AXS Insights

Alternative Investments – What Are They and Why Should I Care?

Traditional investments for individual investors have long been limited to stocks (equity investing) and bonds (fixed income investing). Equity investing involves taking an ownership position in a publicly traded company with objectives that include growth from capital appreciation as the value of the investment increases over time, as well as the potential for income from dividend payments. The fixed income investment approach also has been employed by individuals to generate income and to achieve the preservation of capital. Examples of fixed income investing include allocations to investments like corporate and government bonds, CDs and money market funds. Fixed income can provide a regular stream of income with less risk than stock investing.

Alternative Investments

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Moving beyond traditional equities and fixed income into alternative investments has driven wide-ranging benefits for institutional investors versus their individual investor brethren, stemming from the unique characteristics and distinctive benefits alternative investments can manifest within a portfolio. A few examples of such advantages include greater portfolio diversification, the ability to hedge inflation, achieving higher return potential, and accessing new exposures and opportunities. Let’s look into these.

Diversification

Portfolio diversification is one of the most powerful benefits afforded by alternative investments. The returns and other performance metrics of alternatives typically exhibit low correlations to traditional asset classes such as stocks and bonds. Allocating to alternative investments has the potential to lessen volatility without sacrificing return, thus making them an effective risk management tool for minimizing the risk of an investment portfolio. While all investments involve some level of risk, adding diversifying investments with low or no correlation to other portfolio allocations may lower portfolio concentration, reduce volatility and achieve stronger risk-adjusted returns. It's important to note that no amount of diversification or correlation can ensure profits or prevent losses.   

Inflation hedge

Alternative investments also can serve as an effective hedge against inflation, meaning that their returns have been correlated to inflation. As inflation rises, the returns of these investments also tend to rise. As a result, the investment is considered to protect against the decreased purchasing power of a currency that results from the loss of its value due to rising prices. Put another way, the practice of inflation hedging can help protect the value of an investment. While certain investments might appear to provide a healthy return, when inflation is factored in, they can be sold at a loss. For example, investing in a stock that generates a 4% return, but with inflation at 5%, would result in a loss of buying power. Commodities and infrastructure represent examples of investments often used to hedge inflation.

Higher return opportunity

Pensions, endowments, foundations and other institutional investors also seek higher return potential from alternative investment allocations. This objective stems from the notion that certain alternative investments carry higher risk profiles on a standalone basis but can result in meaningfully higher returns as a reward for taking that risk. Venture capital investments represent an example. While seed and early stage investments can result in exposure to greater risk of investment loss, they also can handsomely compensate investors with substantially outsized returns. A range of hedge fund strategies also possesses this higher risk/higher reward profile.

Distinctive exposures and opportunities

As noted above, traditional stock and bond investing can offer investors the potential for growth and income. However, equities and fixed income allocations do not provide the accessibility to new or other distinctive exposures. That’s where alternative investments can bear very ripe fruit, enabling investment access to real estate, infrastructure, start-up businesses, and a host of other complements to traditional portfolios.

Given these and other portfolio benefits, why haven’t alternative investments been as widely used by individual investors? The answer is simple: lack of access historically.

Access to Alternatives? Now Open to the Public

For individual investors, the message has long been “restricted access” to alternative investments for many reasons. First, traditional alternatives often require accredited investor status and high investment minimums, often commanding $1 million or more to gain access to such investments.

A second factor driving restricted access for individual investors to alternatives is that hedge funds, private equity, real estate and other such asset classes also have been characterized historically by high levels of illiquidity and long lock-up periods. For example, the direct purchase of commercial real estate not only requires significant resources, but also a commitment to a long holding period due to the illiquidity of the commercial property. Pensions, endowments and foundations often can withstand those long periods of illiquidity during which time they don’t need access to their funds. By contrast, individual investors disproportionately have greater needs for liquidity and, therefore, historically have tended to allocate to vehicles such as mutual funds, ETFs and other structures that provide daily liquidity.

A third inhibiting factor making traditional alternative investments less attractive to individual investors has been those investments’ lack of transparency. Hedge funds, for example, are not required by regulations to provide investors with the same level of translucence into their portfolio holdings, performance or other key evaluation criteria. By contrast, mutual funds and other regulated investment structures are offered by prospectus and require their issuers to abide by a high level of transparency that helps ensure greater levels of investor protection.

And that’s where alternative investment strategies have intersected with retail-friendly investment structures. In recent years, liquid alternatives have emerged as a means of providing individual investors with the potential benefits of alternative investments, without the limitations of their historical offerings. Specifically, alternative investment mutual funds can afford individual investors with potential benefits ranging from diversification, inflation protection, higher returns, and distinctive exposures that represent strong complements to their equity and fixed income investments.

At the same time, such mutual funds do not require the high investment minimums, accredited investor status or the requirement to withstand significant illiquidity, as do most traditional alternative investments. Moreover, as a result of their structure being regulated under the Investment Company Act of 19402 and other regulations, mutual funds also ensure heightened investor safeguards that are critical for individual investor protection.

Why Should You Consider Alternative Investments?

One of the most game-changing developments historically for individual investment portfolios has been the democratization of investment management to open up access that enables individuals to invest in alternatives, just like institutional investors. For individuals desiring the investment benefits sought and achieved for decades by pensions, endowments and foundations, allocating to liquid alternative investments may be an effective means of complementing core equity and fixed income holdings. Alternative investments can serve as an effective diversifier, a robust inflation hedge, a volatility dampener, and a means of accessing alternative exposures for growth and income.

More extensively available than ever, alternative investments are your path to invest like the institutions.

1) Having a “long” position in a security means that you own the security. Having a "short" position in a security means that you are selling a stock you do not own.

2) The Investment Company Act of 1940 Investment Company Act of 1940 regulates the organization of companies, including mutual funds, that engage primarily in investing, and whose own securities are offered to the investing public.

This information is educational in nature and does not constitute investment advice. These views are subject to change at any time based on market and other conditions and no forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of any investment or trading intent. This content should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by AXS Investments or any third-party. You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives, financial circumstances and risk tolerance. AXS Investments does not provide tax or legal advice and the information herein should not be considered as such. AXS Investments disclaims any liability arising out of your use of the information contained herein. You should consult your legal or tax professional regarding your specific situation. All investing is subject to risk, including the possible loss of the money you invest. Alternative investments may not be suitable for all investors.

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