Alternative investment strategy

What Is Alternative Investment Strategy?

An alternative investment strategy involves allocating capital to financial assets that fall outside the traditional categories of publicly traded stocks, bonds, and cash. This approach is a core component of portfolio theory, seeking to enhance portfolio diversification and potentially generate uncorrelated returns. Unlike conventional financial instruments, an alternative investment strategy typically involves less liquid assets and a broader range of complex investment techniques. Common types of assets utilized within an alternative investment strategy include hedge funds, private equity, real estate, and commodities. The primary goal of an alternative investment strategy is often to improve risk-adjusted returns or reduce overall portfolio volatility, particularly during periods when traditional markets may be underperforming.

History and Origin

The concept of investing in assets beyond traditional stocks and bonds is not new, with early forms of commodity trading dating back centuries. For instance, in ancient civilizations, goods like spices and metals were traded, laying the groundwork for modern commodity markets.²⁴, ²⁵ However, the modern alternative investment strategy began to take more structured forms in the 20th century. The term "alternative investments" refers to a broad category that has evolved significantly.²³

Key milestones include the emergence of hedge funds, often credited to Alfred Winslow Jones in 1949, who devised a strategy aimed at reducing market exposure by combining long and short positions.²¹, ²² Shortly after, in the mid-20th century, the first venture capital funds were established, notably American Research and Development Corporation in 1946.¹⁹, ²⁰ Private equity strategies also gained prominence, particularly after the 1974 stock market crash, when regulatory changes, such as the Employee Retirement Income Security Act (ERISA), allowed institutional investors like pension funds to explore a wider range of investment opportunities.¹⁷, ¹⁸ The sector has grown substantially, reaching $22 trillion in assets under management, representing 15% of global assets under management as of 2023.¹⁶

Key Takeaways

• An alternative investment strategy involves non-traditional assets like private equity, hedge funds, real estate, and commodities.
• The primary aims are often to enhance portfolio diversification and generate returns less correlated with traditional markets.
• Alternative investments typically entail lower liquidity and higher fees compared to conventional assets.
• Due to their complexity and varying regulatory oversight, these strategies require extensive due diligence.
• Historically, alternative investment strategies were primarily accessible to institutional and high-net-worth investors, though accessibility has increased.

Interpreting the Alternative Investment Strategy

Interpreting the effectiveness of an alternative investment strategy requires evaluating its contribution to a portfolio's overall performance and risk profile. Unlike traditional investments, which often rely on public market benchmarks, alternative investments may offer returns that are less correlated with broader capital markets. The interpretation often focuses on how these strategies enhance risk management or generate excess returns (often referred to as alpha) beyond what standard market exposure would provide.¹⁵ Analysts frequently examine factors such as downside protection, correlation with traditional asset classes, and consistency of returns across different market cycles. Morningstar, for instance, evaluates alternative funds based on their correlation and relative volatility to global equities to help investors assess their diversification potential.¹⁴

Hypothetical Example

Consider an investor, Sarah, who has a portfolio primarily composed of public stocks and bonds. To implement an alternative investment strategy, she decides to allocate a portion of her portfolio to a private equity fund and a diversified commodities fund.

Scenario:

• Initial Portfolio (Traditional): $1,000,000 (60% Stocks, 40% Bonds)
• Alternative Allocation: Sarah decides to reallocate 15% of her total portfolio to alternative investments.
  • $100,000 to a private equity buyout fund. This fund invests in private companies, aiming to improve their operations and sell them for a profit in several years.
  • $50,000 to a managed commodities fund, which invests in futures contracts for raw materials like oil, gold, and agricultural products.

Outcome (after one year, hypothetical):

During the year, the stock market experiences a downturn, and bonds offer modest returns. However, the private equity fund, being less exposed to daily market fluctuations, sees the value of its underlying companies grow due to operational improvements. The commodities fund performs well as global supply chain issues drive up raw material prices. While her traditional stock holdings may have dipped, the gains from her private equity and commodities investments help cushion the overall portfolio. This demonstrates how an alternative investment strategy can potentially provide diversification benefits and mitigate losses during adverse market conditions for traditional assets.

Practical Applications

An alternative investment strategy is employed across various facets of the financial world, particularly where specific return profiles, diversification, or access to non-traditional markets are desired.

