Benefit plan trustees have been giving increased attention to alternative asset classes. Before investing in these classes, it is important define what alternative investments are, identify the most prevalent types and understand why investors are adding alternative classes to their portfolios.
Alternative Investments Defined
Alternative investments are any assets that lie outside the three traditional classes of stocks, bonds and cash. These may include commodities, derivatives, hedge funds or limited partnerships. The most common types of alternative investments are described below.
Types of Alternative Investments
Commodities—Commodities are defined as basic goods that are interchangeable with other goods of the same type. These include agricultural products such as beans, cocoa, coffee and sugar and natural resources and energy products such as copper, crude oil, aluminum and natural gas.
Derivatives—Derivatives are financial contracts with a value “derived” from another asset such as bonds, commodities, stocks or indexes. They pay or receive money in the future based on the performance of an underlying asset such as a currency of a portfolio of stocks or bonds. Derivative types include futures, options and swaps.
Hedge Funds—Hedge funds are managed investment portfolios that use advanced strategies to “hedge out” market risk while producing returns independent of overall markets. This typically occurs through purchasing “long” on assets that are expected to increase in price and selling “short” on assets that are anticipated to decline in price. Unlike mutual funds, hedge funds are characterized by their low levels of regulation, aggressive management style and high management fees. Because of these factors, there are limitations on the amounts that ERISA plans can invest in hedge funds.
[Related: Portfolio Concepts and Management, May 1-4, 2017 at The Wharton School University of Pennsylvania]
Limited Partnerships—Limited partnerships are unincorporated businesses with two or more investors that consist of general partners and “limited partners”, whose liability in the firm ends at their level of investment. General partners pay limited partners a return on their investment that is typically defined in a partnership agreement.
Private Equity—Private equity is defined as funds invested in companies that are not publicly traded on a stock exchange. These investments are characterized by their illiquidity, as sellers must locate willing buyers, resulting in longer investment time horizons.
Infrastructure—Infrastructure investing targets physical assets, facilities and systems that are critical to the functioning of local economies, including transportation, energy, utilities and communication.
Venture capital—Venture capital is money provided by investors to start-up firms and small businesses with perceived long-term growth potential. While these investments generally have higher risks, they also have the potential for higher returns.
[Related: Try our Investment Basics online course for a refresher on the traditional classes of investing.]
Why invest in alternative assets?
Investors allocate assets into alternative classes when seeking returns that do not depend on the performance of stocks, bonds or cash. This is due to correlation, or the extent to which the return of two investments move together. If two investments move in the same direction, their correlation is said to be positive, and if they move in opposite directions their correlation is negative. Correlation is communicated on a scale from -1 (perfect negative correlation) to +1 (perfectly positive correlation). Historically, alternative investment classes have had low or even negative correlations to stocks, bonds and cash. By combining standard and alternative assets into a single portfolio, investors can reduce their risk while not sacrificing returns. In short, when allocated appropriately, the use of alternative assets can enhance the positive effects of diversification.
Of course, investing in alternative asset classes has a number of drawbacks. Many of the aforementioned classes have low liquidity (ease at which an asset is convertible to cash) due to their long holding periods. In addition, plan professionals typically charge higher fees for managing alternative classes, often sharing in the profits of the plan. Finally, investments in these classes may be riskier due to a lack of transparency, making plan valuation more difficult.
Sessions at Investments Institute—March 13-15, 2017 at the Arizona Biltmore—will explore many of these asset classes, helping you evaluate your strategies and determining if your fund is headed in the right direction.
Justin Held, CEBS
Senior Research Analyst/Educational Program Specialist at the International Foundation