Once considered an outlier when it came to investments, alternative investments, or alternatives, are becoming more mainstream. How mainstream? According to Willis Towers Watson’s (NASDAQ: WLTW) Global Alternatives Survey, total global alternative assets under management (AUM) stood at almost $6.5 trillion in 2016. Investors are finding that alternatives may be effective in balancing portfolios, generating higher rates of return and boosting the diversity of their holdings compared to a portfolio consisting only of “traditional” assets such as stocks and bonds. But alternatives do come with higher risks.
“Alternative” – What it Means
An alternative investment is anything that isn’t a conventional investment. Conventional investments are defined as stocks, bonds, and cash.
Digging more deeply into this rather broad definition, alternative investments can include commodities, hedge funds, private equity/venture capital, managed futures, distressed securities, and collectibles. Your Beanie Babies collection from the 1990s could be considered an alternative investment (though probably not a good one). And, real estate – whether through a REIT, Delaware Statutory Trust, or outright buy – is also an alternative investment.
Source: An Introduction to Alternative Investments, www.wealthmanagement.com 3/19/14
Alternative investments aren’t new; people have been investing in anything and everything for centuries. The Netherland’s tulip craze and market collapse in the 17th century is a good example of alternative investments (and what can happen if alternatives demand crashes).
In the early 21st century, from 2005-2007, alternative AUM increased from $2.9 trillion to $5.7 trillion. During the financial downturn, however, scandals, poor liquidity and massive redemptions in certain categories crippled these investments. However, following the Great Recession and its aftermath, alternatives bounced back, and are becoming an important part of many portfolios.
According to an Allianz Global Investors 2016 survey, nearly three-fourths of institutional investment advisors globally use alternatives, with 30% surveyed saying they use these tools to add diversification to a portfolio. Meanwhile, 25% said they invested in alternatives due to their low correlation with other investment strategies and asset classes and 14% indicating the use of alternatives for higher potential returns than conventional investments.
The Upsides
So, why consider alternative investments? Several reasons.
Portfolio diversification. Adding alternative investments to your portfolio could mitigate your risk. If for example, your stocks take a beating, your portfolio could be shored up by an energy-based mutual fund or an apartment REIT.
Inflation hedge. Your portfolio’s rate of return might look great on paper. Then along comes inflation to put a dent in that figure. Because alternative investments don’t follow the same performance track as, say, stocks or bonds, they may be able to keep your portfolio’s rate of return steady, even in periods of high inflation.
Higher rates of return. An exchange-traded fund (ETF), Delaware Statutory Trust (DST) or infrastructure investment could provide a higher rate of return, compared to that generated from your bonds, savings account or stocks.
The Downsides
No investment is 100% free from risk. Alternatives are no different; in fact, such investments can be far riskier than cash, stocks or bonds. Other potential downsides include:
Higher minimum investments/fee structures. Alternatives can offer large rewards, but many require higher initial investments for participation. This is why, on the chart above, investments including hedge funds, venture capital, and private debt funds are geared more toward high net-worth individuals, accredited investors and institutional investors.
Lack of historical performance indicators. Unlike stocks and bonds, many types of alternatives might not have historical data, or any kind of data, from which you can deduce past performance. When dealing with such assets, your due diligence needs to be even more diligent. Rather than relying on your portfolio manager for feedback, you might have to dig deeply into the asset’s industry, for information about the investment.
Greater chance for fraud. As mentioned above, alternative investments can be unregulated (have you heard of a Beanie Babies regulatory group?). Just about anyone can promote just about anything as an investment. Late-night television is rife with ads, proclaiming that certain types of gold coins will help investors retain, and maximize, their wealth during uncertain economic times. However, when it comes time to sell, those investors find that there is no market for these coins, meaning the so-called investments end up with no value.
In closing, alternative investments can be an important part of any portfolio. However, such investments require more knowledge, increased research, and a higher appetite for risk than the more traditional stocks, bonds, money markets and savings accounts.
Interested in learning more about real estate alternative investments? Contact the Realized team to learn more or download the Realized Fractional Investing Ebook below:
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