You may know diversification is one way to weather periods of market uncertainty. During particularly volatile or low-yield times, your investment strategy may benefit from more complex investments with returns that are separate from equity or fixed income markets.
That’s when you may want to consider alternative investments. Alternative investments tend to move counter to stock and bond markets, which may make them an effective diversification tool.1
Before diving into specific types of alternative investments, it’s important to know what distinguishes them as an investment.
According to Kurt Silberstein, managing director, alternative investments at U.S. Bank Wealth Management, alternative investments differ from traditional stock and bond investing in that they’re:
A key distinguishing feature of alternative investments is they’re expected to generate an absolute return, independent of any benchmark.2 “If you look at a relative return investment, such as stocks and bonds,” explains Silberstein, “you’re comparing it to a publicly traded index such as the S&P 500. It’s considered a success if your investment outperforms the index, even if your return is negative.”
For example, let’s say the S&P 500 returns -4.4 percent (like it did in 2018) and your investment returns -3.5 percent. Although your investment lost money, comparatively speaking, it has performed better because it has outperformed the index.
Alternative investments include hedge funds, private equity, real assets, commodities, collectibles and derivatives.
Hedge funds are investments that use pooled funds with the goal of generating high potential returns for investors.3 Unlike mutual funds, hedge funds consist of assets beyond stocks and bonds. Because of the inherent risk associated with hedge funds, most are only appropriate for accredited/qualified investors, those who could withstand the total loss of value of their investment.4
“We look for hedge funds with a unique skill set, competitive advantage and the potential to generate positive returns in difficult market environments,” Silberstein says. There are many different hedge fund strategies, he says, and some come with more risks than others. Additionally, hedge funds aren’t tax-efficient investments, so investors should work with a financial professional to ensure the anticipated after-tax return is consistent with their financial goals.
Consider private equity as the alternative investing counterpart of publicly traded stocks. Unlike stocks, however, when a business seeks private investors, only accredited/qualified individuals may invest.6
“Successful private equity investments have historically shown the ability to outperform their public market proxies, whether it be bonds or equities,” Silberstein says. “Investors may benefit from investing in private equity funds whose investment teams are able to implement changes. Whether it be increasing revenues, cutting costs, or instituting changes among the executive decision-makers, these changes can equate to a higher valuation when the company is sold.” A successful private equity investor has the ability to spot funds that can turn around the fortunes of struggling companies.
There is the potential for some unique advantages for investors who successfully incorporate private equity into their portfolios, but there are also associated risks, including the full loss of the investment. In addition, private equity is considered an illiquid investment with no secondary market, so investors should be prepared to have their money tied up for at least 10 years.
In addition, companies seeking private investors are not required to disclose as much information as publicly traded companies, so it’s important to conduct research in advance and partner with a knowledgeable financial professional.
Typically, seeking a worthwhile investment in this area requires familiarity with a given sector. Silberstein recommends tapping into a network of investors and advisors to help source solid private equity opportunities.
Real assets are an investment class that includes real estate and infrastructure. Real estate investment trusts (REITs) allow investors to purchase shares in portfolios with holdings in homes, apartments and forms of infrastructure such as airports and toll roads. Publicly traded REITs are available to all investors, while privately traded REITs are only available to accredited/qualified investors.7
Infrastructure can be a good way to diversify your portfolio. Silberstein says although infrastructure returns have underperformed public markets over the past 10 years, the returns are generally consistent and can have relatively low volatility. However, investors should be aware of the lack of liquidity often associated with investing in real assets.
Commodities are an investment class referring to raw materials used for consumption or industry such as produce, livestock, precious metals and fuels. When buying commodities or natural resources, you’re anticipating the price of a given product will increase at a later date.
Commodity prices have been volatile, and they are also highly affected by weather, such as droughts, floods and natural disasters. Silberstein suggests the everyday investor take caution and do their own research or contact a knowledgeable financial professional before jumping into the commodities market.
Derivatives apply to many financial instruments, from stocks and bonds to commodities and currencies. They’re called derivatives because they’re derived from the prices that two parties agree upon with respect to these underlying assets.9 The performance of a given derivative depends upon the performance of the underlying assets.
Common forms of derivatives include:
Although there are several derivative strategies, for the most part they’re used to hedge a portfolio or to generate a return regardless of whether the market is trending up or down. Keep in mind, however, that strategies that incorporate derivatives have risk of their own. For example, the implied leverage can result in larger than expected losses if the trade is not structured properly.
Collectibles — including fine art, classic cars, and wine — are another type of alternative investment. Many investors find collectibles to be an alluring investment because they can follow their passions and aesthetic choices while investing. While collectibles can offer high returns, they rely on the fickleness of taste and reputation.
In fact, Silberstein suggests most investors avoid collectibles. “There has been a great deal of fraud within the wine world, and it’s very difficult to determine what’s going to be the next hot collectible in the art world.”
As with any investment, it’s important to consider individual alternative investments within the larger context of your portfolio strategy.
Seek an alternative investment with a unique skill set and a competitive advantage within its market. According to Silberstein, investors should consider three potential benefits of alternatives within a diversified portfolio:
“It’s tough to find one alternative that can do all three, but if you know how to source funds you can find those funds that may achieve two of three,” says Silberstein.
Investors might consider alternatives as another means of offsetting the risks they have in terms of stock and bond exposures. For example, if you have stock and bond investments, you might consider an alternative investment with a low correlation to the stock and bond market. This way, you’ll potentially gain access to a return stream less sensitive to market movement.
If you’re interested in entering the world of alternative investments, be sure to talk with a financial professional about which types can be an appropriate fit within your portfolio.
Read more about diversification strategies for your investment portfolio or check out our approach to investing.