Benefits of Alternative Investment Funds

For an individual investor, the standard investment portfolio is 60 percent stocks and 40 percent bonds. But for many investors, particularly those of high net-worth, alternative investments make sense as well.

These investments include anything that’s not an equity, bond or cash—hedge funds, private equity funds, real estate and commodities, for example. Academic research has shown that alternative investments can provide diversification that boosts risk-adjusted returns if deployed wisely. The case is especially strong now, given the high volatility in stock and bond markets.

Below are the main categories of alternatives and how they work. Keep in mind that for some of them, you need to be an accredited investor, which requires a net worth of at least $1 million, excluding your primary residence, or annual income of at least $200,000 for the last two years.

Your financial adviser can explain which investments have this restriction.

Hedge Funds

Hedge funds originally were designed to hedge—or cushion—declines in other markets. Some are still structured to hedge, while others are designed to speculate on the direction of a particular asset or asset class.

Some of the principal hedge fund strategies are:

• Global Macro. This involves parsing macroeconomic trends and predicting how they will affect stocks, interest rates, currencies and commodities. The fund managers will go long or short on any of those asset classes, depending on their views.
• Long-Short Equity. This was the strategy utilized by the first hedge fund in 1949 and remains common. The idea is to go both long and short stocks, so that you can reduce volatility. The funds seek to achieve positive returns in both bull and bear markets.
• Merger Arbitrage. This technique seeks to take advantage of the opposite movement of share prices frequently seen by the two companies in a merger. Often shares of the buyer fall, because of the money it has to spend on the acquisition. Meanwhile, shares of the company being bought often rise, as the acquirer has to pay up for it. The idea, then, is to sell shares of the acquirer and buy shares of the target when a merger is expected or has been announced.

Private Equity

Private equity represents an equity stake in a company that’s not publicly-listed--i.e. not traded on an exchange. Institutional investors and high net-worth individuals generally invest in this asset class through private equity funds that have multiple holdings.

The funds are designed to provide annualized returns of 15 percent or more and generally expire after five to 10 years, when investors get their money back.

Some funds invest directly in private companies and are known as growth funds, because they invest in companies to help them grow. Other funds buyout public companies, turning them private. Or they might purchase companies that are already private. These funds are known as buyout funds.

There are also funds that specialize in distressed companies. The thought is that turnarounds are possible, which would make the companies profitable and attractive to purchasers or as candidates for an initial public offering.

Private equity funds offer investors the chance to have a stake in companies that would otherwise be beyond their access. Some companies choose to remain private so they don’t have to focus excessively on quarterly earnings. Many private companies are young and growing faster than their publicly-listed brethren.

Real Estate

Investing in real estate is attractive because returns often are uncorrelated with stocks and bonds. The easiest way to invest in real estate is through real estate investment trusts (REITs), which are essentially pools of property and trade like stocks.

REITs must pay out 90 percent of their taxable profits in dividends, so they provide a nice opportunity for income. Blue-chip REITs can have dividend yields over 4%. As REITs hold multiple properties, you get automatic diversification.

Some of the most interesting REITs now are in sectors a little off the beaten path. Warehouse REITs benefit from the explosion in e-commerce, data center REITs benefit from the emergence of cloud computing and demand for data in general.

Cellphone tower REITs benefit from the soaring use of mobile devices, and healthcare REITs benefit from the increased health needs of our aging population.

You also can invest directly in properties, such as an apartment building. But there are a lot more moving parts in that endeavor, so you should consult with your financial advisor if you’re interested.

Commodities

Like real estate, commodities often zig when stocks or bonds zag. Commodities, of course, include energy products, like oil; agricultural products, like soybeans; and metals, such as copper.

There are a myriad of ways to invest in commodities. The simplest are mutual funds and exchange-traded funds (ETFs). For example, some gold ETFs let you invest directly in the precious metal, as they’re backed by physical supply. One of the gold ETFs has more than $40 billion of assets.

You can buy funds that hold a variety of commodities to achieve diversification. One investment option is commodity futures funds, which avoid the complexities of buying and selling physical commodities by using futures contracts.

A futures contract represents a commitment to buy or sell an asset—in this case a commodity—at a set price at a specified time in the future. Typically futures contracts are settled before delivery, so no physical commodity actually changes hands.

Risks

Alternative investments aren’t for the faint of heart. They can be illiquid, making them difficult to sell in times of stress. The investments can carry high fees and can be opaque. Price movement can be quite volatile, with plunges possible.

Conclusion

Despite the risks, alternative investments can make a positive contribution to your portfolio. They give you diversification from your stock, bond and cash holdings. They can dampen volatility and boost returns by staying steady or rising while your other assets are falling. That’s particularly important now amid market uncertainty. If you have any interest in exploring alternative investments, you should contact your financial adviser.