Global alternative assets under management are nearly $8 trillion at the moment, and is expected to rise to $13.6 trillion by 2020 according to PwC. Alternative investments as a whole have grown twice as fast as traditional investments since 2005. While alternatives were previously available only to public pension funds, sovereign funds, and endowments, affluent individuals are starting to tap into this market. As alternative investments become more mainstream and technology platforms such as DarcMatter, where I am the founder and CEO, provide access to these opportunities, it is becoming increasingly important for accredited investors and financial advisors to understand the implications of incorporating alternatives into their portfolios.
Here are four reasons why investors should consider alternative investments.
1. Alternative Investments Help Diversify Your Portfolio
Many investors are aware of the fact that portfolio diversification is key when it comes to investing. As the adage goes, "Don't put all your eggs in one basket". Generally speaking, assets that feature low correlation and expose an investor to a variety of risks will produce the best opportunities for diversification. Following the financial crisis, many investors who believed their portfolios were sufficiently diverse suffered major losses when the stock market fell. Traditional portfolios consisting of only stocks and bonds -- largely considered to be diverse from an asset allocation perspective -- didn't fare so well during the economic crisis.
What we have learned from the events of 2008 and 2009 is that conventional diversification strategies are not enough to protect against market volatility. Since alternatives are non-traditional investments, they do not tend to move in the direction of the public markets. Hedge funds, for instance, are able to invest across various markets using a wide array of instruments. Assets such as timberland are another good example of how correlation relates to portfolio optimization. Since their origin of risk lies outside financial markets (think natural disasters), these investments can be insulated from market fluctuations and their return streams are different than that of public markets.
2. Alternative Investments Can Enhance Risk Return Profiles
Recent global events such as currency instability and the stimulus in Europe contribute to the volatility that exists in today's stock market. Unfortunately, traditional stocks and bonds are largely correlated to these market trends. Many investors try to reduce their exposure to these market risks by investing across diverse sectors, geographies, and instruments. However, as mentioned previously, traditional liquid investments still experience some correlation to market risk.
The below Markowitz Efficient Frontier graph illustrates that including alternative investments in a portfolio moves the efficient frontier up and to the left. In a bear market, some but not all alternative investments will lose money. In the same market condition, all traditional equity funds will lose money. The aim of alternatives isn't always to have high short-term returns, but to protect during these drawdowns and generate long-term, consistent returns over time. Thus, alternatives are able to dampen volatility and provide a degree of downside protection when the markets are not doing so well.
3. Alternative Investments Have Potentially Higher Returns Than Traditional Stocks & Bonds
Alternative investments not only hedge against market risk, but also outperform their traditional counterparts. Below are graphs by RCM Alternatives that illustrate an easy comparison of how alternative investments have fared during the Internet bubble burst and the financial credit crisis respectively. While alternative investments are not completely immune to volatility, its low correlation to the market may help protect one's portfolio.
The above images were taken from this blog post with permission from RCM Alternatives.
A prime example of successful portfolio construction incorporating alternative investments is the Yale Model, an allocation model that invests heavily in alternatives such as private equity and hedge funds. The Yale Endowment has generated returns of 13.8% per annum in the last 28 years under Swensen's leadership. Many investors have followed The Yale Model after noticing its consistently impressive track record. In fact, endowments have increased total allocations to alternative investments by 19% while decreasing equities by 17% between 2007 and 2013.
4. Tax Benefits
Alternative investments such as venture capital, private equity, and hedge funds are typically illiquid and suitable for investors with longer time horizons. These long-term investments may feature certain benefits as they're subject to long-term capital gains tax, which can be lower than the taxes incurred by short-term investments. In addition, capital gains tax is generally incurred upon realized gains. Investors should consult with their financial consultant or tax advisor to determine specific tax benefits of various alternative investments.
Despite the benefits of alternative investments, they do not come without their risks. Alternative investments typically have higher fees, are illiquid, and usually have higher minimum investment requirements. While alternative investments may not be for everyone, they are an asset class investors should consider for their portfolios. Here is a list of 7 common alternative investments for investors to consider.