Alternative Investments
Alternative investments include many different types of investments or assets which fall outside of the three primary or traditional asset classes known to most investors: cash, bonds and stocks. An investment can be considered alternative if it includes or holds real assets, like real estate or natural resources. An investment can also be classified an alternative based on its investment strategy, which strategy might fall under managed futures, hedge funds or private equity or debt. One method of distinguishing between traditional and alternative investments is by their return characteristics. As a group, alternative investments have expected returns that are uncorrelated or only slightly correlated with the expected returns of the three traditional asset classes. An attractive dimension of this low correlation is that it indicates the potential to increase diversification within a portfolio of traditional assets. When two assets have low correlation, we expect that when the price of one asset goes up, the price of the other will go down. Low correlated assets provide an opportunity to get higher risk-adjusted returns in a portfolio. What percent of a portfolio should be allocated to alternative investments? Typically, we target an allocation of 3-5%.
As the world’s largest asset class, real estate offers many compelling opportunities to investors. A popular way to invest in real estate is via a publicly traded REIT or real estate investment trust. REITs are diversified portfolios of income producing properties, which portfolios cover many real estate categories including industrial, office, apartment buildings, data centers, shopping centers and malls, hotels, self-storage facilities and healthcare. Another publicly traded alternative investment is a master limited partnership (MLP) in which investors purchase units of a publicly traded partnership. MLPs typically own “midstream” energy assets which can include mining, process, transportation (marine, pipeline, and road) and distribution activities. REITs and MLPs are both “pass-through” entities which allow their investors to receive a rich yield, typically higher than the dividend yield of the S&P 500 and most fixed income asset classes.
Commodities are natural resources consumed or used to make other products. Examples of commodities include oil and natural gas; agricultural products such as corn, wheat, and soybeans; livestock such as cattle and hogs; and metals like copper, nickel, and zinc. Commodities are typically traded through futures contracts. A managed futures investment involves trading in commodities (or global currencies, indices, or other financial instruments) through derivatives (futures, forwards, and options). Managed futures investments employ investment strategies that are difficult to both explain and understand. Hedge funds are privately managed investment funds that utilize sophisticated strategies (like long-short, market neutral and volatility arbitrage), employ excess leverage, use derivatives and benefit from their less regulated nature to generate investment opportunities that are substantially different from opportunities offered by traditional asset classes. Managed futures (0.05) and hedge funds (0.76) with their low correlations to the S&P 500, were previously the domain of the high-net-worth investor - now both are available to most investors. With this availability, investors must take due caution. These investment vehicles are quite complex, subject to wide swings and offer the potential for both deep losses and large gains. If you see this type of investment in your account, ask your advisor to explain its strategy and the risks associated therein. Please follow my rule of thumb, which is “If I cannot explain a particular investment or investment strategy in two sentences, then it probably is not right for you.”