The opening month of 2016 was not kind to traditional stock investors. Many analysts are forecasting that equity markets in 2016 will be characterized by either volatility or an outright slump. The situation has some investors looking at alternative investments, and they're following the lead of fund managers who openly plan to devote a larger portion of their portfolios to alternatives in 2016. Volatility tends to favor alternative investing strategies used by hedge fund managers, such as long/short investing and arbitrage trading.
Alternative investments encompass a broad range of investments and investment strategies outside the traditional choices of stocks or bonds. It includes commodity or commodity futures investing, hedge funds, real estate, private equity investments, foreign currency trading and derivatives.
Many alternative investments, such as hedge funds or private equity investments, used to be observed exclusively by institutional investors or high net worth individuals (HNWIs) because of the high minimum investments required. However, the expanded offerings in mutual funds and exchange-traded funds (ETFs) have brought most alternative investments within easy reach of small investors.
An investor may not have the capital necessary to make direct hedge fund or private equity investments, but he can still access such investments through mutual funds or ETFs. To qualify, these alternatives must use hedge fund strategies or invest in private equity, like the IQ Hedge Multi-Strategy Tracker ETF or the Listed Private Equity ETF from Invesco PowerShares.
Performance of Alternatives vs. Traditional Investments
Alternative investments generally correlate negatively to most traditional investments, so they tend to outperform when the overall equity market is volatile or performing poorly. For example, alternatives significantly outperformed traditional investments during the financial crisis from October 2007 to April 2009. During that time, the only traditional investment that registered a positive gain was investment-grade bonds. However, while the overall U.S. stock markets were suffering more 40% losses, some alternative investments, such as managed futures and gold, produced double-digit gains.
However, not all alternative investment strategies turned a profit during the financial crisis. During the same time frame, commodities declined 25% overall, and long/short trading strategies saw an average 17% loss. While negative, those numbers still represent better performances than traditional equities.
The period from 2000 through most of 2002 saw the technology sector bubble burst, providing another example of alternatives outperforming traditional investments. During that time, U.S. stocks were down approximately 35% overall, while global macro strategies often employed by hedge funds were up over 40%, managed futures strategies saw an average 21% return and risk arbitrage gained 11%.
Conversely, alternative investments tend to lag behind traditional investments when the U.S. equity market is performing strongly. From 2010 to 2015, during which stocks experienced a major bull market, the IQ Hedge Multi-Strategy Tracker ETF showed an average annualized gain of only 1.77%, while the Vanguard Total Stock Market ETF had average annualized gains over 8%.
Types of Alternative Investments
Investors should consider integrating alternative investment classes or strategies into their 2016 investment portfolio.
A global macro strategy is often employed in hedge funds. This strategy may involve other alternative elements, such as long and short positions or futures. It selects portfolio holdings based on the fund manager's view of global macroeconomic and political conditions.
Futures are a popular alternative investment class that invest directly in commodities such as oil and gold. Investors can choose from direct futures contract investing, managed futures accounts, or mutual funds and ETFs that hold commodity futures contracts.
Risk arbitrage involves making trades to take advantage of temporary price discrepancies. It includes merger and acquisition arbitrage, pairs trading and liquidation arbitrage.
Long/short equity trading adopts both buy (long) and sell (short) positions to minimize risk or maximize profits. There are several different approaches, such as buying one market sector while selling another, or buying one stock in an industry while short selling another stock in the same industry. Long/short trading also encompasses option trading strategies to hedge overall long or short positions.
Real estate tends to outperform when stocks are performing poorly. Investors can buy REIT stocks or invest in ETFs or mutual funds focused on real estate holdings.
The foreign exchange market (forex) may offer opportunities in a global economic climate of divergent monetary policies. Forex trading is open directly to retail investors, or investors can choose to access this investment class through ETFs or mutual funds. Foreign exchange trading is often one element of a global macro trading strategy employed by a hedge fund.