Investing can take many forms, and an investment plan often changes throughout your financial journey. But one of the core principles of building a portfolio remains, regardless of your investment strategy’s time horizon, risk profile, or goal:
Diversification can help smooth out investment returns over time by allocating assets that react differently to the same market or economic events.
Stocks and bonds are usually uncorrelated to each other, which means that when stocks perform well, bonds usually struggle, and vice-versa. The relationship is related to risk. In environments when risk is heightened, investors often flee stocks for the relative safety of bonds.
However, there are periods in which market or economic conditions result in stocks and bonds performing in tandem. This is called positive correlation. When volatility, geopolitical uncertainty, spiking inflation, or rising interest rates are the dominant factors in the market and economic landscape, it can give rise to conditions in which both stocks and bonds struggle.
How do you build diversification into a portfolio when your main asset classes are moving in stereo? Institutional investors have for decades accessed other types of investments to help smooth volatility, called alternatives.
They are so named because they provide an alternative to traditional stock and bond investments, and they generally have low correlation to traditional assets. Why? In some cases, it’s because these investments are private assets. This can insulate them from the volatility of public markets.
Alternatives can be strategies that employ stocks and bonds, but in ways that create diversification from traditional investments. They can also be real assets, like real estate or commodities. While these investments used to be accessible to large institutions or very high net worth investors, they are now available to most investors.
There are seven basic types of alternatives that investors may consider including in their portfolios. However, they all share some characteristics:
- They are usually not regulated by the Securities and Exchange Commission (SEC)
- They can be illiquid or have liquidity constraints.
1) Private Equity
The stocks of public companies are listed on stock exchanges. They are called “equities” because when you purchase a stock, you make an equity investment in the company. Private equity means investing in a company that is not listed on an exchange.
There are different types of private equity investments. Venture capital refers to money invested in start-ups or early-stage companies. Along with capital, the private equity investor often brings expertise, talent, or other resources to help the company grow.
2) Private Debt
Large companies raise capital for business activities by issuing debt, called bonds, or by taking out loans from banks. Companies that cannot access either of these options, usually because of their size, raise capital by borrowing from asset managers or other lenders in private, direct lending arrangements. These companies are called the “middle market,” defined as having between $10 mm and $1 billion in revenue. There are more of them than you would think – the National Center for the Middle Market reports that there are nearly 200,000 of these companies, and they employ almost 45 million people. Private debt can offer enhanced income, as the yields on this debt may be higher to compensate for the lack of liquidity.
3) Hedge Funds
Hedge funds often use liquid investments, like stocks, but deploy them in highly specialized strategies that are meant to exploit different market characteristics or environments. They can sometimes be complicated, have high fees, and have different tax reporting. The lure is that in addition to providing lower correlation, these types of strategies may offer the opportunity for outsized returns. However, the risk taken is usually commensurate with the return potential.
4) Real Estate
This type of real asset is one of the most common. By owning your home you have exposure to the real estate market. In addition, many investors look to buy investment properties to diversify their portfolios. Investors may consider commercial properties, multi-family properties, student housing, single-family rentals, or raw land for development. Real estate investments may offer the potential for income from rents and capital appreciation. For some investors, there are significant tax benefits.
Commodities like timber, oil, metals, and agricultural products are often seen as an inflation hedge. They are not correlated to the public equity markets. Instead, they rise and fall in value in relation to supply and demand factors that cover everything from weather to geopolitical events. Most commodities investments are made through futures contracts. These contracts are set for a price and period of time in the future, and when they expire, they can be rolled over into another contract.
Things like wine, art, jewelry, cars, stamps, and coins are the traditional collectibles – but collectibles can be anything that accrues value. While the conventional way to invest is to purchase the actual item, technology has made it possible to buy shares in collections or individual items.
7) Structured Products
Structured products provide a return that is linked to an underlying asset, which can be a single stock, a basket of stocks, an index, foreign exchange, commodities, etc. They are created by employing a trading strategy involving the underlying asset and a derivative, like an option, swap, or forward contract.
Structured products can offer benefits, but they are complicated and combine several different types of risk.
The Bottom Line
Modern portfolios are no longer limited to traditional asset classes. Adding alternatives can help to diversify investments and can potentially lower portfolio volatility.
While some alternatives may offer higher returns, for a long-term investor, the value is often to be found in smoothing portfolio volatility and reducing overall portfolio risk.
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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.