Alternative investments: one way to manage investment risk
Provided by RBC Wealth Management
and Dave Dupont
Looking for a way to manage portfolio risk? Alternative investments may be a good choice.
An alternative investment is loosely defined as an investment in something other than publicly traded, long-only stocks, bonds or cash. Alternative investments are typically used to enhance the risk-adjusted return of a portfolio that can be achieved through diversifying the portfolio across strategies that maintain low correlation to equity and bond markets; depending on a client’s risk profile this could also be achieved through return-enhancing strategies.
The alternative investment world is primarily made up of three buckets: hedge funds, private equity and real assets.
This type of investment shares typical characteristics. Every investment has its own share of risk and alternative investments are no exception. But some of the common risk factors include:
• Higher fees
• Diverse investment structure from registered mutual funds to less regulated structures such as limited partnerships
• Valuation risk — the value of the investment will fluctuate
• Leverage risk — leverage can cut both ways; in a good year it can enhance returns but it can also magnify losses
• Illiquidity risk — getting capital back is driven by the terms of the structure in which you have invested
Because of these characteristics, due diligence is required before buying alternative investments.
Alternative investments as part of a portfolio
During the 2008 stock market plunge, many investors watched the value of their securities decline and their overall portfolio value shrink. A way to hedge against this is through asset diversification.
There are a number of ways investors can diversify a portfolio. Risk can be reduced by owning stocks from different sectors, bonds from different issuers with different credit ratings and maturities, or a variety of both equity and fixed income investments.
Adding alternative investments to a portfolio is another way investors could reduce risk exposure. These investments are known as “non-correlated asset classes” meaning they are less likely to suffer the ups and downs of the stock, bond and cash markets. By losing less value as compared to a volatile benchmark, an investment may recover faster and grow more quickly even if the growth rate is lower.
Another option for investors may be investing in a mutual fund that holds alternative investments. This provides diversification as well as the professional management associated with any mutual fund.
