I’ve written this summer about the potential benefits of alternative investments. Let’s assume that readers of my previous blogs agree that my ideas have some merit and it is time to diversify into alternatives (alts). The devil is always in the details. Of all the different alt funds available, which is best for a given investor? And where does it fit in a portfolio? In this blog, the fourth in my series explaining the basics of alts, I will suggest a process that may help investors select the best alternative strategy for their objectives.
How to incorporate alts into your portfolio
In order to determine the right plan for you, I recommend following this multi-step process:
- Define your investment objectives. As one of my previous blogs explained, “alternative investments are simply tools investors use in an effort to achieve their investment goals.” As such, prior to making any decisions about alts, it is essential for investors to define their objectives. There are many alternative investment strategies designed to help build wealth, preserve wealth or enhance current income. Defining your goals will facilitate the decision-making process.
- Identify alternatives that are consistent with your objectives. Once you have defined your goals, it is much easier to hone in on the most appropriate alt strategies. To help investors, Invesco has created an investment framework (shown below) that organizes the liquid alternatives universe around common objectives.
To shed further light, the table1 below summarizes the historical performance characteristics of the various strategies comprising the above framework.
- Research specific funds. Once investors have decided which strategies to incorporate, they need to select the appropriate fund or funds to invest in. An investor should only invest in a fund after they understand its unique characteristics, such as expected return and risk, what constitutes a favorable/unfavorable environment, expected performance during different market cycles and key drivers of return. To assist in this research, investors can find a wealth of information using the fund websites and research sites such as Morningstar®. Investors may wish to consider the benefits and risks of a single-manager fund versus a multi-manager fund. With a single manager, investors can adopt a focused strategy, as single-manager funds usually have a well-defined investment approach. However, investors will be assuming manager risk (e.g., the risk of selecting an underperforming manager). Investing across multiple managers (or in a multi-manager fund) can help mitigate manager risk. But, the disadvantage of multi-manager funds is the allocation across managers and strategies typically fluctuates over time, thus limiting an investor’s ability to be targeted in their exposure to a particular strategy.
- Decide how much to invest in alternatives. There is no one correct answer to the question of how much to invest in alternatives. In my experience, investors typically allocate between 5% and 30% of their portfolios to alternatives, and many of the investment firms I work with typically recommend a 10% to 20% allocation (depending on the goals and objectives of the individual client). This decision is typically driven by an investor’s familiarity with these assets, along with their risk tolerance. I believe that, whatever the allocation, if an investor decides to use alternatives, the amount should be sufficient to impact the portfolio. If the allocation is too small, the impact on the portfolio will be negligible, thus defeating the purpose of adding alternatives.
- Choose how to fund the investment in alternatives. I am a big believer that asset allocation is as much an art as a science. Furthermore, every investor has unique investment objectives that will drive their asset allocation decisions. As a result, there is no one-size-fits-all answer to the question of how to fund an allocation to alternatives. That said, I suggest investor alt allocations be based on return and risk characteristics. If the alternative has predominantly equity-like return and risk characteristics, the investment should be funded as if it were an equity investment. Similarly, if the alternative has predominantly fixed income-like characteristics, it should be funded like a fixed income investment.
Applying what we’ve learned
We have covered the basics of alternatives, why these assets may be helpful in investor portfolios, historical performance and how to select an alt strategy. My final blog in this series will seek to apply what we’ve learned to the current market environment. In the meantime, learn more about Invesco and our alternative products.
1 Source: StyleADVISOR, September 2001 – March 2018. Maximum decline refers to the largest percentage drop in performance. Equities are represented by the S&P 500 Index. Fixed income is represented by the Barclays U.S. Aggregate Bond Index. Inflation hedging is represented by 75% FTSE NAREIT US Real Estate Index Series, All Equity REITs and 25% Bloomberg Commodity Index. The 75%/25% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. Principal preservation is represented by the BarclayHedge Equity Market Neutral Index. Portfolio diversification is represented by 60% BarclayHedge Global Macro Index and 40% BarclayHedge Multi Strategy Index. Multi strategy is underweighted in this example due to its potential overlap with global macro. Equity diversification is represented by the BarclayHedge Long/Short Index. Fixed income diversification is represented by equal allocations to BarclayHedge Fixed Income Arbitrage Index and S&P/LSTA US Leveraged Loan Index.
Past performance is not a guarantee of future results.
Investments cannot be made directly into an index.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.
The Bloomberg Commodity Index is a broadly diversified commodity price index.
The BarclayHedge Equity Market Neutral Index includes funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country.
The BarclayHedge Global Macro Index includes funds that carry long and short positions in any of the world’s major capital or derivative markets.
The BarclayHedge Multi-Strategy Index includes funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines.
The BarclayHedge Long/Short Index includes funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market.
The BarclayHedge Fixed Income Arbitrage Index includes funds that aim to profit from price anomalies between related interest rate securities.
The S&P/LSTA Leveraged Loan Index is a weekly total return index that tracks the current outstanding balance and spread over LIBOR for fully funded term loans
Blog header image: Kwangmoozaa/Shutterstock.com
Diversification does not guarantee a profit or eliminate the risk of loss.
Alternative investments can be less liquid and more volatile than traditional investments such as stocks and bonds, and often lack longer-term track records.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.