What are alternative investments? In order to adequately explain what falls into this category, it is probably more helpful to explain what isn’t an alternative investment. Professional investment advisors consider traditional investments to be publicly traded stocks, bonds, and cash/cash equivalents. This includes registered investment vehicles, like mutual funds and exchange-traded funds, that hold a pool of these traditional investments. Everything else could be defined as alternative investments, which includes things like hedge funds, private equity, venture capital, farmland, art, commodities, coin collections, private real estate, and the list goes on.
Now that we have defined alternative investments, here are some of the benefits and risks of this asset class:
Benefits
- Diversification – Diversification is the primary benefit of alternative investments. Some alternatives tend to have low correlations with traditional stocks and bonds. If added to a portfolio, this can help increase diversification and lower portfolio volatility.
Risks
- Low Transparency – Transparency can be limited for alternative investments, especially compared to traditional investments. Many alternatives are largely unregulated, making them more difficult to research and monitor. Overall, low transparency makes it harder to asses risk exposures and performance metrics.
- Liquidity – Liquidity has to do with how quickly you can convert your investment into cash, without a significant loss in value. Many alternative investments are illiquid, because they don’t trade very often. In addition, strategies like hedge funds or private equity often have lock-up periods. A lock up period is a timeframe where you cannot get your money back. These can last for months or years depending on the type of strategy.
- Fees – The underlying fees for investing in alternatives tend to be high relative to traditional investments. For example, hedge funds have historically charged clients based on a 2 and 20 fee structure, which is a 2.00% annual management fee as a percentage of assets and 20.00% of profits above a certain threshold. Fee structures continue to evolve but generally speaking, investors pay more for access to alternative investments. For comparison purposes, the average expense ratio for equity mutual funds is 0.55%1.
- Leverage – Leverage can be implemented in several ways, including margin debt, the use of derivatives, and other types of debt financing. At a basic level, leverage allows the manager to increase the magnitude of their investments by controlling an amount of assets that is greater than cash on hand. If an investment goes well, huge profits can be made. However, if it goes sour, leverage can lead to large losses.
At Foster Group, we recognized the potential diversification benefits of alternative investments and after much evaluation, we recently added an alternative strategy to our investment offering focused on the reinsurance risk premium.
One of our investment principles is to advance with science and as more transparent, liquid, and cost-smart alternative investment vehicles come to market, we continue to evaluate their potential benefit to client portfolios. What does it mean to be Truly Cared For™? It means we understand your passions use proven methods to help you reach your goals. Contact us if you would like to know more about alternative investments.
12019 Investment Company Fact Book
All investment strategies have the potential for profit or loss. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Alternative investments are speculative and involve a high degree of risk. Investors could lose all or a substantial amount of their investment.