Faced with rock-bottom interest rates, higher inflation, higher valuations, and crowded or over-hyped markets for traditional stocks and bonds, it’s only natural for wise, experienced investors to investigate alternatives.
Alternative investments, used by large institutions and endowments for decades, have become more mainstream in recent years. New products have made the asset class more accessible to a much broader group of investors. Because these investments have low correlation to traditional investments, they have the potential to improve the overall risk-return characteristics of a portfolio. Given the benefits of additional diversification and the potential for higher returns, a modest allocation to alternatives is appealing to investors with long-term time horizons and moderate cash flow requirements. However, this non-traditional asset class also presents risks that investors should be aware of.
What are Alternative Investments?
Alternative investments’ relevance on the global investment stage has changed dramatically over the past two decades. In 2004, alternative investments comprised 6% or $4.8 trillion of the global investable market. By the end of 2018, the size of global markets had doubled, while alternative investments had almost tripled. As of 2018, the Chartered Alternative Investment Analyst (CAIA) Association estimated the size of the traditional global asset market at $102.6 trillion, while alternative investments had grown to $13.4 trillion, or 12% of the global investable market. In The Next Decade of Alternative Investments, published in 2018, the CAIA Association estimated that alternative investments will range between 18% – 24% of the global investable market by 2025.
Common stocks, bonds, and cash dominate most portfolios, but represent only a portion of investment opportunities. In the simplest sense, alternative investments are everything that is not one of these three traditional investments. Alternatives are often less liquid, particularly in periods of stress; they are generally more complex and less transparent, making them difficult for untrained investors to understand; they are more susceptible to investment manager failure; and they can have a complicated tax profile.
According to the CAIA Association, there are two key reasons to include alternative investments in an investment portfolio: to reduce risks or to enhance returns. At Fulcrum, we believe cash and bonds serve as a more cost-effective risk mitigation tool than complex products such as hedge funds. We do, however, utilize alternative investments to improve returns. When we employ alternative investments, they serve a very clear role: to potentially generate income or long-term capital appreciation from sources other than traditional stocks and bonds.
Alternative Investment Examples
Examples of the strategies that we have employed or currently employ include income-focused direct private real estate, distressed or opportunistic real estate, insurance-linked securities and reinsurance bonds, structured credit, private credit, timber/farmland, alternative energy, and commodities. Each of these serves as an alternative to traditional bonds and stocks.
Constraints of Alternative Investments
There are several constraints associated with alternative investments:
- Higher fees – Alternative investments can have considerably higher fees than traditional investments so returns need to be considered on a net-of-fee basis.
- Greater sophistication – Alternative managers may invest in a wide variety of investments. Understanding complicated investment strategies and structures requires more upfront and ongoing due diligence.
- Less transparency and information asymmetry – There can be limited transparency into the underlying holdings of these types of investments. Additionally, some managers may be unwilling to share pertinent information with their investors for competitive reasons.
- Limited regulatory oversight – Compared to public market investments, many alternative investments are subject to less regulatory oversight. It is important to select an alternative investment manager with a strong track record, audited financials, and a strong reputation.
- Lower liquidity – Liquidity refers to the ability to trade or convert your investment to cash without impacting the price. Many alternative investments hold illiquid investments such as real estate, which can restrict an investor’s ability to collect their invested funds in a timely fashion. The underlying investments used in an alternative investment strategy may also become less liquid in a stressful trading environment, resulting in the investment vehicle’s being ‘gated.’ Though rare, in this scenario, an investor may only receive a portion (if any) of their capital at redemption, rolling the rest to the next trade window. The exit can take months or years.
- Tax considerations – Most alternative investment strategies have little to no focus on minimizing taxes. Also, those whose legal structure is a limited partnership issue a K-1 statement rather than a 1099, which may require an investor to file for an extension on their tax return.
Benefits of Alternatives
With those limitations, why invest in alternatives? As mentioned earlier, alternatives generally provide differentiated returns depending on your objective. For example, many private credit and real estate investments generate income that rises with interest rates and inflation, while traditional bonds tend to fare poorly under those circumstances. Alternatives complement traditional investments and can offer greater access to unique manager skills. According to the World Bank, the number of publicly traded stocks in the U.S. has shrunk by nearly 45% in the past 25 years. As the universe of public investments shrinks, the universe of private alternatives expands the opportunities available to you..
We believe with careful analysis and implementation, the constraints can be managed, and alternative investments can provide diversification and potentially improve return if used appropriately. Please contact your Fulcrum advisor if you have questions about our approach to alternative investments and their use in your portfolio.
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