Historically, alternative investments (alternatives) have been considered a viable investment strategy, as they invest across asset classes and regions, have different characteristics, and behave differently from traditional investments.
Alternatives have increased since the 1990s due to institutional investors, endowments, and pension fund demand. We have also seen a growing interest from high-net-worth investors seeking diversification and returns benefits.
Some of these alternative investments could be more efficient in protecting purchasing power against inflation and have the potential for higher returns relative to a conventional asset allocation comprising of equities and fixed income.
While traditional alternative investments, such as commodity and real assets have performed well in an inflationary environment, other investments, including private equity, hedge funds, and real estate are also worth considering. This is particularly timely if you are concerned about inflation, market volatility, and low yields.
Market participants have largely considered alternatives in seeking to diversify their portfolios and potentially yielding higher returns.
Institutional investors may choose to allocate assets in alternatives to add non-correlated assets to their portfolios to reduce overall volatility.
Equity Market Correlations and Yields
For example, a defined benefit plan, whose liabilities are sensitive to inflation might benefit from real assets to reduce asset-liability mismatch. Market participants may consider alternatives based on their overall goals and objectives. If they are susceptible to cash flow and income generation, they may lean more toward private credit, high yield, or real estate.
Hedge Fund Strategy Returns
In considering alternatives, market participants should consider the benefits as well as some of the drawbacks.
Most of the traditional options are intuitive to understand and track. For instance, selecting an inflation-linked bond fund to mitigate against inflation risk in a portfolio is relatively straightforward to assess and monitor over time.
However, we should recognize that the regulations, transparency, fees, and tax considerations can be vastly different. Therefore, we need to clearly understand the liquidity provisions along with the operational and reporting complexities.
An investment consultant can assist with the investment decision process and due diligence. The key considerations are the fund manager’s track record, investment strategy and philosophy, fund size, fee and liquidity structure, and eligibility.
While not all alternatives are for everyone, not every alternative has similar returns. Therefore, there is a need to be diligent with manager selection, as only a few of them have the consistency to discover and invest in innovative companies in the private market.
Ryan Lord, Vice President at CAIS Group, noted that “a selective group of alternative’s managers consistently perform in the top quartile.”
In addition, for several investors, alternatives can be a tax-efficient strategy as they could qualify for nonrecognition of gain or loss under section 1031 of the IRS Code: https://www.irs.gov/newsroom/the-treasury-department-and-irs-issue-final-regulations-regarding-like-kind-exchanges-of-real-property