Alternative asset classes and strategies fall outside of the three traditional asset classes (traditional stocks, bonds or cash). They can include special risk that may include less regulation, increased losses and unique tax implications.
Alternative Asset Classes may be referred to as “hard assets” or “real assets”, as they are often tangible items that hold inherent value – that is, their value is not derived from other sources. They may also represent investments into extended areas of the equity or bond markets.
Alternative Strategies are tactics or tools that have flexibility in the way they use assets in the portfolio. They may use traditional assets, alternative assets and/or derivatives.
The potential for consistent returns with less risk
Alternatives can be a valuable addition to a portfolio because they may typically have a low or negative correlation to traditional investments. This means that when the values of traditional investments are decreasing, the value of alternative asset classes is likely increasing. Of course, the inverse is also true – when traditional investments are performing well, alternative asset class investments are likely to earn lower returns.
Remember, investing in alternative asset classes involves special risk. Alternative asset classes may be highly speculative and leveraged or may use various hedging techniques, like options and derivatives. This could increase losses since hedge fund losses are not fully reflected in historical standard deviation measurements. Also, alternative asset classes may incur unique tax implications if traded in foreign markets and may be highly dependent on your manager’s investment techniques and ability to select appropriate risk. Often, alternative asset classes are not registered under U.S. Securities laws or similar laws in other countries; therefore, they’re subject to less regulation than publicly offered investments.
The potential impact of alternatives
While the addition of alternative asset classes may not keep your overall portfolio value from decreasing in a market downturn, it may lessen the impact. As a greater percentage of the portfolio is allocated to alternatives, returns may increase and risk (standard deviation) may be reduced.
Below are four hypothetical portfolios with gradually increasing allocations to alternative investments. Take a look at the standard deviation and the return of the first portfolio that uses a traditional allocation of 60% stocks, 30% bonds and 10% cash; now compare it to the last portfolio that includes 25% of alternatives.
The first portfolio (that does not incorporate alternatives) has a return of 6.27%, and a standard deviation of 8.97%. The fourth portfolio, with 25% allocated to alternatives, has a higher return of 6.61% and a lower standard deviation of 8.28%. You can see that as a greater percentage of the portfolio is allocated to alternative asset classes, the returns may increase and the risk may be reduced.