Asset Class in Focus: Alternative Investments

January 2021

Despite what their name suggests, “alternative investments” have become an increasingly mainstream part of the investment world over the past decade. Most investors have some knowledge of alternative investments as an asset class, but there is still quite a bit of confusion about this eclectic collection of investment types.

While there is no official, comprehensive list of alternative investments (or simply “alternatives” or “alts”), the common thread is that they fall outside of the traditional public equity and fixed income arenas. We provide an overview of the major types of alternative investments and the various roles they can play in a portfolio. We also describe some of the key risks and misperceptions associated with alternatives and BDOWA’s approach to using them in clients’ portfolios.
 

What are the major types of alternative investments?

Alternative investments comprise a diverse set of assets and investment strategies. Some of the most commonly used alts include:
  • Private equity: These funds invest in privately held businesses that tend to generate steady cash flows. Private equity managers may specialize in a specific area, such as manufacturing or healthcare services, and they often employ leverage (through the use of private credit as described below) to enhance returns.
  • Real estate: A diverse category in itself, real estate can involve investing in office buildings, industrial facilities, retail space and more, in various regions of the country or internationally. Real estate investment returns consist of an income component –income is generated from contractual rent payments tied to tenant leases – and a real asset component – tied to the value of the underlying property/properties.
  • Hedge funds: This is a very broad and diverse category. Strategies that hedge fund managers may use to generate returns or reduce risk include merger arbitrage, long/short equities, event-driven equities, global macro, and volatility trading.
  • Private credit: This category consists of privately negotiated or originated debt investments that aren’t traded on the public markets. Unlike most public credit, private debt instruments typically bear a floating interest rate and therefore have limited sensitivity to interest rate fluctuations. Private credit provides the leverage that helps private equity funds acquire their portfolio companies.
  • Commodities: Managed by a commodities trading advisor, commodities strategies involve buying and selling futures contracts on various commodities, such as gold, oil and wheat.
  • Venture capital: These funds hold minority equity stakes in early-stage companies, often in sectors such as technology or healthcare. While moon-shot success stories are legendary, failures are common.
  • Real assets: Typically focused on physical assets, such as timberland and farmland, this category can also include infrastructure lending.
  • Liquid alternatives: These are non-traditional investment strategies for which the underlying securities are traded on public exchanges or otherwise easily marketable. Liquid alternatives (also known as “marketable alternatives”) strategies are similar to those pursued by hedge funds, such as long/short equity or event-driven equity, but they are offered in more liquid vehicles, such as mutual funds and ETFs. 
 

What roles can alternative investments play in a portfolio?

For most investors, the primary motivation for including alternatives in a portfolio should be diversification. The returns of alternatives are driven by different factors than what determines the performance of public equity and fixed income markets. As a result, alternatives offer risk/return profiles and return streams that have a fairly low correlation with traditional asset classes.

This diversification can improve risk-adjusted returns at the portfolio level, which can be particularly appealing in a low interest rate environment like we have today. Traditionally, investors have looked to publicly traded fixed income to provide diversification from their equity exposures. But today’s low yields mean that most bonds are very sensitive to rising interest rates; this reduces bonds’ ability to play their traditional risk-reducing role in a portfolio. Alternatives can be very effective in providing this valuable diversification from the equity market.
 

What are the primary risks associated with alternative investments?

The most notable risk with alternatives compared to public equities and fixed income is illiquidity. Most alternatives require investors to lock up their invested capital for several years, and investors typically are paid a premium as compensation for leaving their capital in place long enough to allow a process to play out. For example, with distressed investing, an extended time horizon is often required for a manager to work through bankruptcies and turnaround situations. And with private equity, funds need time to source, invest in, and develop portfolio companies before selling them. At a high level, investors in alternatives essentially plant seeds by committing their capital and expect those seeds to bear fruit some years down the road.

Liquidity, or the ability to sell assets and turn them into cash, is an important concept for investors to understand. The amount of illiquid assets that an investor can afford to own is a function of the investor’s cash flow needs as well as the composition of the rest of the portfolio.
 

What misperceptions do investors often have about alternative asset classes?

Many investors view alternatives as exotic, “swing-for-the fences” strategies that add risk to a portfolio in exchange for the chance of high returns. While some alternatives can indeed be volatile, we believe that alternatives are best viewed as a tool for reducing portfolio risk and smoothing out returns.

Investors also tend to underappreciate how varied the strategies and potential outcomes are within alternatives. Alternatives are in no way monolithic. This is true both across the various types of alternatives as well as within those asset classes. As a result, manager selection is paramount with alternatives. In other words, you don’t simply decide to invest in private equity and then allocate capital to any available manager. It is imperative to carefully vet a manager’s unique skills and focus areas.
 

What is BDOWA’s approach to investing in alternatives?

We employ alternative investments from a portfolio perspective, with a focus on how alternatives can improve diversification and reduce risk. We vet managers and conduct due diligence carefully, and the private offerings we recommend tend to come from management teams that we have worked with in the past. In addition to focusing on “the three P’s” — people, process and performance — during due diligence, we also carefully examine leverage, transparency, fees and the tax efficiency of the investment opportunity.

Alternatives are primarily appropriate for investors with a fairly substantial portfolio, although our approved list of liquid alternatives can offer most investors the opportunity to benefit from return streams with a low correlation to the equity market. We view alternatives’ differentiated risk and return factors as well as the long-term focus they require as very helpful features for long-term, goals-based investors like ourselves.