Alternative investments: More relevant than ever?

YOU’VE HEARD IT BEFORE: Diversification is a key to managing risk. Historically, when stocks have gone down, bonds have offered a potential buffer. That’s because they tend to rise in value as stocks decline, dampening the effects of volatility on equity investments. However, as today’s markets struggle to adjust to the new realities of inflation and rising interest rates, bonds may not offer the degree of diversification that they have in the past.

In times like these, if you are a qualified investor,¹ alternative investments may be worth considering as an additional means of diversification. Investors should consider looking past traditional formulas, suggests Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. “We have transitioned into a new investment cycle driven by higher inflation and a pivot by global central banks, among many other factors. This is likely to create higher asset price volatility and new market leaders,” he says. “We believe alternative investments can play a role in helping qualified investors pursue today’s opportunities.”

Though they may not be right for everyone, “alternative investments are strategies that can help complement traditional stock and bond investments,” says Andrew Corwin, head of alternative investment strategy in the Chief Investment Office for Merrill and Bank of America Private Bank. “They take advantage of techniques such as hedging, concentration of assets and leverage in ways that increase diversification while addressing specific goals.”

Alternative investments can be particularly useful during volatile markets, Corwin adds, because unlike traditional investments, “some are insulated from the business cycle and market ups and downs. Others take advantage of volatility in targeted ways. In addition, alternative investments can give investors access to markets and strategies that are difficult or impossible for individual investors to access on their own, like asset-backed securities.”

As Hyzy puts it, “With the market transition into a new investment cycle, in our view there are still significant opportunities in alternative investments for portfolio diversification, potential return enhancement and risk mitigation.”

While all investments have risks and costs, alternative investments have certain specific risks that are different from those of traditional stocks or bonds. These risks include limited liquidity (redemptions are only available on certain dates), leverage (using borrowed money) and investment concentration (fewer but larger positions). But they are counterbalanced by their ability to provide a portfolio with two types of diversification — strategic, relying on specific trading strategies, and asset-based — both of which can help investors achieve their goals, given their potential to lower portfolio volatility and help enhance both returns and income.

Below, Corwin highlights three alternative investment strategies for qualified investors to consider. Ask your financial advisor whether one or more might make sense for you.

Hedge funds: A variety of approaches

Hedge funds utilize a wide variety of trading strategies not generally available to traditional asset managers, notes Corwin. Equity long/short funds, for example, position themselves to extract gains from stocks that may perform well over the long term, as well as those that may lose value. Global macro funds are designed to benefit from broad macroeconomic trends, including interest rates, foreign currencies and commodities. Event-driven funds focus on corporate restructurings and mergers and acquisitions. These are sophisticated strategies, Corwin cautions, and hedge fund managers may use derivatives, make frequent trades, take short positions in different instruments and use concentrated positions to achieve their goals. They generally provide less transparency to investors and can charge higher fees.

Potential benefits for investors: Adding hedge funds to a portfolio may be worth considering as they can help provide a buffer when markets experience a downturn and assist with capital preservation, Corwin notes. Although hedge fund strategies can, of course, suffer losses, the performance of hedge funds over the past decade has demonstrated their resilience. During each of the six biggest market drawdowns since 2011, hedge funds have held up better than stocks.

Private equity: Buying and selling companies

Private-equity funds aim to acquire private and some public companies with the ultimate goal of selling them at a substantial profit and returning capital to investors. They invest in companies that might benefit from an infusion of capital and shifts in business strategies and then work with them to change management, reduce costs, refine product lines or enter new markets before the sale. Investors should be aware that in some cases, they may have to wait up to a decade before realizing returns.

Potential benefits for investors: Historically, private equity has outperformed public markets ² and may also help manage portfolio volatility. “Some of the best-performing private-equity funds are the ones that operate during or shortly after recessions,” says Corwin. “This makes sense in our view because dislocations and market volatility can create favorable entry points.”

Real assets: In a category all their own

Real assets, sometimes also known as tangible assets, have an intrinsic value and usually a physical form. They cover a wide range of investments, from gold and other precious metals and commodities to commercial and residential real estate, infrastructure funds, agricultural land and natural resources. Such assets tend to behave differently than stocks and bonds, and also other alternative investments. Some may be less liquid than traditional investments and, like private equity, can require an investment horizon of a decade or longer.

Potential benefits for investors: Real assets’ low correlation with the performance of traditional investments makes them especially suited to increasing diversification. Historically, real assets have accrued value when consumer prices rise, which may also provide a hedge against inflation. “Many of these assets don’t have much of a relationship to the business cycle, and that’s the point,” says Corwin. “Historically, real assets have performed well during periods of high inflation.”

A mix of alternatives may be appropriate

Alternative investments can be mixed, matched and calibrated to pursue specific goals. For example, in a rising interest rate environment like the one we’re in presently, an investor could look to a defensive alternative investment strategy such as private credit, which features predominately floating rate securities and has a shorter duration than traditional bond portfolios. Diversifying alternative strategies, such as global macro and managed futures, seek to generate returns that don’t depend on market direction; they may help reduce volatility in portfolios during dislocations. Because these strategies are directionally agnostic, they offer as many opportunities in declining markets as in rising markets. For investors who are willing to accept higher risks and greater exposure to market volatility, growth-focused alternative investment strategies may use concentrated positions, leverage and other approaches that could potentially generate competitive total returns.

“These three outcomes — defensive, diversification and growth — aren’t mutually exclusive,” says Corwin. “They can be used in combination within your portfolio, and the right mix will depend on your goals, risk tolerance, liquidity needs and the time you have to pursue your goals.”

Finding an allocation that’s right for you

“Private equity and real estate typically require an investment horizon of five to 10 years or longer, while hedge funds offer limited liquidity,” Corwin says. Weighing your need for liquidity and other considerations can help you and your financial advisor determine what kind of allocation to alternative investments you might consider as a qualified investor. In most cases, you’ll want to diversify not only across stocks, bonds and alternative investments, but also within those asset classes, with a broad range of hedge fund strategies, private-equity holdings and real assets.

Of course, even the addition of alternative investments doesn’t change the need for a disciplined approach to investing that looks past current market conditions.

“Remembering why you’re investing and sticking with an asset allocation aligned with your goals is almost always the best course,” Corwin says.