The basics of alternative investments - Part 2: Why invest in alternatives?

     

Jul 23, 2018 | Walter Davis

As I highlighted in my previous post, I’m using this summer to write a series of post covering the basics of alternatives, with an emphasis on those alternatives available via mutual funds. This is the second installment in the series, and focuses on the topic of why investors should consider alternatives.

Why use alternatives?
Like stocks and bonds, alternatives investments are simply tools that investors use in an effort to achieve their investment goals. Given their unique characteristics, alternative investments have the potential to help investors meet three key investment goals:

1. Building wealth - The primary reason people invest is to build wealth, be it to provide for a comfortable retirement, buy a home or pay for a college education. Alternatives can help investors build their wealth as they have the potential to generate attractive long term returns.  Furthermore, alternatives offer the potential to profit from opportunities outside of stocks and bonds in things such as currencies, commodities, real estate, master limited partnerships (MLPs), and infrastructure. Additionally, some alternatives have the ability to generate positive returns during both rising and falling market environments.

2. Preserving wealth – Alternatives can help investors preserve wealth in a number of different ways. Alternative investment strategies that have the ability to short (i.e., profit from a decline in the value of an asset) offer investors the potential to generate positive returns in a falling market environment and thus offset losses incurred by other assets held in the investor’s portfolio. Several alternatives have low correlation to traditional stocks and bonds, as well as low volatility, and as a result, can reduce the risk (as measured by standard deviation) of an investor’s portfolio. Additionally, investments in alternative asset classes can help investors preserve their purchasing power in the face of inflation, while other types of alternatives such as leveraged loans (e.g., senior secured loans to non-investment grade companies, also known as bank loans) can help protect investors against rising interest rates (which cause prices of bonds to decline).

3. Enhance current income – Historically, government bonds were the preferred investment for many investors as they provided an attractive level of current income with very low risk. For example, during the 1980s and 1990s the yield on 10-year US government bonds ranged between approximately 5% and 10%. Since the year 2000, however, yields have fallen sharply, and 10-year US government bonds currently yield only 2.855%. As a result of low rates, many investors are searching for investments that can deliver attractive levels of yield. There are a number of alternatives that offer investors the potential to achieve attractive levels of current income, albeit with greater risk than that associated with government bonds. Examples of alternatives that can provide investors with current income include leveraged loans, real estate income funds, MLPs, and infrastructure funds.

The ability of alternatives to help investors both build and preserve wealth is best demonstrated by looking at the historical performance of alternatives1 and comparing that performance to that of equities, fixed income and the traditional 60% stock/40% bond portfolio. This comparison is illustrated in the chart2 below.

On a historical basis, alternatives have generated a compound annual return slightly above that of stocks, with volatility well below that of stocks. Furthermore, the maximum decline for alternatives was less than half that of stocks. To me, the biggest take away from the above chart is that, while alternative can enhance return, their greatest contribution is reducing risk within a portfolio by dampening volatility and decreasing maximum decline.


1For purposes of this analysis, only the performance of liquid alternatives is included. The reason for this is that liquid alternatives are widely available to all investor types. In contrast, illiquid alternatives (e.g. private equity, venture capital, direct real estate, etc.) are only available to high net worth and institutional investors and are not available to retail investors. 
2Source: Invesco, August 1998– March 2018. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Alternatives portfolio is represented by a portfolio consisting of: 20% Inflation-hedging assets; 20% Principal preservation strategies; 20% Portfolio diversification strategies; 20% Equity diversification strategies; 20% Fixed income diversification strategies. Traditional 60/40 Portfolio is represented by 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index. Equities are represented by the S&P 500. Fixed Income is represented by the Barclays U.S. Aggregate Bond Index. 20% Inflation-hedging assets are represented by 15% FTSE NAREIT US Real Estate Index Series, All Equity REITs and 5% Bloomberg Commodity Index. The 15%/5% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. 20% Principal preservation strategies are represented by the BarclayHedge Equity Market Neutral Index. 20% Portfolio diversification strategies are represented by 12% BarclayHedge Global Macro Index and 8% BarclayHedge Multi-Strategy Index. Multistrategy is underweighted in this example due to its potential overlap with global macro. 20% Equity diversification strategies are represented by the BarclayHedge Long/Short Index. 20% Fixed income diversification strategies are represented by the 20% BarclayHedge Fixed Income Arbitrage Index; N/A% S&P/LSTA US Leveraged Loan Index. Data for the Leveraged Loan index became available on Aug 20, 2001, and is not included.

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