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Investing in Alternatives

Investing in alternatives

Considerations to keep in mind when investing in alternatives.

Alternative investments are becoming more common among retail investors. The adviser community has a better understanding of the potential advantages of adding alternative investments to client portfolios as a way of diversifying and, hopefully, further managing risk in client accounts. Many advisers seem to be managing their clients’ assets in a manner similar to the way large institutions and endowments manage their assets. The overall differences between managing the two are many, but for this post, I will concentrate on the use of alternative investments.

It is well documented that institutions and endowments generally have better long-term performance than the average investor. I believe the use of alternative investments plays a role in this outperformance.

Alternative Investments May Outperform

I recently returned from a conference in New York on alternative investments where it was noted that not only the number of advisers using alternatives but also the percentage of client assets invested in alternatives has been increasing. The percentage of alternatives used in the panelists’ client portfolios varied from a low of 10 percent to a high of 30 percent. This is different from what you may find in the portfolios of large institutions and endowments, where it is not uncommon to have allocations of 40 percent to 60 percent or more invested in alternatives.

The Definition of an Alternative Investment

Another topic of discussion at the conference was the definition of alternative investments. Most attendees seemed to have a similar but slightly different opinion. The differences generally came down to what types of assets are included in the definition. Real estate was the most common difference. To provide a definition of an alternative investment, I turn to Wikipedia, which states that an “alternative investment is an investment product other than the traditional investments of stocks, bonds, cash or property. The term is a relatively loose one and includes tangible assets such as art, wine, antiques, coins or stamps and some financial assets such as commodities, hedge funds, venture capital, film production and financial derivatives.”

Alternative Investments and Liquidity

A question faced by retail investors is how to participate in these asset classes with modest sums of money and the possible need for liquidity. The answer is that it’s very difficult. Many of these assets are not liquid investments unless you happen to be an art/wine/antiques/real estate/commodities/film distributor and venture capitalist all in one. My guess is that leaves most of us out.

In an effort to solve this problem, most investors turn to mutual funds, of which there are plenty to choose. However, the funds themselves are not necessarily investing in actual hard or tangible assets. A fund may instead be investing in the stocks or bonds of the companies that produce those assets, which brings the investor back to where he started: investing in stocks and bonds, although indirectly.

Diversifying Alternative Investments

While it is true that historically, different asset classes tend to move separately in various economic environments and having a diversified portfolio of alternative mutual funds can potentially help smooth out investor returns, it is also true that in periods of severe uncertainty, it doesn’t matter what the funds invest in, but rather how they own the assets. The point I am trying to make is that if the fund owns stock and bond shares, in times of uncertainty the fund will likely react like a stock or bond.

There is no easy answer to this problem, but there are some potential strategies. Having a long-term financial plan and a knowledgeable and trusted adviser can help.

Read the article on U.S. News & World Report here! >

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for individuals. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results.

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