The basics of alternative investments - Part 1: What are they?

Thus far in 2018, we have seen an uptick in interest in, and demand for, alternative investments as investors grew increasingly concerned about the future direction of stocks and bonds. In an attempt to address these worries, investors are searching for investments that could either cushion their portfolio should stocks decline, or thrive during a more challenging market environment. Alternative investments, due to their unique investment approach and performance characteristics, are potentially such investments.

Given the increased interest in alternatives, I thought I would use the summer to write a series of blog posts covering the basics of alternatives, with an emphasis on alternatives available via mutual funds. My hope is that these posts will provide an opportunity for investors to get fully up to speed on this topic and be well prepared as we head into the second half of 2018. 

What are alternative investments?

While there is no one common definition for alternative investments, Invesco defines alternatives as investments other than publicly traded, long-only equities and fixed income. By design, this definition is intentionally broad and inclusive. Different investors often have their own unique definition of alternatives and may classify specific investment types differently.

Based on this definition, investments that have any of the following characteristics would be defined as alternative investments:

• Investments that engage in “shorting” (i.e., seeking to profit from a decline in the value of an asset), such as global macro, market neutral and long/short equity strategies).
• Investments in asset classes other than stocks and bonds, such as commodities, natural resources (e.g., timberland, oil wells), infrastructure, master limited partnerships (MLPs), and real estate. 
• Investments in illiquid and/or privately-traded assets, such as private equity, venture capital, and private credit.

At a high level, Invesco divides the universe of alternatives between liquid and illiquid alternatives. Liquid alternatives predominantly invest in underlying instruments that are frequently traded and regularly priced, and provide investors with the ability to redeem their investment on a regular basis. Alternative mutual funds and most traditional hedge funds are examples of liquid alternatives. Alternative mutual funds are available for investment by retail investors, high net worth investors (i.e., individuals with a net worth in excess of USD 5 million) and institutional investors (e.g., pension plans, foundations, endowments, and sovereign wealth funds). Traditional hedge funds, however, are typically only available to high net worth and institutional investors.

Illiquid alternatives predominantly invest in underlying instruments that are privately traded, priced on a periodic basis (often quarterly) and require investors to hold the investment over a prolonged period (typically several years) with little to no ability to redeem the investment prior to its maturity. Private equity, venture capital, direct real estate, private credit, direct infrastructure, and natural resources are examples of illiquid alternatives. Illiquid alternatives are typically offered as private placements, and are only available to institutional investors and high net worth individual investors (i.e., access that is not typically available to retail investors).

Invesco further divides the universe of alternatives between alternative asset classes and alternative investment strategies: 

- Alternative asset classes are investments in asset classes other than stocks and bonds. Investments in real estate, commodities, natural resources, infrastructure and MLPs are all examples of alternative asset classes. Alternative asset classes can be accessed through either liquid or illiquid investments. 

The performance of an investment in an alternative asset class is often driven by the underlying performance of the asset class as a whole. Investors frequently invest in alternative asset classes in order to hedge against inflation (alternative assets historically appreciate during inflationary periods), to seek equity-like returns (alternative asset classes historically have generated equity-like returns with equity-like levels of risk), and to receive attractive levels of current income (many types of alternative asset classes generate attractive levels of current income for investors).

- Alternative investment strategies are investments in which the fund manager is given increased flexibility with how to invest. The manager is often given the ability to trade across multiple markets and asset classes such as stocks, bonds, currencies and commodities, as well as given the ability to short markets. Common hedge fund strategies such as global macro, long/short equity, market neutral, managed futures and unconstrained fixed income are all examples of alternative strategies. Alternative investment strategies are typically offered through liquid structures, such as mutual funds. 

Strategies such as global macro, market neutral, long/short equity, and managed futures all typically invest on a long and short basis. The ability to short has the potential to significantly impact the return stream of these investments, as shorting gives these strategies the potential to generate positive returns in a falling market environment. At a minimum, the use of shorts provides these strategies with a powerful tool to potentially limit losses during such an environment.

The performance of an investment in an alternative investment strategy is highly dependent on the skill of the underlying manager, and performance across managers can vary greatly. Investors frequently invest in alternative investment strategies in order to diversify their portfolios, to protect their portfolios during falling market environments, to add an investment with an absolute-return orientation (i.e., an investment that seeks to generate positive returns in both rising and falling market environments), and/or to reduce portfolio risk and volatility.