Interest in alternative strategies has increased dramatically, but explanations for how to use them effectively are lacking.
Adopting one-size-fits-all allocations to alternative investments can result in a portfolio where the risk/return profile does not match the investor’s goals.
In this article, we suggest two methods of incorporating alternatives, with careful consideration of risk tolerance and expected returns.
Few topics have generated more spilled ink than alternative investments. Neither those who defend them nor those who assail them are lacking for editorial content to support their point of view. What is lacking, though, are simple explanations of alternative investments and how to use them within investment portfolios.
What are alternative investments?
Broadly speaking, most alternative investments fall into two categories: (a) Strategies that seek to invest in traditional ways (buy and hold) but in asset classes that are alternatives to stocks, bonds and cash*; or (b) Strategies that may invest in either traditional or alternative assets but do so in an alternative manner**.
Incorporating alternatives into an investment portfolio
Most investors understand the relationship between risk (volatility) and return, and they build portfolios using a mix of stocks and bonds that generally have a given long-term expected level of risk and return. Appropriate alternative investment strategies have to fit into a similar context, meaning that it is no more possible to employ a one-size-fits-all alternative investment mix than it is to find a one-size-fits-all basic portfolio mix.
A good example is the recent popularity of gold and other commodities as alternative investments. Many investors have adopted these as an alternative solution, and employed a 5%–10% allocation, without fully considering their goals and risk tolerance. Introducing highly volatile strategies into a conservative portfolio drastically alters the portfolio’s overall risk and return expectations. It can be difficult for investors to sense this change in environments that favor the asset class (such as recent years for gold and commodities). But, when the volatility is experienced on the downside, investors appreciate it quite viscerally. On the flip side, introducing alternative strategies with relatively low levels of expected risk and return into aggressive portfolios may make those portfolios unable to meet long-term return expectations.
One way to introduce alternative investments into an allocation is to match the return expectations of the alternative assets with the investor’s overall risk profile. In this way, you match the return characteristics of assets being replaced with an alternative investment that has similar expectations. For example, consider replacing equities with higher volatility alternatives and replacing fixed-income investments with lower volatility alternatives (see Exhibit 1). In addition, it makes sense for aggressive investors to emphasize higher volatility alternative investments and more conservative investors to emphasize lower volatility alternatives.
On the other hand, investors could consider a portfolio of alternatives as an entity unto itself (see Exhibit 2). In this way, investors identify specific strategies or mixes of strategies that approximate their individual risk tolerance and return requirements. In this context, an allocation to alternatives becomes part of the overall strategic allocation, and the decision about how to fund the allocation becomes moot.
Alternative investments involve substantial risks and are more volatile than traditional investments, making them more suitable for investors with an above-average tolerance for risk.
*Examples include gold, timber, real estate, precious art and stamp collections. Investors incorporate these investments in order to produce an income stream or appreciation in value over time.
**Examples include market-neutral equity strategies, absolute return investing strategies, go-anywhere global macro strategies and a variety of arbitrage strategies.