The basics of alternative investments - Part 5: Applying what we've learned


Aug 13, 2018 | Walter Davis

Welcome to the fifth and final post in our summer series on alternatives. The goal of this series is to help educate investors about alternatives, with an emphasis on those alternatives available as mutual funds. 

Over the course of the summer, we have defined alternatives, explained why investors should consider alternatives, discussed performance expectations, and outlined how to implement alternatives in a portfolio. In this final installment, the focus is on applying what we’ve learned to the current market environment. To this end, listed below are several common investor concerns and/or objectives aligned with specific alternative strategies that can potentially address those concerns and objectives. All of the strategies highlighted are available as mutual funds and are available to all investor types.

• If looking to boost returns in a lower return and more volatile environment for equites, consider alternative asset funds, and funds that have the ability to invest on a long/short basis across multiple asset classes, such as global macro – Alternative assets (also known as real assets) are investments in asset classes other than stocks and bonds. Investments in real estate, commodities, natural resources, infrastructure and master limited partnerships (MLPs) are all examples of alternative asset classes. Such investments have unique performance characteristics relative to equities, and, collectively, have outperformed equities over the past 20 years1. Meanwhile, strategies such as global macro and managed futures invest opportunistically on a long and short basis across the global equity, fixed income, currency, and commodity markets. These funds have the ability to select what markets they participate in, and, because they can invest on both a long and short basis, they have the potential to achieve profits in both rising and falling market environments. For this reason, they have the potential to outperform equities, especially during more challenging periods for equity performance. Additionally, they have the potential to perform well during periods of heightened market volatility. 

• If looking for principal preservation or loss avoidance, consider market neutral – Market-neutral funds trade related equities on a long and short basis, such that the fund has close to zero net market exposure. In market-neutral funds, the key to generating a positive return is security selection – determining which equities to go long and which to go short. Given the lack of net market exposure, these funds tend to be insulated against market swings, have the potential to generate positive returns in all market environments, and typically produce returns that have low correlation to stocks and bonds.

• If concerned about the impact of rising interest rates, consider senior loans and market neutral - Senior loans (also known as bank loans) are loans made by banks to non-investment grade companies, commonly in relation to leveraged buyouts, mergers and acquisitions. The loans are called “senior” because they are contractually senior to other debt and equity, and are typically secured by collateral. Given that the loans are made to non-investment grade companies, the yield associated with them tends to be higher than on investment grade corporate bonds. Another key aspect of senior loans is that the interest rate paid is a floating rate that resets every 30 to 90 days. This means that in a rising interest-rate environment, as long as the rate rises above a predetermined minimum level, the investor will benefit from rising rates by receiving increased payments from the borrower. In addition to senior loans, market neutral funds might make sense given that they are typically not exposed to interest-rate risk and have a return/risk profile similar to that of bonds.

• If concerned about a return of inflation, consider alternative assets – Alternative assets have historically increased in value during periods of inflation, and for this reason, can potentially help protect a portfolio during inflationary periods. 

• If looking for upside participation in a rising stock market with downside protection, consider long/short equity - Long/short equity funds combine both long and short equity positions in a portfolio, while typically being net long to equities. As a result, performance tends to directionally follow the equity market. Furthermore, the short positions have the potential to cushion performance during periods of stock market decline.

• If looking to boost current income, consider senior loans and income generating real assets such as real estate income funds, infrastructure and MLPs – For the reasons mentioned above, senior loans tend to produce attractive yield for investors. Income-producing real-asset investments such as infrastructure, MLPs, and certain types of real-estate investments, have the potential to deliver levels of current income above that of government and investment grade corporate bonds.

One final word on alternatives: the most common mistake investors make with alternatives is they invest on a reactive basis, and only invest in alternatives following a period in which they would have benefitted from holding alternatives. For this reason, I strongly encourage investors to proactively consider and allocate to alternatives, especially given the current market environment.

1See the performance table contained in my previous blog. 

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