Many investors are never exposed to the diverse array of alternative investments. These opportunities are generally relegated to large institutional investors including endowments and pension funds. Additionally, the world of venture capital is often available only to Silicon Valley elites. Where does that leave investors who are interested in capitalizing on these investments but have little idea how to access them? The JOBS Act and the recent proliferation of investment platforms serve to change this dynamic and facilitate access to alternative investments for individuals looking for ways to diversify their portfolios. This democratization is still in its infancy as the old regime of investing and capital allocation still dominates. Financial professionals and individual investors should gain exposure to alternatives providing enhanced diversity and return strategies.
The problem with traditional stocks and bonds is that they maintain correlation to market trends. There are several risk factors involved with traditional investment portfolios. Market risk, also called systematic risk, involves risk factors outside an investor’s control including events such recessions or natural disasters. These events cause market turmoil. Systematic risk factors cannot be eliminated through diversification with traditional investments. Your exposure to beta in a portfolio, which is the tendency of the portfolio to move with the market, is your exposure to systematic risk.
Unsystematic risk is directly and specifically tied to the performance of a particular security. This type of risk involves the understanding that there are both firm-specific risks (the notion that a company or firm in which you invest may go bankrupt), and sector-specific risks (oil is performing poorly due to a glut in supply). These risks can be diversified by purchasing investments across diverse sectors, geographies, and instruments (stock, bonds, ETF’s). However, investors will still always be left with some systematic risk in a traditional portfolio. To be sure, these traditional types of liquid instruments present many opportunities for great returns, but inherently lack characteristics typical of alternative investments that greatly diversify a portfolio.
Many alternative investments display low correlation to traditional investments. This enhances the risk/return profile of a portfolio that might only contain traditional investments correlated to systematic risk. The long time horizon and illiquid nature of these investments contribute to the different return profiles of alternatives. Combining alternative investments such as private equity, hedge funds, and venture capital funds moves a portfolio’s efficient frontier up and to the left (see below graph). This means that for a given level of return the risk is lower when combining strategic alternative investments to a portfolio.
Alternative investments are less constrained to regulation compared to traditional investments. The unregulated nature of alternative investments also means only accredited investors can participate in most investments. Hedge funds have a wide universe of strategies and tools that investors in traditional stocks and bonds do not have. Additionally, the nature of pooled funds produces an environment in which fund managers possess increased buying power particularly with the use of strategic leverage. This presents an opportunity, especially in private equity, where strategies are utilized to buy companies. Inherently, this will present its own risks, but it is a world teeming with great opportunities. Investors should not forgo traditional investments altogether, but instead pursue alternative investments as a supplement to diversify and participate in unique opportunities with huge potential upside.
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