We’ve heard the saying that “the rich get richer,” and we all know that it takes money to make money. If it seems like wealthy people have special tools we don’t know about that help them grow their wealth more successfully, alternative investments could be the key.
Alternative investments — like private equity, direct real estate and reinsurance — have been staples in the high-net-worth portfolios of individuals and institutions for decades. For those new to the concept, alternatives are investments that tend to move independently from the stock market, unlike traditional asset classes such as stocks and bonds.
Average retail investors generally have been relegated to those traditional asset classes, and alternatives have been virtually unavailable to them — until recently.
Since 2000, retail investors in the Standard & Poor’s 500 index have had to stomach two major market crashes, losing over 49% each time. Although the market has climbed back up each time, the swings can be unsettling, and advisors and chief investment officers predict that volatility will remain a key theme in 2016. With the future just as uncertain, and interest rates in flux, many everyday investors feel handcuffed, worried and confused about what to do next.
Indeed, the world and investing are not the same as they used to be. The traditional, diversified strategies that used to work may no longer be enough. So the question becomes: How can investors accomplish their goals in the modern market? The answer may lie in alternatives.
At first glance, it might sound risky, but the benefit of “alternative” asset classes is that they can actually help reduce risk when added to a diversified portfolio.
In the past, when one part of the market went down, generally another would go up. For generations, investors could diversify portfolios across investments like large-capitalization stocks, small-capitalization stocks and international stocks to reduce risk and improve returns over the long run.
Recently, however, many parts of the market have started to move together. Data over the past two years indicate that large-cap stocks correlated 84% with global small-cap stocks and 76% with international stocks. Such high correlation rates indicate that these stocks are moving in the same direction in the market. Ideally, you want correlation to be as low as possible — if your investments are all moving the exact same way, then you essentially have only one investment.
The effect? More risk and less return. This drastic erosion in the risk-reducing power of traditional diversification has left many investors with riskier portfolios than they realize. The “noncorrelated” characteristic of alternatives might be the missing piece they’ve been looking for. Investors implementing alternative allocations are somewhat insulated from this new investment environment.
According to a study by investment firm Columbia Management, “adding just one zero-correlated asset to a portfolio reduces risk 29.5%, while adding a thousand 66% correlated assets reduces risk by only 19%. In short, correlation matters … a lot. One can make one correct and impactful portfolio choice, or a thousand fairly meaningless ones.”
In other words, just holding multiple investments does not necessarily mean your portfolio is diverse. If you’re adding only assets that correlate with your holdings, you won’t be lowering your risk. As the Columbia Management study indicates, by adding assets with zero correlation to how they move relative to other parts of your portfolio, annual volatility is lowered and better diversification is achieved.
Access to alternatives
But how does the average investor find access to these noncorrelated alternative investments? Thanks to modern technology and innovative investment vehicles, many alternative asset classes are accessible to everyday investors with everyday account balances — not just to institutional managers who could handle million-dollar minimums.
Although you may have to work with a financial advisor, many alternative asset classes are available for purchase daily, with the provision that investors may sell only during specific windows — usually quarterly. This limited liquidity provision allows the portfolio manager the ability to invest heavily in private alternative assets, while still giving investors daily pricing, lower minimums and the transparency required in a regulated structure.
Of course, it’s not all rainbows and unicorns. Just because an investment is “alternative” does not make it a good one. At best, it just makes it different. Investors must evaluate each alternative option on its own merits.
There are different costs and risks that need to be considered. For example, limited liquidity may not seem like a big deal until you need the money and cannot get it. Many alternative investments are also more concentrated, meaning it can be harder to spread out your risk because there are fewer underlying assets within the investment.
Before jumping in headfirst, be sure you are comfortable with the concepts of the investment. Make sure the allocation is appropriate for your situation, and confirm that you can manage the potential illiquidity of these types of products. And, of course, ensure that your portfolio is well diversified with other asset classes.
Investors can no longer simply rely on the market, close their eyes and hope everything will work out. To be successful, investors need to be practical, proactive and progressive. An appropriate allocation into alternative asset classes might be a good place to start.
This article also appears on Nasdaq.