There isn’t one strict definition of what an alternative investment is, but a key element is that they should provide diversification that is uncorrelated to other core portfolio exposures, such as equities.
Alternatives could encompass a global currency fund, a hedge fund, gold, an emerging markets debt fund, or a range of direct assets – be it property or something more exotic like wine or art. This is a fairly broad range of investment types, but the one thing that ties them together is that they play a differentiated role in portfolio construction.
This doesn’t mean all alternatives are created equal. Simply including an ‘alternative investment’ in a portfolio doesn’t automatically provide useful diversification.
While it is becoming easier for investors to access alternative investments thanks to the increasing choice of managed funds and listed investments, this only makes it more important for investors to fully understand why they are investing in alternatives.
There are three main criteria when assessing whether an alternative is the right fit for an investment strategy, and each must interact and influence success.
Rationale
Investors must have a logical basis for the investment.
There must be an easily understood reason as to why a particular correlation between two assets exists.
If it doesn’t make fundamental sense, then the identified relationship between the two assets is more likely to be a coincidence. In this instance the relationship is far more unlikely to persist over time, and at some point will probably end in tears.
For example, it’s possible to show a substantial correlation between US crude oil imports from Norway and the number of drivers killed in a collision with trains, but it is unlikely in the extreme that there is any effective link between these two statistics. As Mark Twain said, ‘there are lies, damn lies and statistics’!
However, a statistic that shows a correlation between the growth in the number of Chinese people getting passports and the expansion in the number and size of airports globally does make sense, and suggests that investing in companies providing airport infrastructure could be worthwhile.
Performance
The focus of alternative investments shouldn’t be the best absolute return but rather better risk-adjusted returns.
It’s important to remember that the investment isn’t happening in isolation, but rather is part of an overall portfolio. Therefore how it correlates and interacts with other assets is paramount.
Diversification is a key aspect of structuring a robust investment portfolio, but it’s more than a numbers game. Adding more investments that perform or correlate highly with an existing asset isn’t adding true diversification – it’s not improving the portfolio’s risk/return outcome.
It’s important to stay the course in order to achieve long-term performance and the overriding investment objective.
If an alternative asset is chosen to achieve a lower level of portfolio volatility when equity markets fall, don’t be disappointed when the ‘normal’ market outperforms. The aim wasn’t necessarily to improve performance every month.
Context
That leads to a key question: what is the desired outcome from adding alternatives to a portfolio? Is it to provide downside protection, to offer a more consistent provision of income, or to counter negative equity markets?
There’s no value – and potentially significant risk – in investing in alternatives without being clear on what the aim is.
It’s important to be clear on the objective for using an alternative investment and to use this as an anchor point. This will help an investor work through shorter-term ups and downs and be better armed to stay the course and achieve their longer-term investment objectives.
Stuart Fechner, account director of research relationships at Bennelong Funds Management
