Global View Commentary

Why are Alternative Investments the latest buzz words?

Written by Joe Hines | May 2, 2022 10:00:00 AM

The term is thrown around often, but what does it mean? It sounds interesting. It sounds complicated. Is it something cutting edge? Is it expensive? We all know “if it sounds too good to be true, it usually is.” So, let’s find out if this holds true for alternative investments.

Traditional Investing

When you think about “traditional investing,” it usually is investing in stocks and bonds, outright or through mutual funds or ETFs. A Moderate Portfolio may have 60% stocks and 40% in bonds. This has been the bread and butter of investing for many years.  In general, the broad stock market has had a low correlation to bonds; that is, they tend to balance each other through the ups and downs of the market.

 

What are “Alternative Investments?” 

“Alternative Investments” are anything outside of conventional stock and bond investing. They typically have a low correlation to the stock and bond market, meaning their returns are not always aligned. These investments could include: 

  • Managed Futures, which is a managed portfolio of commodities contracts
  • Direct lending to businesses rather than buying publicly traded bonds
  • Private equity is a pool of investors’ funds purchasing private companies and/or consolidating companies with synergies for greater growth. 
  • Venture Capital is a group of entrepreneurial-minded investors that are injecting capital into small companies for fast growth in exchange for equity in the group. 
  • Hedge funds, which is structured with a tactical management approach in an attempt to manage volatility, or possibly other target goals. 
  • Real estate, commercial and residential
  • Commodities, buying commodities directly.
  • Tangible Assets can be purchased in art, classic automobiles, a stream of royalty income, and other collectibles. 
  • Most recently, digital assets and cryptocurrency.

These investments have only been available to institutional investors for much of their existence. As markets have evolved, they have been repackaged and are now accessible to the average investor. This can be valuable but also harmful if not used properly.

 

Alternatives Investments used as a Marketing Tool

Many financial advisors and investment managers have tried to set themselves apart by offering something different from other firms by using alternative investments. Alternatives can sound sexy and alluring when other investments seem to be out of favor or when there is a lot of uncertainty in the markets. They are often used to sell against traditional investments, as though you should only be invested in this alternative investment. Gold and Silver are great examples.   Have you ever noticed that they only become popular investments during times of “extreme uncertainty”?  Have you considered the commercials are worded so precisely to appeal to investor fears and are being represented by celebrities whom you are supposed to “trust”?

While some of the marketing ploys are misleading, there can be a fit for alternative investment in some portfolios. 

 

Higher Cost

Often these asset classes are more expensive to own. They have higher management costs because transaction costs, storage costs, and management is more difficult overall. In some cases, it may be worth the additional cost. But the due diligence must be done to make sure the fees are not excessive. 

Sometimes the fees are hard to explain. When a portfolio manager owns a portfolio of stocks or bonds, the cost is pretty clear. It is only the trading and management cost. What is not shown in the traditional stock and bond portfolio is the cost that the underlying company incurs. For example, if you purchase Amazon stock, you are investing in a stream of future earnings. When you look at the cost of the investment fund, you don’t analyze the expenses the underlying companies have. This does have an impact on the performance of the fund. You would typically look at the cost of the actual fund/portfolio management and trading cost. 

In some alternative investments, such as direct lending, the actual underwriting cost shows up in the fund's management and operating costs, making it look much higher. You do not see the underwriting cost to issue those bonds with a traditional bond manager. 

When analyzing the fees, one must make sure they are making relative comparisons and not oversimplifying things.

 

Illiquidity

Due to the nature of some of the assets, it is more difficult to sell or exit. Some only allow you to get a certain percentage out each quarter or each year. For example, if you are in a portfolio of private real estate or private lending, they can’t have a lot of investors coming at once asking for their money back. Therefore, there must be some restrictions. As an investor, you must be aware of this and make sure it is placed into your portfolio appropriately. It has to be a long-term investment. 

For other investments, the holding requirements are much longer. 

 

Should I have them in my portfolio? 

Alternative Investments may sound scary. But like any investment, there are good and bad considerations.  Ask yourself, “How is this complementing my overall portfolio strategy?”

There are benefits to having these types of assets or strategies. The goal may be to have a low correlation to the other parts of the portfolio. In other words, it helps balance out the volatility and stabilize the portfolio's returns.

We have always believed in keeping things simple with our portfolios while keeping in line with our core philosophy. I often say, “chocolate, vanilla, and strawberry are all you need.” However, you could add some sprinkles, Hersey syrup, or other toppings. 

 

If you are a Global View client, you may very well have an allocation to “alternative investments.” This could be on the fixed income side or the equity side. When we invest with portfolio managers, like boutique mutual funds, we want them to have a core philosophy but also have a “go anywhere” spectrum. We want them to be able to apply that core philosophy to any geographic market or take advantage of undervalued assets in any market. This may mean an equity manager buying bonds when there is a tremendous disparity. 

We have always used investments that may not fit into one box for this same reason. 

Today, we have more flexibility in how we invest in these alternatives. They come in the form of institutional mutual funds and ETFs, among other vehicles. 

We believe alternative investments can be a helpful compliment to a portfolio. However, be cautious not to get lured into the high fee, illiquid investments that may not fit your needs. As your dedicated fiduciary, we will only recommend these investments if they are the most appropriate solution for your individual needs.