Are Alternative Investments for Me?
by Gregg Dunn and Dolores Wheless
Have you ever found yourself frustrated because the traditional stock and bond investments don’t meet all of your investment needs? Do you want less volatility in your overall portfolio? Do you wonder what to do about inflation?
If you answered yes to any of the questions above, you may find at least part of your solution in Alternative Investments. While there is no clear cut definition to what constitutes an Alternative Investment, it is an “alternative” to traditional assets like stocks, bonds, and certificates of deposit.
So what are these alternative investments and how can they help? Since we cannot cover all of the nuances, we will attempt to give you the basic idea and a little flavor for how alternative investments may be of help to you by walking through a few examples.
The Not-So Evil Hedge Fund
One of the most common alternative investments is the hedge fund. Few investment classes have received as much attention in the press as hedge funds. It should be noted that the one thing that those notorious funds had in common is that they were examples of the misuse by fund managers. They do not serve as good examples of what a hedge fund can do for you. The idea behind a hedge fund is that it allows much more flexibility than simply owning stocks and bonds like a traditional investment approach. With a hedge fund strategy, you can own stocks and bonds, you can short them, and you can pair them in combinations where you are long one asset and short another asset. A good example is called a market neutral strategy. Here is a very simple example of how a market neutral strategy works.
With traditional stock investing, you have a choice of owning Coca Cola stock or PepsiCo stock. If you own the stock and it goes up in value, you will make money. If the stocks go down, you will lose money. Sometimes, Coke and Pepsi perform well as companies, and the investor would expect their stocks to rise. However, it is possible that due to an overall poor economic environment, the stocks are pulled down with the overall market, and the investor loses money. Within the hedge fund strategy, an investor may still make money. The hedge fund manager may determine that Pepsi is just doing alright, but Coke is doing excellent. That manager would sell Pepsi stock that he does not own and buy stock in Coke. This strategy of selling stock that you do not own is called “short selling”. By doing this, the hedge fund manager has now taken the overall market risk out of the equation. Assume that both stocks start at $50 per share. If the market rises, Coke which is performing better as a company should appreciate more. Let’s say that Pepsi stock rises to $55, and Coke stock rises to $60. The hedge fund manager can sell the Coke stock making a $10 profit and buy the Pepsi stock that he earlier sold losing $5 per share. This strategy just netted a gain of $5 per share. If the overall market drops, Coke which is doing better as a company should still do better than Pepsi. Let’s say that Pepsi stock drops from $50 to $40, and Coke stock drops from $50 to $45. The hedge fund manager can then sell the Coke stock losing $5 per share and buy the Pepsi stock making $10 per share. The end result is that the hedge fund manager still gained $5 per share. As you can see, this is a strategy that depends on the manager’s ability to determine which of the two stocks will perform better, but he does not have to predict which direction the market will go. Since success depends on the skill of the hedge fund manager versus the direction of the market, the investor has added diversification.
Volatility Everywhere….Look Again
Diversification tends to reduce volatility, and one of the greatest advantages of less volatility is the smoothing out effect on returns. This concept is many times misunderstood by investors. For example, when your portfolio is down 50% one year then up 50% the next year, you are not even at the end of the second year. You are actually down 25%. However, if you are down 20% in the first year then up 20% in the second year, your final result is a loss of only 4%. Not only does the lower volatility strategy result in less pain for the investor, it also results in a better final return. Of course, if the more volatile portfolio is up 50% the first year and up another 50% in the second year, it will perform better than a strategy which is up 20% in both years. Although history has shown us that while the stock market is up approximately 70% of the years, it tends to be unpredictable and volatile. The investor who chooses alternative investments for their portfolio is choosing the lower volatility strategy because they want to be prepared for a wider variety of market conditions.
There’s More Out There
While hedge funds are great for lowering volatility and potentially increasing the frequency of positive returns, other alternative investments meet other needs.
- Real Estate Real estate can be a good source of income or a hedge against inflation.
- Commodities Owning commodities can help an investor hedge the risk of inflation.
- Currencies Investments in currencies of faster growing countries can work as hedges for our larger U.S. holdings which are denominated in the U.S. dollar.
- Master Limited Partnerships MLPs offer a steady source of income.
- Private Equity Owning companies before they go public can have its own set of rewards.
Some investors invest in funds that offer only one strategy, but the more common practice has become to use a fund of funds where a manager oversees several other managers who are each executing different strategies.
Alternatives Do Have Advantages…
We hope these examples have shown you how alternative investments have been developed to meet the challenges of today’s investor. The advantages can be many, but among the most important is true diversification as these asset classes generally have a low correlation to the traditional asset classes. It is the old adage of not having all of your eggs in one basket. Other advantages are volatility reduction, inflation protection, currency protection, and the opportunity to earn attractive returns from non-traditional sources.
Any time you hear so many advantages, you probably hear a voice in your head telling you another old adage, there are no free lunches. Like any asset class, alternative assets have disadvantages as well. To know the specific disadvantages, you would need to know the specific asset type as they can vary much across the group. However, in general, some of the most common are higher fees, less transparency, difficulty of bench marking, more complex strategies and less tax efficiency for some investors.
After weighing the advantages and disadvantages of alternative investments, we believe that you may still find a compelling argument for including alternative assets as part of your investment plan. Only through careful examination of your needs, goals and objectives can you and your financial advisor determine which of the many alternative investments might be right for you.
Gregory V. Dunn, Chief Investment Officer, Broadway Bank Wealth Management
Dolores F. Wheless, Wealth Strategist, Broadway Bank Wealth Management