Been watching the stock market recently? Does it make you feel warm and fuzzy, or, like many investors, do you feel a bit uncertain and powerless?
If so, join other Investors seeking higher returns, lower volatility, less correlation, and greater flexibility across their portfolios by investing some of their wealth in “Alternative Investments”.
1. Nature of the Investment Return
The investment returns of many Alternative Investments result from the fundamental performance of the underlying business or project versus stock and bond valuations often following the broader swings of an equity and bond (Fixed income) markets. Alternative Investments tend to offer Total Returns which are Non-Correlated to a market trend. They are based upon an Issuer’s business performance rather than being “market driven” (such as interest rates moving up and down in the bond markets or stock prices swings with equity markets).
As such, many Investors, both institutional and individuals, who are looking to reduce their portfolios’ vulnerability to market movements they can’t control, have increased their allocations to private Alternative Investments.
What do “Total” and “Non-Correlated” mean?
A Total Return is the difference between the amount invested and the amount earned. Its purpose is to measure the gain or loss that the investment has generated over time.
Relative Return, on the other hand, measures a security’s performance against a benchmark, such as the DOW Industrial Average for equities or the U.S. treasury market for debt investments.
Correlation is the relationship that one investment class has to another. If there is a 1.0 correlation, it means that the two investments move in perfect tandem with each other.
So to be diversified and to seek to achieve both lower volatility and increase returns, Investors are adding an Alternative Investment allocation in their portfolios. Investing in alternatives, especially in years that financial markets perform poorly, can add significantly to the overall performance of a portfolio.
2. Reduced Volatility
A number of factors outside of Issuers’ business performance are now having a dramatic impact on financial market volatility and its overall direction. These include:
- Hedge fund proliferation (hedge funds often put on corresponding long and short positions with little consideration to a company’s underlying financial performance);
- Algorithm-driven institutional trading (again, trading based upon relative stock price);
- High speed trading; and
- Global events affecting financial markets.
Because their returns are often tied directly to obligations of the Issuer (i.e. payment of an interest rate, preferred dividend and/or equity value increases), Alternative Investment strategies can provide a much less correlated substitute to major public market indices, whether equity or fixed-income, thereby offering a diversified investment strategy.
Prices of traditional securities move up and down all the time. Watch the S&P 500 or the NYSE pictured here, and you’ll see small and, sometimes, very large swings in prices. These typically are motivated by various factors, such as geopolitical events, other pronouncements from Washington, and economic news, among others. For most individual investors who are not actively investing throughout each day, the higher the volatility, the greater the risk to their investment performance.
The benefits of Alternative Investments also include greater flexibility, such as:
- Helping to prioritize current income or capital gains;
- Offering tax efficiency, depending on the vehicle;
- Transaction structure;
- Blending in a higher risk/greater potential returns within an otherwise conservative strategy;
- Industry selection – Alternative Investments provide a means to invest in up and coming industries and business opportunities which publicly traded investments don’t yet offer.
Alternative Investments provide a variety of unique benefits. They also present many challenges. Look at “Are Alternative Investments Right for You Now? Answer these 4 Questions First” to learn four considerations when adding these to your portfolio. And be sure to read “Alternative Investments: Common Challenges to Know Before Investing.”