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Beyond Stocks and Bonds

Alternative Investments Have the Potential to Enhance Performance and Help Smooth Portfolio Volatility

Not long ago, investing in an alternative investment strategy—hedge funds, private equity and other alternatives to equity and fixed income investments—may have seemed to be a privilege reserved for the ultra-wealthy or for institutions like pension funds. Today many investors at multiple points along the wealth spectrum are leveraging these strategies and with good reason: alternative investments have the potential to bolster returns and mitigate portfolio risk. As such, the question facing many investors is not whether to add alternative strategies to their portfolios but which ones.

The answer to that question depends on each investor’s time horizons, and financial goals. Someone concerned about the prospect of rising inflation might seek a hedge against rising prices. Investors approaching retirement might want to mitigate the impact of market volatility on the value of their nest egg. A younger investor actively building wealth might want to pursue outsized returns not available through traditional equity and fixed income strategies. An allocation to alternative investments may help address these challenges.

Achieving Portfolio Diversification

In the past, building a diversified portfolio usually meant allocating funds to three traditional asset classes: equities, fixed income and cash. Today, however, even a carefully considered allocation to those assets may not deliver the diversification benefits investors seek. International trade, information technology, and the rapid flow of capital across borders have increased the linkages among the world’s economies and financial markets. As a result, even a seemingly well-diversified portfolio limited to equity, fixed income and cash instruments can suffer a significant decline in value during turbulent markets.

An allocation to alternative investments may address the challenge of achieving true portfolio diversification because historically they have been less correlated with stocks and bonds due to their diverse assets and sophisticated investment practices. While there is no guarantee of performance results, many managers of alternative strategies look beyond stocks and bonds, targeting real assets, such as commercial real estate and commodities; companies in need of capital; or distressed businesses seeking to revitalize themselves. They also employ strategies typically not available to traditional managers, such as leverage, investment concentration and portfolio hedging, which potentially could increase returns without necessary increasing expected portfolio volatility.

The challenge for investors considering alternative strategies is that the complexity of these investments can make it difficult to determine the appropriateness of a given strategy for one’s portfolio or even the optimal allocation to alternative asset classes. The investment specialists at Merrill Lynch recommend investors allocate a portion of their portfolio to alternative investments with the size of the allocation determined by investors’ risk tolerance and financial goals. This allocation may be achieved by targeting the opportunities presented by the following alternative strategies:

Hedge funds, which are private investment funds through which investors can gain exposure to a variety of markets. Common hedge fund strategies include:

  • Equity long/short, whose managers seek to extract gains from stocks they believe will perform well over the long term, as well as from those they expect to decline in value over a specified time period.
  • Global macro funds, which attempt to benefit from global macroeconomic trends
  • Event-driven strategies that seek to profit from corporate developments, such as complex restructurings and mergers and acquisitions.

Hedge funds of all kinds derive a significant portion of their returns from active management, which means their managers seek to outperform the broader markets, often through security selection and frequent trading. They also may use leverage, derivatives, short selling and concentrated positions to boost risk-adjusted returns (although those tools also can generate significant losses as well). The primary benefit of hedge fund investing is the opportunity to realize attractive returns in any market environment, even those that typically create strong headwinds for traditional assets.

Private equity strategies, which include leveraged buyout funds that acquire companies using significant amounts of borrowed funds and venture capital funds that invest in start-up businesses. Private equity managers seek to identify promising companies that might benefit from capital infusions and changes to their business strategies. Working closely with the companies’ leadership teams, private equity managers strive to increase the businesses’ value by changing their management, reducing costs, refining their product lines or entering new markets. Their goal is to exit their investments by selling the companies for considerably more than they paid. Private equity funds typically return capital to their investors over time by selling the companies to a strategic acquirer or taking them public.

Real assets, which include real estate (both commercial and residential properties) and commodities, such as gold and other precious metals, oil and agricultural products. Historically real assets have behaved differently than stocks and bonds and even other alternative investments due to their low correlation to all other asset classes. In addition, they have delivered especially strong outperformance during periods of high inflation, making them a potentially attractive hedge against rising prices.

