What are Alternative Investments?
Alternative Investments are comprised of non-traditional asset classes, such as private equity, hedge funds, real estate, and commodities, i.e. “alternatives” to fixed income and equity securities.
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Alternative Investments Overview
Alternative investments, or just “alternatives,” refer to any non-conventional approaches to investing.
- Traditional Investments → Common Shares, Bonds, Cash & Cash Equivalents
- Non-Traditional Investments → Private Equity, Hedge Fund, Real Assets, Commodities
Generating outsized, above-market returns has become increasingly difficult — therefore, alternatives have emerged to become an integral part of many modern portfolios.
In particular, alternatives have become regular holdings in the portfolios of those managing a larger amount of assets (e.g. multi-strategy funds, university endowments, pension funds).
Traditional investments comprise of debt issuances (e.g. corporate bonds, government bonds) and equity issuances by publicly-traded companies — which are vulnerable to the prevailing economic conditions and market fluctuations.
In contrast, alternative investments utilize riskier tactics such as leverage, derivatives, and short-selling to increase upside potential while still limiting downside risk with strategies like hedging.
Types of Alternative Investments
The common types of alternative investments are defined in the chart below.
Portfolio Asset Allocation of Alternatives
Alternative investments — in theory at least — should “complement” an investor’s traditional equities and fixed income holdings, rather than comprise the entirety of a portfolio.
Since the 2008 recession, more institutional investors have diversified their portfolios into alternatives such as hedge funds, private equity funds, real assets, and commodities.
While most of these institutions — e.g. university endowment funds, pension funds — have opened up to alternatives, the proportion of their capital placed in such vehicles as a percentage of their total assets under management (AUM) remains relatively small.
The recommended asset allocation into alternatives versus traditional investments depends on a specific investor’s risk appetite and investment horizon.
In general, the benefits of alternative investments are as follows:
- Diversification: Complement traditional portfolio holdings and mitigate market risk (i.e. not entirely concentrated on just one strategy).
- Return Potential: Alternatives should be viewed as another source of returns from the exposure to more securities and strategies.
- Lower Volatility: Despite many of these funds being riskier, their inclusion in the portfolio can reduce the total portfolio volatility if strategically weighted (e.g. they can help offset losses against traditional investments in a recession).
Performance of Alternative Investments
Risks to Alternative Investments
One major drawback to alternative investments is liquidity risk, since once invested, there is a contractual period during which the capital contributed cannot be returned.
For instance, an investor’s capital could be tied up and be unable to be withdrawn for long duration of time as part of an alternative investment.
Since most alternative investments are actively managed vehicles, there also tend to be higher management fees plus performance incentives (e.g. the “2 and 20” fee arrangement).
Given the higher risk of losing capital, certain strategies like hedge funds are only available to investors that meet certain criteria (e.g. income requirements).
The final risk to consider is that certain alternative investments have fewer regulations and oversight from the U.S. Securities and Exchange Commission (SEC), and the reduced transparency can create more room for fraudulent activities such as insider trading.