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It is no secret that over the past few years stock markets have been very volatile, and as we know, volatility is another way to say that markets have experienced high levels of risk. The best way to manage risk in your investment portfolio is by diversifying your investments and this can be done in a few different ways, such as across geographies, industries, or even asset classes.
One popular asset class to be used as a diversifier is alternative investments. Remember that an asset class is a group of financial instruments that have similar characteristics and will behave similarly in the marketplace. So, what are alternative investments, what are their shared characteristics and how can they be used in your portfolio?
An alternative investment is any type of unconventional investment that does not fit into the other categories such as equities, bonds, or cash. A few examples of alternative investments are venture capital, hedge funds, collectables and in some broader definitions can also include property and commodities.
Characteristics of alternative investments are that they are usually rather illiquid and may require a level of experience and knowledge of the particular market due to their more complex nature. It is also well known that alternative investments have a high barrier to entry not just due to their complexity but also in terms of the minimum investment required. Due to this it is more common for institutional investors or high net worth individuals to directly own such investments.
As mentioned above, alternative investments are a valuable diversification tool, but why? Firstly, they are well known to have a low correlation to the market. This means that when the market, usually equity, declines, alternative investments keep their value or may even increase in value due to it possibly becoming more in demand. Further to their low correlation to markets, they are also referred to as “inflation beaters” as their high risk can lead to increased return, especially if held over a longer period of time.
Although most investors can’t own such investments in their individual capacity, knowing about alternative investments will help investors make more informed investment choices. Choose to invest in retirement funds and unit trusts that do have a mandate to invest in alternative investments, but take a look at their factsheets to see how much of the investment pool is actually invested in alternative investments and how much risk the fund does take on, assessing if this is inline with your own investment goals.
One alternative investment that is commonly used by fund managers as an alternative asset class is hedge funds and therefore we will look at hedge funds in a bit more detail.
Hedge funds are complex investments that aim at earning active returns for their investors. Active returns means that with superior investment tactics the hedge fund managers aim at delivering returns above what the market is delivering. These market-beating returns are usually achieved by using various tools and strategies that may come with increased risk.
The most common hedge fund strategy is the long/short equity strategy. This strategy is based on the idea that profits can be made from market winners as well as losers. Short positions can therefore be taken when the manager holds a conviction that a particular equity investment will nosedive and if their conviction is correct, they can make profits from the particular share’s decline.
Leveraging is another tool used by hedge fund managers to increase risk, aiming at increasing return. Leveraging means that the fund effectively borrows money to be used to take bigger market positions. This can lead to superior returns if the manager’s call was correct, however the risk and potential losses are also amplified should their conviction be inaccurate.
It is clear to see how hedge funds can be useful in a portfolio to not just increase potential returns above the rate of inflation, but also how they can be used to bring down the concentration risk of only investing in conventional asset classes.
With increasing inflation levels and much uncertainty present in the market it may be time to consider the role alternative investments play in a portfolio and if it can indeed benefit your investment goals.