Earn sound risk-adjusted returns with alternative assets

These investments can lower portfolio volatility and allow you to stay invested across market cycles. But remember that any promise of high returns will come with commensurate risk

While the basic premise of Modern Portfolio Theory and the so-called efficient frontier have remained unchanged, the availability of uncorrelated asset class choices has extended well beyond traditional equities and bonds. Large institutions have been using private capital, real assets, commodities, hedge funds, and other structured products as part of their asset allocation for decades. In more recent times (after the great financial crisis or GFC), many of these offerings have been repackaged into liquid alternatives, such as in the form of mass-marketed mutual funds. In other cases, the minimum amount required for investment has been lowered or syndicated via algorithmic trading platforms. 

Today there are financial instruments such as exchange-traded funds (ETFs) that mimic specific sectors across 6,000 global offerings. The move toward less expensive passive investing has spawned over 5,000 investible indexes. The long-standing and popular 60/40 model of portfolio investing now seems almost quaint for the smart investor seeking better risk-adjusted returns in her portfolio. The tool kit to accomplish this has a lot more in it today than the basic stocks and bonds.

The alternative way to wealth

• Assets under management of alternative asset classes have grown massively since the financial crisis of 2008
   
• The key benefit of investing in alternative assets is diversification and reduction in portfolio volatility
   
• Divergence in return between the best and the worst performing fund manager can be very high, so choice of fund manager becomes important
   
• Investors also need to be mindful of costs

With increased complexity, broader absolute-return mandates, and wider latitude in investment process, comes the potential for much higher dispersion of returns between the so-called average manager versus the top or bottom performer. To be sure, this is also the case with stocks and bonds. But the magnitude of differences in the alternative investment space can be massively wider than anything that the more traditional investor has experienced. You can understand this by simply thinking about the deployment of varying degrees of leverage or the use of investment choices that do not have the immediate and verifiable price discovery you would find in more highly liquid and efficient markets.

Rapid growth in alternative assets: While these alternative asset classes have come into more mainstream focus since the GFC, they are not at all new. In fact, by some accounts, the origins of the first hedge fund date all the way back to 1949. However, what is new is the significant growth that we have seen in this space in the last decade where hedge funds, as an example, have grown 10-fold when measured by committed capital, and there are now over 10,000 offerings as alternatives. Similarly, for private equity, there were only 24 general partners in the early 1980s while there are over 7,000 today. Finally, private debt barely existed as an asset class at the time of the GFC and it is now expected to crest the $1 trillion mark by 2020. 

These are just three examples of asset classes that have now mushroomed into full-blown industries, providing even greater choice and potential opportunity for the educated investor.

Does greater choice equal higher return? There is an old saying that the last free lunch in the investment cafeteria is diversification and that remains true even today. However, more choice does not automatically provide for a brightly lit path to true diversification of risk. It is even more important today that the smart investor does her homework and proper due diligence especially when seeking actively managed products. For many of these asset classes, the fees are substantially higher, and the investor must clearly understand that those fees will either come out of gross returns in the good times, or directly out of your savings in periods of stress. The aforementioned dispersion of returns is also an issue, and manager selection is even more important in many cases, than simply getting access to a particular strategy such as long/short equity. Due diligence and informed consent on your own, consulting a reputable and trusted financial advisor, will be time and money well spent.

The more passive product entry points do exist through mutual funds and ETFs where desired exposures can be realised in a less expensive and more liquid way. But the same rules around basic due diligence apply even here. 

In the final analysis, all investors must have expectations that are grounded in reality. The very best use-case for any alternative investment is to lower your volatility, to keep you fully invested over market cycles, and to ultimately provide for better risk-adjusted returns over time. 

Many investors begin their saving plans too late in life or set aside amounts that will be too small to realistically fund their retirement needs. If they then come to the alternative investment window thinking they will be accessing the higher-octane path to financial freedom, it will end badly. Rest assured there are plenty of highly-leveraged products in the market today with real or perceived outsized return profiles, but any return above the risk-free rate is simply subject to even greater risk. That risk goes up substantially as you dreamily look further out on any yield curve, and tremendous caution should be exercised for any promises of return profiles that are “too good to be true”. 

Investing is a very long-term endeavour and your goals must be realistic relative to capital markets today and into the future. You should start early and remain fully invested. Understanding your risk tolerance relative to your investment horizon is also very important. Retirement needs are not as pressing when you are young, and less concern needs to be put on the nearer-term ebbs and flows of the market. As you get older or other liabilities become due, risk should be dialled back. Ultimately, all investors need to think about this risk as an asset to be actively managed even if they are using passive investment product. The outcome will result in a far better and more realistic path toward financial security. 

The writer is president and CEO, Chartered Alternative Investment Analyst Association