Home Alternative Investments Not Just Any Alternative Investment Will Do

Not Just Any Alternative Investment Will Do

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Investors looking to diversify portfolios made up of equities and fixed income often turn to alternative investments, which are recommended because they add return without necessarily adding a lot of risk. But the category has ballooned in recent years, and investors need a new level of discernment when picking their shots, experts say.


“A lot of people might wonder what we mean by alternatives,” said Hilary Wiek of PitchBook, a Morningstar subsidiary specializing in private transaction data, news and analysis. In a presentation she made at this week’s Morningstar Investment Conference, Wiek, a lead analyst in PitchBook’s fund strategies and sustainable investing group, said her definition of alternatives includes commodities, insurance, collectibles, timber, metals, crypto, peer lending, events, land, private debt, options training, venture capital, infrastructure, private equity, relative value hedge strategies, forestry, trends, digital, and macro and distressed strategies, among other sub-categories.


“These are the sorts of things that people tend to bucket into ‘alternatives,’ and we have to try to make sense of all that,” she said.


Different Purposes

Her co-presenter, Simon Scott, director of alternatives ratings in Morningstar Australia’s global manager research group, said the first exercise in narrowing the field is understanding why an alternative is a good idea in the first place.


“It’s simply a switch of potential risk loading,” he said. “If we take a traditional portfolio, obviously it’s dominated by traditional equity and bond beta risks,” he said—beta referring to the volatility of individual securities compared to the overall market. “As we want to move beyond that, we incorporate an alternative to bring in other elements.” For example, an investor could add alpha risk (the risk of a security or group of securities outperforming or underperforming the market) or factor risk (which turns to groups of securities that have certain higher return characteristics). “An example is a relative value strategy, which is switching a lot of the equity beta for factor and alpha risk, and to an extent leverage. “


“So in our parlance, we say we’re buying an alternative to modify, diversify or eliminate those dominant risk factors that you see in portfolios.”


A classic example is an equity long-short strategy, where the equity exposure remains but the risk has been modified, or private credit, where the bond betas and core credit risk from fixed income remain, but there are other elements brought in, he said. And in private equity, the equity remains but there’s added complexity risk. There are also added risks from regulations, valuations and liquidity, he said.


He said these strategies should be funded from the core growth part of a portfolio.


Beyond strategies that modify a risk that’s already in a portfolio, there are also alternatives that diversify—that provide something completely different. “These are more your traditional strategies that really, in normal market environments, should have very little codependency over those core equity or bond betas,” Scott said. “In that space we tend to have our liquid alternatives, tangible assets; also some of the real estate, and commodities, would sit in there. And what I call marketplace assets—crypto, collectibles, some forms of art. Those newer styles of products that really have, apart from broad economic exposure, no linkages to your core equity and bond markets.”


And then finally there are opportunistic strategies. These are the strategies that can benefit when equities are struggling. “That’s not to say that they always will, but these strategies will tend to vary those risk loadings,” he said. “These are volatility strategies, currency, and systematic trend investing, which we’ve seen recently do very well. These all tend to perform when equities are falling.”


A financial advisor should be looking at risk and making decisions from there, he said.


“Determine the risks that you have and decide which ones you want to keep and which ones you want to mitigate. Once you’ve found those strategies, there are some very simple groupings from which you should be able to pick to build a broader portfolio,” he said.


He pointed to the $40 billion inflow into liquid alternatives alone over the last 12 months. That inflow has been going primarily to two sectors: derivative income (a strategy in the modifier category that is based on options, futures and forward contracts) and options trading (an opportunistic strategy).

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