Do you ever wonder if your portfolio is diversified enough? Or maybe you get the sense it’s missing something?
If you answered yes, you are not alone. As the access to alternative investments has increased in recent years, investors like yourself have been looking to incorporate them into their portfolios. But how, and is it right for your investment portfolio? In this blog we’ll walk you through the basics of alternative investments.
What Are Alternative Investments?
Alternative investments are assets outside of your traditional portfolio of stocks, bonds, and cash. They are non-correlated assets, meaning their performance does not follow other assets. The broad universe of alternative investments can be broken down into two categories: alternative asset classes and alternative strategies.
Alternative asset classes, such as real estate, commodities, and currencies, provide exposure to risk/return sources different than your traditional stock or bond exposure. Timber, farmland, art, wine, coins, and collectibles also fall into this category.
Alternative strategies are typically actively managed and may include investing within special vehicles, such as private equity and hedge funds. Private equity and hedge funds are often characterized by their lockup periods, higher fees, and minimum initial investments, as well as their accredited investors/qualified purchaser limitation. Accredited investors are investors with $1 million or more in assets excluding their primary residence, qualified purchasers are those with $5 million or more in assets excluding a private residence.
Liquid alternative strategies came to bear after the global financial crisis in an attempt to bring hedge fund-like returns to retail investors. Liquid alternatives are a group of accessible vehicles including mutual funds, exchange-traded funds (ETFs), and exchange-traded notes. Relative to their private counterparts, liquid alternatives have lower fees, daily liquidity, greater transparency, and lower minimums. The most common liquid alternative strategies include long/short equity, managed futures, and long/short fixed income.
Which is Better – Liquid or Illiquid?
As with any other investment decision, the answer depends on your unique circumstances, preferences, and constraints. Hedge fund returns may “benefit” from an illiquidity premium and would likely outperform similar liquid alternative funds on average.
However, investors may be deterred by hedge funds’ limited pricing transparency, higher fees, and inability to access the capital invested. Further, hedge fund managers have the flexibility to use leverage and derivatives, to invest in illiquid assets, and to short positions at their discretion. Because of these characteristics, investors may decide liquid alternative strategies or asset classes align better with their preferences and constraints.
Why Invest in Alternatives?
The market environment appears to support the case for alternative strategies as a standalone or part of a 60/40 portfolio. Investors may seek exposure to liquid alternatives or hedge funds for various reasons, such as:
- Capitalize on current or short-term market conditions
- Return enhancement
- Portfolio diversification
- Capital preservation in uncertain markets impacted by inflationary pressures
- Reduce risk in a rising-rate environment
- Inflation protection
- Achieve a rate of return above inflation
- Manage risk in periods of extreme drawdown
Are Newer Investments Considered Alternative Assets?
It is worth noting that liquid alternative strategies have evolved in recent years, with some funds increasing allocation to special purpose acquisition companies, or SPACs. SPACs, often called “blank check” companies, essentially create a way for companies to go public without the time and expense of an initial public offering (IPO.) While buying SPACs individually in the over-the-counter (OTC) market has proved to be a risk-aggressive trading strategy in 2021, certain liquid alternative funds may enable you to gain diversified exposure to this segment.
Buffer funds are also touted as a way to manage downside risk. Similar to structured notes, these offerings are now in ETF form and provide a collar around a stock price – meaning they provide a cap and a floor on the potential price of an active investment. That is in contrast to the structured product form which often had little pricing transparency, liquidity, higher fees, and more credit risk. These strategies have worked well enough but have a limited track record, and the terms can be complex depending on the provider. In my personal opinion, they could be helpful for certain investors but have significant drawbacks for long-term investors.
Lastly, I would be remiss if I ignored cryptocurrency. There is popular debate as to whether “crypto” qualifies as an alternative investment in your portfolio. We’ll write more on that in the coming months. Until then, cryptocurrencies are still new and very volatile. It’s becoming easier to gain exposure with the first Bitcoin ETF being launched on the NYSE in October 2021. It’s still a very risky asset class, not your traditional diversification tool that liquid alternatives have served in recent years. Talk to your financial advisor to see if there is a place for crypto in your financial plan.
How Do I Choose an Alternative Investment?
Your objectives and risk tolerance will determine the most appropriate strategy. First, review your current portfolio and consider whether you have already incorporated traditional holdings in an attempt to meet your objectives at a lower cost. For example, if your objective is to beat inflation, you may already have incorporated this objective with a higher equity allocation to outpace inflation. In other words, keep it simple where you can.
