Alternative investments are not simple or inexpensive. However, if they work, your investment portfolio potentially has better returns with less volatility. And, the availability of these investment options is increasing. But, are they right for you?
In the past, alternative investments were utilized mainly by large institutions. However, because this investment option has been red hot in attracting assets since the 2008-2009 financial crisis, alternative investing has become more accessible to individual investors.
According to the SEC, mutual funds using an alternative investment strategy held $365 million in total assets in 2005. Fast forward to 2014, that number ballooned to around $334 billion across 569 funds. Just between 2011 and 2014, total assets grew by a whopping 58 percent per year! Investors are clearly desperate for something that will hold up well the next time the stock market sinks.
What are Alternative Investments?
In general, these are investments which are not included in the traditional asset classes of equities, bonds, and cash. Examples of alternative investments are precious metals like gold and silver, real estate, private equity, hedge funds, and absolute return funds.
Alternative investments employ a different approach to investing compared to traditional investments. This approach may include holding private securities instead of publicly traded investments, shorting positions, or utilizing derivatives. As a result, these types of investments tend to act differently than stocks and bonds.
Why use Alternative Investments?
We live in a global world where economies are more intertwined than ever before. This has made it difficult to rely solely on investing in bonds and stocks to build a diversified portfolio that can withstand major swings in the markets without decreasing the return potential.
Since alternative investments act differently than stocks and bonds, adding them to your portfolio can provide broader diversification, which can reduce the potential ups and downs of your overall portfolio. How is this possible? If the performance of alternative investments, such as precious metals, does not follow the stock market, then potentially these investments may do better when the stock market is down. Additionally, with their ability to be more flexible by investing in a wider range of opportunities, alternative investments can increase the potential return of your investment portfolio.
Incorporating Alternative Investments into Your Portfolio
Let’s take a look at factors you need to consider when incorporating alternative investments into your investment portfolio:
How much to invest: When determining how much to allocate to alternative investments, make sure it’s large enough to make a difference, but not so large that it dominates your portfolio. Although the allocation can be higher in unique situations, typically allocating 10-20 percent of your total investment portfolio to alternative investments is considered appropriate.
Where to get the money: Not all alternative investments have the same objectives; as such, they should be funded differently. Strategies that are focused on an absolute level of return regardless of market conditions should be funded from the fixed income portion of your portfolio. On the other hand, strategies that are seeking enhanced returns like venture capital and private equity should be funded from your equity portion. Strategies that are looking for both better returns and lower volatility can be funded proportionately from the equity and fixed income allocations.
Picking the best: With so many new products popping up in this fast-growing space, it can be overwhelming to navigate through the sea of options. Exercise caution by choosing strategies with a proven track record for at least 5 years, as well as a stable investment team and process. This is crucial because unlike traditional investments, in which much of the performance is driven by asset class exposure, performance in alternative investments is typically largely dependent on manager skill. Moreover, confirm that the performance has been demonstrated, meaning it actually happened as opposed to back-tested track records which are also referred to as "paper" portfolios. Lastly, make sure you review the costs. Some strategies have layers of embedded fees in their vehicle structure that can quickly add up.
While alternative investment strategies can potentially enhance your investment return or reduce the overall risk of your portfolio, it is a complicated area. Understanding the investment strategy being used, the fees you will be charged, and the appropriate allocation within your portfolio is paramount to being a successful investor. It may be wise to seek the counsel of a financial advisor or investment professional who is active in this area before committing your hard-earned money.
Anthony Bykovsky, CFA, an Associate Portfolio Manager at Bedel Financial Consulting, contributed to this article.
Elaine E. Bedel, CFP, is CEO and president of Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. She is a featured guest each Wednesday on the WTHR (NBC, Indianapolis) Channel 13 News at Noon, "Your Money" segment. Elaine’s book, "Advice You Never Asked For… But wished you had," is available on Amazon.com. For more information, visit www.BedelFinancial.com or email Elaine at firstname.lastname@example.org.