In this edition we would like to explore the topic of utilizing alternative investments in a portfolio.
Framing the conversation:
Traditional portfolio construction typically consists of an allocation of stocks and bonds. The amount allocated to one or the other is widely regarded as the main element associated with risk and return of a portfolio. By adding alternative investments into a portfolio you are effectively adding in things that are not stocks, bonds or cash.
What exactly are alternatives:
Alternative investments include hedge funds, managed future, commodities, real estate, private debt and derivatives. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity.
Why add Alternatives to a portfolio:
Alternative investments are favored mainly because their returns have a low correlation with those of standard asset classes. This strategy is used by many investors who seek to stabilize a portfolio more so than by using traditional stock and bond only investments. Another important element to consider is the inefficiency of the alternative investment space. We believe that the publicly traded markets (stocks and bonds) are extremely efficient as evidenced in Eugene Fama’s Efficient Market Hypothesis*. This means that the prices of public investments are based on so much public information that they are accurate and reflect the true value of the investment. Due to the private nature of most alternatives the prices do not necessarily reflect the true value. This lends opportunity for finding value where others may not and challenging conventional wisdom about portfolio construction**.
As mentioned these investments can be complex in nature and lack liquidity. It is very important to be educated on the “what, how, and how much does it cost” prior to purchasing an alternative investment for your portfolio. Some can have excessive fees and fail to achieve their desired results*** as seen recently in the hedge fund world. Other alternative investments can serve as an excellent addition to a portfolio, further creating diversification and capturing market like returns.
To learn more about how alternative investments might add value to your portfolio contact us and we would be happy to share the types of alternative investments that have been vetted by our investment committee and are currently in use at LWM.
* Eugene Fama reference to Efficient Market Hypothesis/Efficient Capital Markets written April 1970
** Pioneer Investments reference to Challenging Conventional Wisdom About Portfolio Construction 2016
*** Alpha Q reference to article “Hedge fund capital declines” 4/20/2016