If you are contemplating adding alternative investments we encourage you to speak with an investment professional or your financial advisor. Active manager selection can be a challenging task for retail investors and investment professionals alike. Alternative strategies are even more complex and have a wide range of potential outcomes that require ongoing evaluation. Consider your preferences and constraints – for example, some strategies and managers may use more leverage and derivatives than others.
How Can Tull Financial Help?
The investment advisors and certified financial planners at Tull Financial Group are happy to talk to you about how you might incorporate alternative investments into your overall investment portfolio. Liquid alternatives may offer enhanced returns and the potential to better manage risk if implemented successfully.
Disclosures and Definitions
The information contained in this document is based on sources believed to be reliable. However, accuracy and completeness cannot be guaranteed.
Past performance does not guarantee future results. As with any investment strategy, there is potential for profit as well as the possibility of loss. Tull Financial Group does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. This document does not constitute a complete description of our investment services and is for informational purposes only. It is in no way a solicitation or an offer to sell securities or investment advisory services. All investments involve risk, including foreign currency exchange rates, political risks, market risks, different methods of accounting and financial reporting, and foreign taxes. Your use of these materials, including the tullfinancial.com website, is your acknowledgment that you have read and understood the full disclaimer below.
The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. Investments in bonds are subject to interest rate, credit, and inflation risk. High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings. Futures trading is speculative in nature and involves substantial risk of loss. Futures are not suitable for all investors.
Risk of Loss
All investments have certain risks that are borne by the investor. TFG’s investment approach keeps the risk of loss in mind. However, as with all investments, clients face investment risks with particular instruments discussed in this article which including the following:
Important considerations regarding liquid alternative funds
- Fund performances vary. The strategy of any liquid alternative fund is set by the portfolio managers, and the performance of individual funds varies widely. Research your fund options and understand the strategy behind them before you invest in any one.
- Personal risk tolerance. Because these funds can include short positions, use of derivatives, and illiquidity, there’s the potential for significant losses. Establish your own risk tolerance and then invest accordingly.
- Investment goals. Talk to your financial advisor about your goals, and whether a liquid alternative fund makes sense for your return expectations and overall investment strategy.
Definitions and descriptive statistics for strategies
The definitions were adapted from HFR or Morningstar or both.
- Long/short equity strategies are designed to provide variable equity exposure while allowing for broader management of market risk and/or the ability to benefit from short exposure with improved downside risk mitigation. Because of the higher associated trading costs, long/short mutual funds tend to have higher fees than traditional mutual funds. For example, long/short equity funds averaged a 1.9% expense ratio, compared to a .57% expense ratio average across all mutual funds, according to 2016 data from Morningstar. In addition, the funds make use of more complex investment strategies and can be considered riskier than traditional mutual funds.
- Long/short credit – These funds seek to profit from changes in the credit conditions of individual bond issuers and credit markets segments represented by credit indexes. Typically, portfolios purchase bonds, or sell credit default swaps, expecting to profit from narrowing credit spreads; or the funds sell bonds, or purchase credit default swaps, expecting to profit from the deteriorating credit of the underlying issuer. This category includes funds that use credit derivatives to hedge systematic risk of credit markets to isolate credit selection returns.
- Managed futures – These funds primarily trade liquid global futures, options, swaps, and foreign exchange contracts, both listed and over-the-counter. A majority of these funds use trend-following, price-momentum strategies. Other strategies in this category are systematic mean-reversion, discretionary global macro strategies, commodity index tracking, and other futures strategies. Often, much of a fund’s exposure is invested through derivative securities. These funds obtain exposure primarily through derivatives; the holdings are largely cash instruments.
- Currency – Currency portfolios invest in multiple currencies by using short-term money market instruments; derivative instruments, including and not limited to forward currency contracts, index swaps, and options; and cash deposits. Funds include systematic and discretionary strategies.
- Purchasing Power Risk – Purchasing power risk is the risk that a client’s investment’s value will decline as the price of goods rises (inflation). The investment’s value itself does not decline, but its relative value does, which is the same thing. Inflation can happen for a variety of complex reasons, including a growing economy and a rising money supply.
- Cryptocurrency is a digital representation of a stored value secured through cryptography. Although Bitcoin might be one of the most widely known cryptocurrencies today, there are many others. The markets for cryptocurrencies remain highly volatile and risky. Before turning your hard-earned cash into crypto, review investor alerts and other resources from regulatory authorities here.