Alternative Investments: Diversification Potential
Posted by Richard on May 15, 2013
Prolonged stock market volatility has caused many investors to question how much of their portfolios should be allocated to equities. The world of investing isn’t solely about stocks and bonds. There are alternative investments, which may provide ways to diversify your portfolio and potentially maximize your portfolio’s risk-adjusted return.1
Alternative investments can help protect purchasing power, acting as a hedge against inflation. Additionally, they tend to have very low correlations with stocks and bonds. However, it’s just as important to understand that alternative investments also come with risks.
Alternative investments take many forms. Here is a look at several common investment types.
These investments include metals such as gold or silver, oil, and agricultural products. The advantage of commodities is that they exhibit a low correlation to both equities and bonds. Consequently, when the stock market is experiencing weakness, commodities tend to hold their own. However, commodity prices are volatile, thus there is more risk. In the case of gold or silver, there are dealers who trade these precious metals. If you take physical possession of gold or silver, you will need to arrange for storage and insurance. Because many investors do not want to make these arrangements, exchange-traded funds (ETFs) have become a popular and much simpler way to access commodities.
The term hedge fund is a catch-all phrase describing funds that follow aggressive investment strategies such as intensive use of derivatives, selling short, and proprietary computerized trading. Hedge funds typically are engineered to seek a more favorable risk-adjusted return than their investors might obtain from a fund that follows a market benchmark. By law, hedge funds are restricted to a low and limited number of accredited investors and are primarily organized as limited partnerships. As a result, the vast majority of hedge funds target institutions and wealthy individuals.
Major categories of private equity include venture capital, leveraged buyouts, managed buyouts, and mezzanine financing. Investors participate in private markets through collective investment vehicles such as partnerships that actively manage the investment assets on the investors’ behalf. Once a particular partnership has reached its target size, the partnership is closed to new investors, including new funds from existing investors. Private equity firms frequently require investors to make commitments ranging from $5 million to $10 million or more. Successful investing in this area requires the ability to assess complex financial structures, assume outsized risk in pursuit of superior reward, and tolerate extended periods of illiquidity.
All investing involves risk, including loss of principal; and alternative investments by themselves can be highly volatile. But when used in combination with stocks or other assets, they may help to smooth out long-term returns and provide an alternative when stock returns are choppy.
1There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure a profit or protect against a loss.
2Exposure to the commodities market may subject investors to greater volatility as commodity-linked investments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity.
3Hedge funds often engage in speculative investment practices that may increase the risk of investment loss. Hedge funds can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees.
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