Many retail investors are considering alternative investments as a tool to diversify their stock and bond portfolios. Alternative investments are not closely correlated with stock and bond performance, but these investments are complex and more expensive.

Defining Alternative Investments

Most individual investors own a portfolio that combines stocks, bonds and cash. An alternative investment does not fit into these traditional categories. Private equity investments and hedge funds are considered alternative investments, as are commodities, derivatives, managed futures and real estate. Until recently, individual investors did not have access to these types of investments.

Solving the Liquidity Problem

Traditional investments do not offer sufficient liquidity to meet the needs of retail investors. For example, most private equity and hedge funds require lockup agreements. These agreements only allow the investor to liquidate their holdings once per quarter or year. This policy allows the portfolio manager to invest most of the assets without the need to meet investor withdrawal requests.

Other alternative investments do not trade in traditional markets. Real estate, for example, is sold through negotiation between buyers and sellers, so it can take months to finalize. Private equity funds may invest in companies that do not have common stock trading on an exchange. As with real estate, selling a private equity fund’s ownership interest may require a long negotiation process.

Liquid alternative investments are now offered to investors through exchange-traded funds (ETFs) and mutual funds. These portfolios are managed to track the investment performance of a particular alternative investment asset class. The investments are liquid because an investor can buy or sell on any business day.

Retail Investor Interest

Individual investors are starting to consider investments that do not correlate with stock and bond portfolios, such as alternative investments, which retail investors are using to diversify their portfolios.

Two events have prompted individual investors to consider alternative investments. The sharp market declines in 2007 and 2008 caused many investors to think about their risk tolerance for equities. Record-low interest rates and the risk of rate increases will also affect the value of bond portfolios. Cash inflows into liquid alternative investments are increasing dramatically as investors diversify and reduce their exposure to stock and bonds.

Alternative Investment Risk

Liquid alternative investments have a number of risks. These portfolio managers must meet the liquidity requirements of an ETF or mutual fund while managing investments that are more difficult to sell. Suppose your mutual fund invests in real estate. If the demand for investor redemptions is high enough, the real estate firm may have to sell its holdings sooner than planned. This situation can affect the price received for the assets sold and hurt the overall value of the fund.

Because these investments are more complex than stock and bond portfolios, the portfolios are more expensive to manage. The annual expense ratio for a liquid alternative investment can be much higher than an actively managed stock or bond portfolio, which can reduce the rate of return over time.

Pension Funds

Many large pension plans have also diversified into alternative investments. Two of the largest pension plans in the United States are based in California. For the period ended June 30, 2015, both plans had assets invested in private equity. The California State Teacher’s Retirement System (CalSTRS), for example, had 10.1% of its assets in private equity investments. Another fund, the California Public Employees' Retirement System (CalPERS), had approximately 9% of its portfolio invested in private equity. Pension funds are also affected by the higher costs of alternative investing.

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