Beyond the world of stocks and bonds lies another category of assets: alternative investments. Learn about the alternative investment market and the types of “alts” that may be available to retail investors.
If you’re an investor who has only stocks and bonds in your portfolio, you could be forgiven for thinking of the word “alternative” in terms of a rock music genre popular in the 1990s. But in the parlance of Wall Street, alternative investments are a potential portfolio diversifier you may never have heard of.
Just so we’re not confusing “alternatives” (or “alts,” as they’re often called) with flannel-clad bands from Seattle, let’s take a look at the alternative investment market.
The goal of adding alts to a portfolio is usually to diversify by holding some assets with a historically low correlation to stocks and bonds. Ideally, the price movement of some alternative investments tends not to follow the broader market. And even when they do, such moves may be dampened.
“Alternatives usually act differently from traditional asset classes, and that can be a good thing,” said Joe Correnti, director of portfolio construction and guidance for TD Ameritrade.
John Zaller, chief investment officer with MAI Capital Management, said his firm is becoming increasingly interested in alts, based on a view that returns on stocks and bonds are going to be challenged over the next 10 years, he said.
Once you start drilling down into individual alternative assets, there can be some quibbling about what exactly counts. Depending on how you define them, alts can include private equity, private credit, hedge funds, commodities, options and other derivatives, private real estate, exchange-traded real estate investment trusts (REITs), master limited partnerships (MLPs), and currency investments.
Some alternatives tend to be more suited for institutional investors, but other alts such as commodities, currency investments, REITs, and MLPs can be accessed by average retail investors, Correnti said. However, just having access to these alternatives does not mean they are appropriate for every average retail investor.
For qualified investors looking to get alternative exposure, Correnti would put exchange-traded REITs as among the first alts to consider, followed by MLPs, commodities, and currencies. REITs tend to be understandable, offer the potential benefit of rising rents without the day-to-day hassle of having to manage properties yourself, and can pay dividends that at times can be higher than the average company dividend, Correnti said. However, sentiment can weigh heavy on them as interest rates rise.
Alternative investments should offer diversification, be understandable, and have reasonable fees.
MLPs generally provide opportunities to participate in the energy market without a direct correlation to energy prices, Correnti said. After all, oil and gas have to be moved through the infrastructure typically owned by MLPs regardless of what the markets for those commodities are doing. But, like REITs, these investments can be pressured by rising interest rates.
Average investors may not need exposure to commodities, Correnti said. Those markets are notoriously volatile, and owning futures is more complicated than owning stocks. Still, they may offer diversification.
Currency markets might not be something every retail investor wants to dabble in. True, investing in currencies where interest rates are declining and inflation is curtailed can help offset inflation and interest rate risks in parts of the world where the opposite is true, Correnti noted.
For retail investors, there are some mutual funds—although somewhat expensive relatively speaking—that invest in alternative asset classes and can offer competitive returns with equities and bonds, Zaller said.
In addition to offering diversification, it’s also important that the alternative investment be understandable and that the fees are reasonable, Zaller said.
For retail investors, a portfolio allocation of alts would typically be between 3% and 8% of a total portfolio, Correnti said. For someone with a portfolio of, say, 80% equites and 20% fixed income, a conservative strategy would be to take the money from the equities portion. A more aggressive play would be to take the money from the fixed income portion.
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