By Keith Black
Investors are most familiar with traditional investments, which are the stocks, bonds, and cash that make up most or all of our portfolios. In a search for diversification, investors may include higher and lower-quality bonds, as well as domestic and international stocks. This diversification, however, leaves something lacking, as credit markets and equity markets comprise the entire risk of the portfolio. A portfolio invested 60% in equities and 40% in fixed income securities derives more than 90% of its total risk from stock market investments and may suffer during times of inflation and rising interest rates.
Investors around the world are turning to alternative investment to increase the diversification of their portfolios across a greater number of markets and risk factors. Globally, alternatives account for $15 trillion in total investments, nearly 12% of the global investible market.
One role of alternative investments in a portfolio is that of a return enhancer, where adding alternative investments is expected to increase the total return of the portfolio.
Private equity and venture capital investments are the main source of return enhancement. Venture capital invests in young and growing companies with a goal of becoming a market leader or establishing a new technology or industry. While the vast majority of companies in venture capital funds will lose money, the winners (such as Flipkart) are so large that the total return of venture capital funds can be up to 5% per year larger than the returns to a broad equity index. Private equity buyout funds have a lower risk profile than venture capital funds, as the firms purchased by buyout funds are larger, more established, and less risky. Because the life of buyout or venture funds can be ten years or longer, investors expect these illiquid investments to have a return substantially higher than the return of the broad stock market to compensate for the risk of long-term investments.
While relatively few investments are return enhancers, most of the alternative investment universe is focused on risk reduction. That is, when these alternative investments are added to a portfolio, the total risk of the portfolio declines. While commodities have volatility similar to equity markets, they can reduce the risk of a portfolio as measured by the exposure to inflation, where commodity prices rise during times of inflation when stock and bond prices may decline. It is also easy to see, after the large recent losses in commodity markets, that the correlation between commodities, stocks, and bonds is low (recently negative). Low correlation helps to reduce portfolio risk. A portfolio diversified across gold, energy, agriculture, and industrial metals tends to have different return patterns than stocks and bonds across the full business cycle.
Hedge funds, included in SEBI’s category III of alternative investment funds (AIFs), often seek to reduce portfolio volatility by including risk-reducing trades in each fund. There are many types of hedge funds, such as relative value funds that take both long and short positions in bonds, and long-short equity funds that take long and short positions in stocks. Most are familiar with long positions, where investors purchase stocks and benefit when prices rise. Short selling is the opposite, where investors who sold stocks short can benefit from falling prices. A long-short equity hedge fund may hold 100% in long stock positions and 50% in short stock positions for a 50% net long position. This long-short fund would have just half of the risk of an investment in the overall stock market, producing lower losses in down markets, lower gains in rising markets, and lower total risk overall. Ideally, the manager’s security selection skill would add alpha, or extra return, to the expected return of half of the return of the underlying market index.
Finally, investors can consider investments in infrastructure and real estate. These hard asset or real asset investments are very easy to understand, as it is straightforward to understand how the cash flows work. Investments can be made in a wide variety of properties, such as office buildings, retail stores, apartment buildings, toll roads, electric grids, airports, or other similar assets. Users of those properties pay monthly rent or fees for daily use that creates a steady and predictable income. Ideally, the income can rise as inflation rises, while the properties maintain or grow their value as the economy rises. Investors who seek to build new projects or renovate existing properties are taking greater risk in the hopes of earning higher returns than investors in fully leased and well-maintained existing properties who seek lower returns and lower risks.
(The author is CFA, and Managing Director, Curriculum & Exams, CAIA Association. The views expressed here are his own.)