Nontraditional Assets Can Complement a Diversified Portfolio

For some investors, alternative investments can help boost diversification and temper the effects of market volatility.

Your portfolio should reflect your individual goals, time horizon, tax profile and risk tolerance. It should also be well-diversified to better weather the ups and downs of the markets. Although it won’t ensure profits or guarantee against losses, diversification can help mitigate risk by spreading capital across differentiated securities and asset classes.

Investors looking to diversify beyond the traditional trio of stocks, bonds and cash may want to learn more about how alternative investments can complement conventional portfolios. The alternatives category encompasses nontraditional asset classes, as well as various investment strategies and structures intended to help minimize risk, dampen portfolio-level volatility or enhance returns. The risk profiles of alternative investments vary greatly depending on the strategy’s objective, so ample due diligence is recommended prior to making investment decisions.

Examples of nontraditional asset classes include global real estate, managed futures, commodities and currencies. On the vehicle side, hedge funds, derivatives and other leveraged instruments can offer sophisticated investment strategies requiring expertise that individual investors may not possess.

Be aware that alternative investments are somewhat more complex – and often more expensive – than traditional investments, so consult your financial advisor before making any moves.

Low correlation is desirable

The rationale for using alternative investments rests upon an investment concept known as correlation, a statistical measurement of how two or more securities or asset classes behave in relation to one another. For example, when one investment has demonstrated a historical tendency to decline in price when another investment is appreciating, they have a negative correlation. If they both tend to move in the same direction at the same time, they have a positive correlation.

A well-diversified portfolio includes a number of investments that have low correlation to traditional markets, meaning that if one holding or asset class declines in price, the less correlated strategy may – based on its historical behavior – moderate portfolio-level losses. The idea is to assemble holdings that can generate differentiated and therefore less volatile returns relative to traditional stock and bond investments.

There’s no one-size-fits-all portion of a portfolio that should be dedicated to alternative investments – the appropriate percentage, if any, depends on your specific financial profile and strategy.

Accessing alternatives

Alternative investments have long been regarded as something only institutional investors or the wealthiest individuals should consider. While they often do involve higher fees, innovations in investment structures have resulted in the creation of a number of alternative packages that may be useful to a broader group of investors. These types of investment vehicles enable individual investors to access specific asset classes or investment strategies with lower minimum investment requirements, potentially lower fees and fewer liquidity constraints than those often associated with many alternative investments.

It may help to think about alternative investments as a range of investments that come in a variety of packages, some targeting individual alternative securities and others focusing more on differentiated strategies. For example, certain currency and real estate investments are not tied to the performance of traditional stock or bond investments. Alternative strategies, on the other hand, approach the markets from a different angle; say with a long/short process. Still others use alternative structures that could encompass many portfolio management styles designed to nimbly provide exposure across different markets. Your advisor can summarize the range of choices and help you select ones that may be appropriate for your particular situation.

Terms to know

Convergence and divergence: Many alternative investments rely on one of these two strategies. Convergence strategies seek to generate returns when securities trading at different prices converge to the same price. By contrast, divergence strategies attempt to generate returns by focusing on securities with divergent returns – one security appreciates in value while another one declines.

Suitability: This term that refers to whether a given investment is appropriate for a specific investor in terms of their ability and willingness to tolerate the risks it entails. A high-risk investment may not be suitable for a conservative investor relying on that money to provide income, but might be suitable for investors with a longer time horizon, seeking to aggressively grow their portfolios, for example.

Liquidity premium: This refers to the additional amount of return an investor reasonably expects to receive in return for giving up the ability to quickly and easily convert their investment into cash. Many alternative investments cannot be sold at will and therefore should carry a liquidity premium.

Transparency: This refers to how readily an investor can determine what’s in an investment vehicle. Some are highly transparent because shareholders get regular reports on exactly what is owned. Others, by contrast, are typically less transparent because managers are not required to pro- vide details about their strategies.

A nuanced conversation needed

Alternative investments – by definition – are likely to involve asset classes and investment strategies you may not be familiar with and have not held in the past. If you decide to venture in, you almost certainly will be relying on the experience and expertise of the investment managers overseeing those investments. While you should always do your homework with an investment and be sure you understand what you own and why, alternatives require an extra degree of due diligence. Speak with your advisor to determine how they might serve your overall financial objectives.

Alternative investments involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements, including minimum net-worth tests. You should consider the special risks with alternative investments including limited liquidity, tax considerations, incentive fee structures, potentially speculative investment strategies, and different regulatory and reporting requirements. You should only invest in certain strategies if you do not require a liquid investment and can bear the risk of substantial losses. There can be no assurance that any investment will meet its performance objectives or that substantial losses will be avoided.