The Basics of Alternative Investments
Alternatives have been growing fast as an asset class. To help your clients make sense of them, here is an overview of the basics.
April 22, 2024 - Alternative investments have grown – 20 years ago, alternative investments represented $4.8 trillion, or 6%, of global assets. Today, they represent $22 trillion in assets under management, or 15% of the worldwide total.1 Some of this is driven by investors looking to alternatives for diversification benefits or a hedge against inflation. Yet, some investors may have hesitations about alternatives, particularly non-traded versions. However, alternatives have changed in surprising ways over the years, and the perceptions that many investors hold about them may no longer be accurate. In fact, alternatives may warrant a closer look for some financial professionals and retail investors. To that end, it’s helpful to start with the basics.
This is the first in a three-part series of articles. The second will discuss the history of alternatives, and the third will cover key misperceptions about alternatives.
What are Alternatives?
It’s almost easier to describe alternatives in terms of what they aren’t. Alternative investments represent asset classes of just about anything outside the realm of traditional stocks, bonds, mutual funds, annuities and cash equivalents. These include investment vehicles with underlying hard assets such as real estate, precious metals, art, antiques, coins and even stamps. Other kinds of alternative investments include financial assets, such as hedge funds, commodities and managed futures, private equity and debt, distressed securities, carbon credits, cryptocurrency and financial derivatives.
Traded Versus Non-Traded Alternatives
Broadly, alternative investments can be grouped into two categories: traded and non-traded. As the name indicates, traded alternatives have greater liquidity—they can be bought and sold relatively easily and are priced daily. Liquidity leads to other characteristics of traded investments. Investors in these investments are able to invest with a shorter time horizon, may see volatility similar to overall stocks, prices can be more heavily influenced by market sentiment rather than the value of the underlying asset and they have lower fees and expenses than their non-traded counterparts. In extreme cases, this liquidity may pose challenges for asset managers. If enough investors sell their holdings during a volatile period in the market, asset managers may have to sell holdings at lower prices to meet redemptions.
In contrast, non-traded alternatives are long-term investments that do not trade on public exchanges, feature limited liquidity and less frequent price valuations. Some have minimum holding periods, while others have redemption plans that offer limited liquidity. That means they would not be suitable for investors who may need access to the underlying capital in the near term. However, for those who can accept limited liquidity for the mid-to-long term, non-traded alternatives may benefit in several ways.
The Benefits of Non-traded Alternatives
Non-traded alternatives offer several potential advantages. One is that they can help to better diversify a portfolio outside of the traded markets.
Lower Volatility – Volatility refers to the amount of uncertainty or risk related to the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically and tends to be more steady.
Investors can help address volatility by diversifying and staying invested for the long haul. Non-traded alternatives may help investors stay invested for the long term because there is no secondary market on which to sell positions. In this way, investors are prevented from making impulse moves driven by fear or trying to time the market. They are priced less frequently and are less likely to experience dramatic swings in value driven by market sentiment, and portfolio managers do not have to sell positions in order to meet investor redemptions.
Lower Correlation – Correlation is a statistical measure of how two securities move in relation to each other. Perfect positive correlation (a correlation coefficient of +1) implies that as one security moves the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation (a correlation coefficient of -1) means that securities will move by an equal amount in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; their movements in relation to one another are completely random.
The correlation between stocks and bonds hasn’t been this high since 2005.2 This can mean that bonds aren’t reducing risk in a typical 60/40 stock/bond portfolio. Investors may think that they’re diversified and have some protection from volatility, but they may not. In contrast, many alternatives have a lower correlation to traditional assets. Holding a diversified set of holdings can help reduce volatility—when the market for one asset is doing poorly, the market for another may be performing well. In 2022, for example, both stocks and bonds were down for the year, yet some alternative asset classes were positive.3
Alternatives offer other benefits as well, including the potential for growth and/or income. Income-oriented alternatives are structured to make regular distributions to investors, growth-oriented alternatives can appreciate, and some alternatives offer a combination of both income and growth.
Managers Matter
Another key aspect of alternatives is the influence of investment managers. There have been a number of new entrants into the space, so reviewing the management team’s experience is important. Unlike passive investing, where there is less dispersion among investors, many alternatives are actively managed, meaning that talented management teams can have a significant difference in returns.
Risks
Investors need a clear understanding of the risks and benefits of non-traded alternative investments to determine if it’s right for them. They are more complex to evaluate and have higher risks and fees compared to traditional investments. In working with clients to make this assessment, financial professionals should consider a range of factors, including investment time horizon, risk tolerance and suitability. Depending on an investor’s goals, risk tolerance, and other factors, alternative investments could help increase a portfolio’s diversification while also offering the potential for income and/or growth.
A Changing Landscape
Many attributes about alternatives have evolved. In the past, for example, some alternatives have been restricted to qualified investors. Today, however, they are becoming more accessible. The range of options is growing as well, with new types of assets and share classes along with increased transparency and liquidity. To read more about this, check out the blog post New Era of Alternatives.
Alternatives are a growing part of the investment landscape. Help your clients navigate potential diversification benefits and risks if alternatives fit their financial goals.
1 Aaron Filbeck, “The Next $20 Trillion in Alternative Investments,” CAIA, January 2024.
2 Josh Schafer, “The 60/40 investing strategy is broken. But it's 'far from dead.” Yahoo! Finance, Oct. 10, 2023.
3 Marc Guberti, “Alternative Investments: What They Are, How to Invest,” US News and World Report, Jan. 9, 2024.
Represents CNL’s view of the current market environment as of the date appearing in this material only. There can be no assurance that any CNL investment will achieve its objectives or avoid substantial losses. Diversification does not guarantee a profit nor protect against losses.
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