Last week we discussed the importance of understanding correlation. Today we will cover “alternative investments,” which are often used to add non-correlated assets into a portfolio. The definition of alternative investments is very broad. Essentially it encompasses anything that isn’t stocks, bonds, or cash. Traditionally, alternative investments were mostly “private” investments, meaning that they were not just offered to the general public. Investors had to “qualify” in order to buy them. This means that they had to have either a certain level of assets or income or both. The reason for the restrictions was because many of these investments lack liquidity. Unlike traditional investments, private investments can’t just be sold at any time. There is typically a window of time in which sales can be made, and also limits on the amounts that can be sold. Because of the lack of liquidity, regulators want to know that you have the ability to “tie up” the investment for a set time period. There may also be limits on the minimum amount you can invest as well. These restrictions are put in place because most of these investments are not subject to the normal regulation of other investments. Today, there are what is referred to as liquid alternatives. Liquid alternatives are public versions of the private investments. Anyone can typically buy them since they are traded openly and are completely liquid at any time.
Alternative investments can include things such as private equity, private debt, hedge funds, commodities, managed futures, collectables/art, real estate, and cryptocurrency. The appeal is that they are designed to have low correlation to other traditional investments in your portfolio which can both reduce your overall risk as well as potentially enhance your returns. Different alternative investments serve different purposes. Hard assets such as real estate, gold, oil, cryptocurrency, etc. can be used as a hedge against inflation. Private debt could be used as an alternative to current low bond yields. Managed futures when added to a traditional stock and bond portfolio has typically lowered risk and enhanced returns. Large foundations as well as some college endowments have long used alternatives as a significant investment in their portfolios. As individual investors however, we are typically limited in how much private alternatives we can buy based on the state you live in. In New Jersey, that limit is 10% of your investable assets. This only applies to private alternatives, not public or liquid alternatives.
Alternative investments are not without their own risks, however. As mentioned, they may lack liquidity making it difficult to sell and a given time. Alternative investments tend to carry higher fees due to the nature of the investments themselves. Some alternatives since they don’t trade on an exchange like other investments may not be easy to value compared to traditional investments. A potential upside to the lack of liquidity is that when traditional markets drop due to investor’s panicking, alternatives are more insulated from those drops since they can’t be readily sold. Lastly, as risks go, alternatives can be fairly complex and not as easy to understand as traditional investments.
Now that liquid alternative investments (liquid alts) have become more mainstream, some of the risks or difficulty in investing in them have been reduced. Adding alternatives can potentially be a great way to both diversify a portfolio as well as reduce the overall risk level.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or firstname.lastname@example.org.
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