• Institutional Portfolio Management: Large pension funds, endowments, and sovereign wealth funds are significant users of alternative investment strategies. They often allocate substantial portions of their portfolios to private equity, hedge funds, infrastructure, and real estate to achieve long-term growth and stable returns.¹³
• Wealth Management: High-net-worth individuals and family offices increasingly utilize alternative investments to preserve capital, generate income, and enhance overall portfolio diversification in a sophisticated manner.
• Risk Management: Certain alternative strategies, such as market-neutral hedge funds, are designed to generate returns irrespective of market direction, offering valuable tools for risk management and downside protection during volatile periods.¹²
• Regulatory Frameworks: The growing prominence of alternative investments has led to increased regulatory scrutiny. For instance, the U.S. Securities and Exchange Commission (SEC) has adopted new rules and amendments to enhance oversight of private fund advisers, addressing areas like performance reporting, fee disclosure, and preferential treatment of investors to increase transparency and investor protection.¹⁰, ¹¹ This oversight highlights the significant role alternative investments play within the broader financial ecosystem.⁹

Limitations and Criticisms

While an alternative investment strategy offers potential benefits, it also comes with notable limitations and criticisms.

• High Fees: Alternative investments often charge higher fees than traditional investments, typically including a management fee (e.g., 1-2% of assets under management) and an incentive fee based on performance (e.g., 20% of profits). These fees can significantly erode net returns over time.⁷, ⁸
• Lack of Liquidity: Many alternative investments, such as private equity and direct real estate, are illiquid, meaning they cannot be easily bought or sold on public exchanges. Investors may have their capital locked up for extended periods, sometimes several years, limiting their ability to access funds if needed.⁵, ⁶
• Complexity and Opacity: The underlying strategies and financial instruments within alternative investments can be highly complex and less transparent than publicly traded securities. This complexity can make it difficult for investors to fully understand the risks involved and perform adequate due diligence.
• Limited Regulatory Oversight: While regulators like the SEC have increased scrutiny on private funds, alternative investments generally face less stringent regulatory requirements compared to mutual funds, which can expose investors to different types of risks.³, ⁴
• Performance Variability and Risk: Despite the potential for alpha, the actual performance of alternative investments can vary widely, and some strategies may carry substantial risks, including the use of leverage which can magnify losses.² Additionally, some studies suggest that while alternative investments offer diversification, their risk-adjusted returns may not always be compelling compared to traditional assets.¹

Alternative Investment Strategy vs. Traditional Investment

The distinction between an alternative investment strategy and traditional investments lies primarily in the asset classes involved, their market characteristics, and accessibility.

Confusion often arises because both aim to generate returns and manage risk within a portfolio. However, their methods and underlying structures are fundamentally different. An alternative investment strategy seeks to expand the investment opportunity set beyond readily available public securities, often targeting inefficiencies or unique market exposures not found in mainstream asset classes.

FAQs

What types of assets are considered alternative investments?

Alternative investments encompass a broad range of assets beyond conventional stocks, bonds, and cash. These include private equity, hedge funds, real estate (private, not publicly traded REITs), commodities, infrastructure, and private debt.

Why do investors use an alternative investment strategy?

Investors often employ an alternative investment strategy to achieve portfolio diversification, potentially enhance returns, and reduce overall portfolio volatility. These investments may offer returns that are not closely tied to traditional markets, providing a buffer during market downturns for traditional investments.

Are alternative investments suitable for all investors?

No, alternative investments are typically not suitable for all investors. They often involve higher fees, lower liquidity, and greater complexity and risk compared to traditional assets. They are generally more appropriate for sophisticated or institutional investors with a long-term investment horizon and a higher tolerance for risk.

How are alternative investments regulated?

The regulation of alternative investments varies significantly depending on the specific asset class and jurisdiction. While publicly traded securities are subject to extensive oversight, many private alternative investments, such as private equity funds and hedge funds, have traditionally had less stringent public disclosure requirements. However, regulators, like the SEC in the U.S., have been increasing their oversight of private fund advisers to enhance transparency and investor protections.

What are the main challenges of an alternative investment strategy?

The main challenges include high fees, a lack of liquidity, and the inherent complexity and opacity of many alternative assets. Investors may also face challenges in accurately valuing these investments and performing adequate due diligence due to limited transparency.