Alternative Investments: Part 1 — Overview

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By their very nature and structure, alternative investments provide a different return stream from that of “traditional” asset classes (i.e. buying stocks and bonds); and due to this characteristic they are often lumped into an “everything else” category after addressing the stock and bond needs of a client, yet this indicates stark misinterpretation and crude misuse — various alternative investment styles do not apply to every investor just as stocks and bonds do not apply to every investor.

The forthcoming Alternative Investments posts are an attempt to further distinguish various alternative investments — to highlight their risk attributes and to explain why their return streams differ from traditional investments; because, although alternative investments have often been viewed as risk-mitigation tools that dampen volatility (i.e. Market Neutral, Long-Short Equity, Hedged EquityAbsolute Value, among others), there are several that should be viewed as volatility diversifiers (Absolute Return Currencies, Managed Futures, Duration-Oriented Unconstrained Bond) on a very different volatility and return path from that of traditional stocks and credit-sensitive bonds.

Why the confusion?

The misclassification and misuse of alternative investments may be partly due to a lack of understanding on the part of financial advisors and partly due the relative newness of the liquid alternative investment format.  For years many of the various alternative investment styles were restricted to institutional investors, high net-worth (or accredited) individuals, and endowments due to a lack of transparency and risk (i.e. hedge fund format); but well-known alternative investment styles once restricted to these groups are now being pursued in the liquid alternative format — a transparent and liquid investment (i.e. you can see exactly what the underlying investments are and you can withdraw your investment as needed, instead of being restricted from withdrawals for a particular period of time).  A mutual fund focusing on alternative investments is just one example of a liquid alternative investment, and many are now available to the average investor — even in 401k plans — yet they’re still rarely added as investment choices and are often unused due to a lack of understanding from investors and advisors alike.

The liquid alternative space is becoming easier to access for the average investor and in a method that encourages openness, transparency, and lower fees than the hedge fund format.  They have their own set of risks (just as traditional asset classes do) but the alternative-investment nature of liquid alternatives places them on a different volatility and return path from that of traditional asset classes — a desirable attribute for those interested in diversification and one that is critical in an environment of low long-term expected returns for equities and fixed income (see Six Charts Worth Remembering).