Alternative investments have long been associated with more exotic forms of investments. Perhaps this was because, as a broad asset class, they were typically available only to institutional investors or the very wealthy – often restricted to such investors by law (as hedge funds still are). Average individual investors rarely had access to them. That has changed dramatically over the last several years however and it is a change that has significant implications for everyday investors and for the conventional wisdom of asset allocation.
Traditional asset allocation consisted of a mix of investments between equities, bonds, and cash. A portfolio was considered well diversified if the equity portion had exposure to large, mid, and small cap stocks as well as international and emerging markets. Similarly for fixed income, a prudent portfolio would hold not just government securities but agency and corporate debt and even some high yielding bonds. Cash would round out this model for safety and security, and how much you held in cash depended on your immediate liquidity needs as well as your risk aversion.
But this version of asset allocation has started to come under scrutiny. As any good crisis should do, the 2008 financial crisis – which saw correlations across asset classes ratchet up to an unprecedented degree – taught us some lessons. In particular, it revealed cracks in the traditional diversification model. It forced many to reconsider what proper asset allocation should look like and to rethink just how broadly investors should look for investment opportunities. What many professionals are discovering is that limiting asset allocation to just equities, fixed income, and cash is like having a zoo of only apes, elephants and housecats and then calling it complete.
Of course, there will always be some animals that are just too rare, too exotic, or too expensive to own and care for. But the market has been developing innovative ways to allow individual investors to gain exposure to previously elite investment options that had solely been the domain of institutions or the very wealthy. While it behooves us to sometimes be cautious of new financial innovations, they also open new doors that allow us to take advantage of strategies that have benefited institutional investors for years. Accessing alternative investments through ETF (or ETN) vehicles is a viable, cost-efficient way for individual investors to put this new model of asset allocation to work for them.
So what are alternative investments? In the largest sense they are essentially any investments that can’t be categorized as stocks, bonds, or cash. Examples include: commodities, managed futures, real estate, foreign currencies, hedge funds, private equity, and others. Within some categories such as hedge funds exist strategies that, although utilizing stocks or bonds, are of such a nature that they are considered alternatives themselves and are not counted in traditional asset classes. Examples include Long/Short, Distressed Debt, Arbitrage, and Cryptoassets.
A big reason these types of investments were out of reach for regular investors was because of capital requirements and/or illiquidity. It could take extremely large sums just to take a position in commodities and futures contracts, hedge funds, or to own real estate directly, let alone to build a diverse portfolio of these holdings. However, ETF’s are increasingly providing access to many of these asset classes. Today, ETF’s exist for commodities, real estate, currencies, and even managed futures, with others on the horizon that are utilizing innovative methods to track alternative indexes. This doesn’t mean that just any ETF representing the Aussie Dollar or a Managed Futures index is worth jumping into. You still need to research the underlying holdings of the fund, evaluate its expense ratio, and weigh various ETF options within the same asset class.
Nevertheless, the data are strongly suggesting that alternative investments should be more than mere accoutrements to traditional assets and should go far beyond something you could use to just spice up your core holdings. Given their low correlations to stocks and bonds, the data reveal that they should be core holdings in their own right, and at much larger allocations than traditionally accepted. Indeed, what the data are showing is that the inclusion of alternative investments can lead to higher returns over the long run while at the same time reducing portfolio volatility and risk.
If you would like a deeper discussion into Alternative Investments please let us know at skrase@commonfinancialsense.com
