relative’ return mentality makes it difficult for you to know when your portfolio is doing well or not. In a bull market, you would be disappointed with a 5% return. However, in a bear market, you would be jumping for joy for that very same 5% return. Many alternative investments ignore their performance relative to any benchmark, but rather focus on generating absolute returns, that is, making money in all market environments. For example, take a portfolio that is comprised of various first mortgages that focus on residential, industrial, and commercial lending. A group of investors pool their money to invest across a diversified pool of income producing properties in the hopes of earning interest every month. The performance of the mortgage fund will depend on the manager’s ability to assess the credit worthiness of the borrowers, not whether the market was up or down that month.
Adding alternatives with lower correlations and absolute return mandates help reduce overall portfolio volatility, which to many professionals, means it helps reduce risk. Extreme market fluctuations are driven by human emotions. During a financial crises, investors notice substantial declines in many of their holdings. Scared that there is no bottom in sight, many investors panic and sell – usually at the worst possible time. A portfolio that exhibits lower volatility can help mitigate these dangerous swings in investor sentiment.
Adding alternatives with lower correlations and absolute return mandates help reduce overall portfolio volatility, which to many professionals, means it helps reduce risk. Extreme market fluctuations are driven by human emotions. During a financial crises, investors notice substantial declines in many of their holdings. Scared that there is no bottom in sight, many investors panic and sell – usually at the worst possible time. A portfolio that exhibits lower volatility can help mitigate these dangerous swings in investor sentiment.
In addition to tapping into high growth private market opportunities, there are other ways that alternative investments can beef up your portfolio’s return. First, realize that the alternatives industry attracts the best and brightest investment talent. How fees are structured and the resulting interest alignment between GPs and LPs means that successful managers can earn significantly more money than if they operated in the public markets. Now this doesn’t guarantee higher returns, but it surely increases the probability. What does guarantee higher returns is the liquidity premium that alternatives command. When you own a stock or bond, you can sell it at any point in time and convert that asset back into cash. Because many alternatives are illiquid compared to public market assets, investors should be compensated for this with higher returns.
Blackstone noticed that over the last 40 years, less liquid large capitalization stocks outperformed those with higher liquidity by almost 3% per annum. The outperformance was even greater with small capitalization (even less liquid) stocks and estimated to be well beyond 3% per annum for illiquid alternatives (private equity, real estate, infrastructure, venture capital, etc).
Going forward, the returns from a traditional 60/40 stock-and-bond portfolio will likely fall short of satisfying your investment requirements. Including alternatives in your portfolio will ensure you’re actually diversified (when you need it the most) and most importantly, help you achieve the return required to meet your financial goals. Like stocks and bonds, not every alternative is created equally and there are risks that an investor needs to be aware of. The key is finding the right AI to include in your portfolio.