Each of these strategies has a distinct risk profile and return potential. Investors seeking to maximize the potential benefits alternative strategies offer, should consider an allocation to each type of alternative strategy. By blending private equity, hedge funds and real assets, investors may be able to better diversify their current portfolio.

Benefits and Risks of Alternative Investments

An allocation to alternative investments potentially can deliver stronger returns than those provided by stocks and bonds without increasing portfolio volatility. That benefit does not come without drawbacks intrinsic to alternative assets, however. Chief among these is illiquidity. Investors in hedge funds and private equity strategies, for example, typically must commit their capital for several years to provide managers time to fully exploit the opportunities they are targeting. The lack of liquidity has some potential upside, though, as there may be an illiquidity premium in the form of above-average long-term returns that help compensate investors for the lack of access to their cash. With more limited liquidity, the managers of alternative strategies need not lock in losses by selling into the teeth of punishing markets; they also have more time to recoup any losses that might be sustained.

Another trade-off for the potential benefits alternative investments can deliver is the strategies’ lack of transparency compared to that of traditional equity and fixed income investments. Because alternative strategies are not required to provide as much information about their holdings as mutual funds and other traditional investments are, it can be challenging to evaluate the risks and performance prospects of the strategies.

Navigating the Alternatives Landscape

To identify the optimal strategies for their clients, investment advisors are able to parse across multiple alternative strategies, and recommend strategies they believe are best positioned to address their clients’ investment goals.

Of course, to effectively integrate alternative investments into their clients’ portfolios, advisors must know more than the strengths and weaknesses of a given strategy; they also must know their clients. A private equity investment that might be right for one investor could be inappropriate for another because of differing financial goals, risk tolerances and time horizons. For example, a high-risk growth strategy probably would be inappropriate for a client who is sensitive even to short-term, unrealized losses. A defensive strategy designed to smooth portfolio volatility would be more appealing to a conservative investor. Investors who value liquidity generally would not be well served by strategies with long lock up periods, especially when similar opportunities might be accessed through non-traditional mutual funds that provide investors with greater access to their cash. Put simply, investing in alternative strategies present investors with many questions; to answer them, advisors can help you understand their value and appropriate role in your portfolio.

Alternative Investments: an Increasingly Mainstream Solution

Alternative investments are among the most complex and least understood investment strategies, which is why many investors fail to include them in their portfolios. As more investors understand that an allocation to alternative strategies may be able to both increase return and mitigate portfolio volatility, a solution once reserved for institutions and the ultra-wealthy likely will find a home in the portfolios of a far larger and more diverse population of investors.

3 Questions to Ask Your Advisor

  1. Could adding alternative investments to my portfolio help me achieve my long-term financial goals?
  2. How much should I allocate to alternative investments based on my risk profile and liquidity needs?
  3. What types of non-traditional mutual funds are there? Could they help to diversify my current investment mix?

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Diversification does not ensure a profit or protect against loss in declining markets. Alternative investments involve limited access to the investment and may include, among other factors, the risks of investing in derivatives, using leverage, and engaging in shorts sales, practice which can magnify potential losses or gains. Alternative investments are speculative and involve a high degree of risk and volatility.

Some or all alternative investment programs may not be suitable for certain investors. Investors must have a pre-existing relationship of six months or longer with the financial advisor before becoming pre-qualified to receive information on alternative investment products. No assurance can be given that any alternative investment's investment objectives will be achieved. Many alternative investment products are sold pursuant to exemptions from regulation and, for example, may not be subject to the same regulatory requirements as mutual funds. In addition to certain general risks each product will be subject to its own specific risks, including strategy and market risk. Certain alternative investments require tax reports on Schedule K-1 to be prepared and filed. As a result, investors will likely be required to obtain extensions for filing federal, state, and local income tax returns each year.

Alternative Investments are speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment. There is no secondary market nor is one expected to develop and there may be restrictions on transferring fund investments. Alternative investments may be leveraged and performance may be volatile. Alternative investments have high fees and expenses that reduce returns and are generally subject to less regulation than the public markets. The information provided within this presentation does not constitute an offer to purchase any security or investment or any other advice. 

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