Managing Market Volatility with Alternative Investments

market volatility

 

Original post on Investopedia

Managing the effect of market volatility on portfolios has become the primary concern for the sophisticated global investor as we see macro tremors reverberate throughout the capital markets. Traditional diversification techniques with 60:40 allocations are proving inadequate, and geographical diversification is even less helpful as the true impact of globalization is being felt in the price of investments. This is why investors and financial advisors are looking toward alternative investments to provide the edge that investment portfolios require to be truly diversified. However, there are several elements of the alternative investment asset class that need to be properly understood before they are effectively used as a diversification tool.

Not All Alternative Investments Are Created Equal

Alternative investments comprise a wide and diverse set of asset classes that are often misconstrued as a single type of investment. Alternative investments encompass various products created by money managers, real assets, and commodities that fall outside the realm of the traditional stock and bond assets that are tradeable and relatively liquid in the open market. As such, it’s important that advisors and investors fully appreciate the fact that alternative investments shouldn’t be considered a specific type of investment, but an overall strategy to properly hedge portfolios against market volatility and other systematic risk. In the same manner, each type of alternative investment is an asset class of its own that needs to be properly understood and due diligenced before being included in an investor’s portfolio.

 

Investor Profile Is Critical in Selection of Alternative Investments

Due to the depth and breadth of the different types of investments within the alternative investment universe, it is even more critical that each approach be customized for specific investors. There are very few generalizations that can be made when allocating to alternative investments. An investor’s specific risk profile, return horizon and potential liquidity needs are critical variables to consider as many alternative investments do not have a readily available liquid market. Oftentimes alternative investments are also highly illiquid (which contribute to their diversification capabilities) and are available to only a few eligible investors.

 

Return Profiles Are Wide and Tied Directly with Risk

While alternative investments have the ability to provide a diversification effect on portfolios when utilized properly, these assets are widely variant not only in type and liquidity, but also in their underlying risk profiles and return capabilities. Additionally, even within specific types of alternative investment – hedge funds for example – there is an extremely diverse spectrum of risk/return profiles which must be properly understood before making any investor allocations. And while there could be systematic risk such as the events of 2008 that lead all investments into a specific direction, generally speaking, alternative investments have a lower correlation to market investments. As such, the risk-return profiles of alternative investments may be better understood without the context of specific market volatility that is often driven by investor fear or short term profiteering.

 

Alternative Investments Are More Mainstream than You Think

As with many different types of investments, the institutional market often gets involved first due to a perceived sophistication and illiquidity associated with new market entrants. This has been historically the case with many alternative investments, but asset managers and other financial service firms are recognizing the need and the appetite expressed by retail investors. With this change, the discussion around alternative investments has changed to a mainstream need as opposed to an esoteric strategy only restricted to the most wealthy and sophisticated investors.

 

 

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