Are Alternative Investments Worth the Risk?

Grouping similar things into a descriptive category helps us manage complexity. The field of investment management has three major asset categories:

  1. Cash - includes short-term deposits at banks, short-term loans to the government (Treasury bills) or to corporations (commercial paper).
  2. Bonds - longer-term loans.
  3. Stocks - a share in the future profits of a business.

All other investments are referred to as alternative investments. These include:

Alternatives are added to a stock and bond portfolio to generate higher compound returns over time or to lessen the impact of severe market drops. Investors for most of the 20th century used real estate, gold, diamonds and antiques for this purpose. These helped diversify the inflation risk of bonds and the business failure risk of stocks.

Hedge Funds

 In 1949, Alfred Winslow Jones ushered in a new era by launching the first hedge fund which exploited leverage and derivatives to enhance performance. Over the last three decades, financial innovation has greatly expanded the range of available alternatives. Today there are more than 10,000 hedge funds in the U.S. and Morningstar lists over 1,500 U.S. registered mutual funds in their alternatives category. The term “hedge fund” is now used to describe a limited partnership with limited liquidity and a performance-based fee in addition to an annual management fee. It does not necessarily describe the investment strategy. 

Accessing alternatives through mutual funds has developed in the last 10 years, providing investors with the advantages of daily prices and liquidity and without performance-based fees. The category now includes strategies which buy under-valued stocks and sell over-valued ones (equity long/short), buy and sell mispriced bonds (fixed-income arbitrage), capture price trends (managed futures) and earn returns from specific risk/return factors (style premia). 

Selecting attractive alternatives requires three types of analyses:

  1. Statistical tests are applied to past results to determine whether they would have added risk-adjusted returns to a portfolio after fees.
  2. The investment process is studied to determine whether the past performance is likely to continue in the future.
  3. A due-diligence of the investment firm is performed, including the depth of their talent and risk controls, in order to assess the accuracy of their data and ability to respond to events in the future.

Risk and Return

Some brokers like to “sell” alternatives as offering equity-like returns with bond-like volatility. This is misleading. Risk and return are related.  Alternatives simply introduce new sources of returns and risks. One risk is that the short performance history of many of the funds makes it impossible to predict how each will be impacted by the next surprise in the markets. To mitigate this risk, our approach is to invest across a wide array of alternatives, limiting the combined exposure to 15% to 20% of your total portfolio.

While alternatives are more complex than stocks and bonds, many of the strategies can be clearly explained. Taking the time to discuss alternatives with an investment advisor can increase your understanding of and conviction in them. For many investors, it is time and effort well spent. (For more from this author, see: A Simple but Not Simplistic Investment Strategy.)