SprottWealth Insights

Introduction to Alternative Investments

Alternative investments are a category of investments that employ non-traditional assets (traditional assets are stocks, bonds and cash) and strategies. The strategies employed by alternative managers are typically unavailable to traditional managers. Alternative managers can use derivatives for leverage and speculation, have the ability to short, as well as the ability to hold illiquid assets.

In the past, alternative investments were almost exclusively held by institutional investors or high-net worth individuals because of their sophisticated nature, high minimum investments and fees, lack of transparency, lack of liquidity, tax inefficiencies, limited regulations and perceived higher risk. Some examples of alternative assets include gold, commodities, currency, infrastructure, real assets and real estate. Some examples of alternative strategies include long/short, market neutral, short bias, private equity, convertible/merger arbitrage, credit arbitrage, opportunistic/unconstrained fixed income strategies, distressed debt.

Following the Global Financial Crisis, retail investors started looking for strategies that would continue to post gains the next time stocks crashed. Traditional diversification strategies were ineffective as most asset classes plunged together. This caused investors to seek out alternatives as they were uncorrelated to traditional asset classes and each other.

Alternative investments are gradually becoming part of the mainstream. Investment managers are supporting the trend by making products more available to retail investors, wrapping alternative hedge fund-like investment strategies into mutual funds and ETFs, and selling them through traditional retail distribution channels. The mutual fund structure addresses investor concerns over liquidity of alternative investments, and is subject to greater oversight and regulation.

By 2020, McKinsey & Company predicts that alternatives will comprise about 15 percent of global industry assets and produce up to 40 percent of industry revenues as they continue to become more mainstream1.

Alternative Investments

What are the objectives of alternative investments?

Alternative managers have a greater range of strategies available due to less stringent regulation of their strategies because they are intended for more sophisticated, or at least, wealthier investors. The benefits of this include2:

  • Broader diversification and lower correlation
    • Correlation is a measure of how the returns of asset classes perform in relation to each other. When one asset class goes down, if you are well diversified, another asset class you hold would go up, helping to neutralize the volatility (risk) in your portfolio.
    • Alternative asset classes and nontraditional strategies provide returns that are uncorrelated to traditional asset classes and to each other
    • Diversification of this nature is perhaps the best way for investors to diminish risk in their portfolios
  • Lower portfolio volatility
    • By adding alternative investments to the core portfolio, investors can reduce volatility and cushion portfolios against extreme market environments
    • Some alternatives hedge against specific risks, such as interest rate fluctuations and inflation
  • Potential for enhanced long-term performance and risk management
    • Reducing the frequency and severity of losses in a portfolio allows a portfolio to compound returns quicker and more efficiently
  • Hedge fund capabilities with mutual fund benefits
    • Mutual funds offer lower investment minimums, lower fees, no pre-qualifications, efficient tax reporting, and liquidity
  • Access to talented active managers

Conclusion

Alternative investments can be a worthwhile addition to your portfolio depending on your objectives, risk tolerance and net worth. Alternative strategies are intended to produce positive returns, reduce volatility and cushion portfolios against extreme market conditions. They are able to do this because the strategies alternative managers employ make use of a broader range of tools than their traditional counterparts. All investments however are subject to risk. Alternative strategies can pose risks including, but not limited to: credit risk, currency risk, derivative risk, market risk, sector risk, country risk, leverage risk, liquidity risk.

To learn more about alternative investment strategies, and how they can be a benefit to your portfolio, please contact your SprottWealth advisor.

1 http://dailyalts.com/wp-content/uploads/2014/08/McKinsey-Company_2014_Capturing-the-Next-Wave-of-Growth-in-Alternative....pdf
2 http://us.pioneerinvestments.com/misc/pdfs/brochures/whyalts.pdf