Thinking outside the box: demystifying alternative investments
Continued volatility across equity and bond markets has led to investors searching for additional asset classes or sub sectors of asset classes that can add further diversification to their portfolios. As a result, alternative assets have become a popular allocation for model portfolios and multi-asset funds.
The alternative investment universe broadly includes assets which are not the traditional stocks, bonds or cash.
But what is an alternative asset exactly? There are several key characteristics that define these types of assets:
- Alternative investments are often only available to institutional investors or high net worth individuals, due to their perceived complexity and high minimum investment requirements.
- Some investments, such as private assets, can be less liquid relative to traditional investments, meaning that they cannot be easily bought or sold on public markets.
- The risk and return profile of alternative investments is often less dependent on traditional market drivers and therefore they may follow a return journey that is less correlated to traditional investments.
Let’s break it down
This still covers a broad range of available assets, so let’s break it down into sub sectors. We categorise alternative assets into five key groups: Private Equity, Hedge Funds, Commodities, Real Assets and Specialised Property. Each asset has its own unique set of characteristics and associated risks. If we look at Private Equity as an example, this involves investing in companies that are not publicly traded on stock exchanges. Investors typically take an active role in the management of the companies they invest in, with the goal of improving their performance and increasing their value. The investment horizon is therefore several years and may require a high minimum investment amount.
Hedge Funds are another example and these include a diverse group of strategies. The method of portfolio construction and risk management technique defines the approach. Long/Short strategies are the most common type of hedge fund. The goal of this strategy is to profit from both rising and falling markets by reducing exposure to overall market movements. Fund managers buy (go long) investments they expect to increase in value and sell (go short) investments they expect to decrease in value. A long position is the traditional way of investing - buying low and selling high. A short position, on the other hand, is a more complex strategy where the fund manager borrows a security and sells it with the expectation that its price will fall in the future. If the price does fall, the fund manager can buy the security back at a lower price, return the borrowed security, and profit from the difference. It's essentially a way to profit from a decline in a securities price.
The need for true alternatives
The purpose of adding alternatives to a portfolio is not to replace other asset classes but rather to bolster diversification. Understanding the type of contribution that different alternatives offer and how these can be blended to achieve a defined objective is a critical starting point. Some ways you might define the purpose of such an allocation are:
- Less risk or sensitivity than global equities
- Minimising loss to a certain percentage over a given time frame
- Downside protection during periods of market stress
- Returns which are not dependent on traditional market movements
- A lower correlation relative to traditional asset classes
Access is everything
The key characteristics which define alternative assets, and make them attractive from a diversification perspective, also make them difficult for retail investors to access. One potential solution is to invest in a portfolio that can dynamically allocate across the five key groups of alternative assets. Constructing a well diversified portfolio of alternative assets requires expertise and experience to conduct due diligence on underlying funds, assess market conditions and identify potential investment opportunities. Professional management also ensures that potential risks are identified, assessed and mitigated against. In addition, pooling resources from multiple investors can meet the higher minimum investment requirements and offer more liquidity than directly investing in alternative assets.
At Schroder Investment Solutions, alternatives are part of our strategic asset allocation for our range of model portfolios and multi-asset funds. We have a clearly defined objective where each holding is classified as a risk diversifier or return enhancer. This allows us to be more defensive or add more risk depending on our analysis of the market cycle. We lean into each strategy to balance the level of risk taken relative to the return we expect to generate. It’s important to allocate to alternatives across a multi-asset solution and not think of them as a standalone investment to meet your investment goals.
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The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.