Klingenstein Fields, a New York based wealth advisory firm, defines alternative investments simply as any investment product other than so-called "traditional" investments - i.e., stocks, bonds, and cash in an unleveraged portfolio. Due to alternatives' low or even inverse correlation to these traditional investments, adding "alts" to a typical portfolio can result in diversification benefits and dampened volatility. In a September 2015 white paper titled "Are You Ready for an Alternative?" Klingenstein divides alternatives into two broad categories - hedge-fund strategies and private strategies - each with several sub-categories.
Hedge Fund Strategies
Klingenstein divides hedge-fund strategies into three principal categories: Opportunistic equity strategies, enhanced fixed-income strategies, and absolute-return strategies.
Opportunistic equity strategies include:
- Long/short equity
- Global macro
- Short equity
- Long/short specialty
- Long/short international
Enhanced fixed-income strategies include:
- Distressed securities
- Global/ emerging market debt
- Structured credit
- Long/short credit
- Leveraged loans
- Loan origination
And finally, absolute-return strategies include:
- Equity market neutral
- Convertible arbitrage
- Fixed-income arbitrage
- Statistical arbitrage
- Event driven
- Managed futures
Although hedge funds are technically "private" investments, they are generally more liquid and under a bit more regulatory scrutiny than other "more private" investments, which Klingenstein divides into three groups, each with their own sub-categories: Real estate, private equity, and energy and natural resources.
Private real-estate strategies and assets include:
- Long/short REIT
- Real estate partnerships
Private equity categories include:
- Early-stage venture
- Late-state venture
- Growth capital
And finally, private energy and natural resource investments include:
- Long/short energy
- Exploration and production
- Midstream energy
- Services and technology
The Role and Benefits of Alts
Klingenstein's broad definition and intricate, systematic categorization of alternative investments illustrates the space's diversity. "Alternatives" should not be considered a single asset class or a monolithic strategy - different strategies can serve different roles and provide different portfolio benefits.
Since alternatives are not stocks, bonds, or cash, they typically exhibit low correlation to these traditional asset classes. This low correlation can result in diversification benefits when adding alts to an existing stock-and-bond portfolio. The chart below details the historical correlations, which in most cases are low and in some cases are negative, of traditional assets and alternatives from December 2005 to December 2014:
Adding alts to a traditional portfolio can also result in lowered portfolio volatility. As a result, "the careful addition of an allocation of alternatives to a typical portfolio of traditional investments may substantially improve overall outcomes," according to the paper's authors.
"There are many different types of alternative investments, each of which can serve different roles in a thoughtful asset allocation strategy," said Klingenstein Fields President James Fields, in a statement announcing the white paper's publication. "A primary reason for including alternatives in a portfolio is to try and improve the risk/return profile. Other goals include enhancing overall returns or providing additional sources of income."
Risks and Challenges
Alternatives, including hedge funds, are under far less regulatory scrutiny than traditional investments. The comparative dearth of required disclosures also inhibits investors' ability to conduct thorough due diligence, and of course, many alternative strategies are benchmark-agnostic.
Since hedge funds and private investments are generally only accessible by accredited investors - currently defined as individuals with more than $200,000 in annual income in each of the past two years and net-worth excluding primary residence of at least $1 million - and since hedge funds and private investments don't trade on exchanges, they are obviously less liquid, too.
All of these factors should be taken into account before allocating to alts.
The Rise of Liquid Alts
Fortunately, some of these issues have been addressed with the rise of liquid alternatives. Liquid alts are regulated by the same Investment Act of 1940 ("the '40 Act") that regulates all mutual funds. As such, they are prohibited from taking on the enhanced leverage of some hedge funds and private investments, and they're required to make regular disclosures of their holdings. Liquid alts can be purchased by any investor, and they have the same liquidity as mutual funds, too, which has helped lead to their massive growth since 2007:
In conclusion, the white paper's authors write: "Liquid alts have helped address issues of transparency, oversight, cost, valuation, and liquidity that have historically prevented investors from moving beyond traditional investments."
For more information, download a pdf copy of the white paper.
Jason Seagraves contributed to this article.