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Consider the Alternatives—Beyond Stocks & Bonds

Hedge funds, private equity and real assets could help you manage volatility as you pursue your goals, but they carry some risk. Here’s what you need to know.

YOU’VE HEARD IT BEFORE: Diversification is a key to managing risk. When stocks go down, bonds are likely to rise in value. Owning both can help you minimize losses in a down market. But in today’s volatile market environment, many people are wondering: Is there anything else investors can consider to increase their diversification?

“Some alternative investments are insulated from market ups and downs. Others take advantage of volatility in targeted ways.”

Anshul Sharma, head of alternative investment strategy for the Chief Investment Office for Merrill and Bank of America Private Bank

Well, yes. Though they may not be right for everyone, “alternative investments are strategies that can help complement traditional stock and bond investments,” says Anshul Sharma, head of alternative investment strategy for the Chief Investment Office for Merrill and Bank of America Private Bank. “They take advantage of techniques such as hedging, concentration of assets and leverage in ways that increase diversification while addressing specific goals.”

Alternative investments are particularly useful during volatile markets, notes Sharma, because unlike traditional investments, “some are insulated from the business cycle and market ups and downs. Others take advantage of volatility in targeted ways.”  While all come with risks and costs (including, often, high minimum investments), and they can be less liquid than traditional investments, they are increasingly viewed as a valuable addition to a truly diversified portfolio, with the potential to help enhance both returns and income.

Below, Sharma highlights three alternative investment strategies for qualified investors to consider. “Ask your advisor whether one or more might make sense for you.”

Hedge Funds: A Variety of Approaches

Hedge fund managers engage in a wide variety of trading strategies not generally available to traditional asset managers, says Sharma. Equity long/short funds, for example, position themselves to extract gains from stocks that may perform well over the long term, as well as those that may lose value. Global macro funds are designed to benefit from broad macroeconomic trends, and event-driven funds focus on corporate restructurings and mergers and acquisitions. These are sophisticated strategies, Sharma cautions, and hedge-fund managers may make frequent trades and use leverage, derivatives, short-selling and concentrated positions to achieve their goals. They may also provide less transparency to investors and charge higher fixed fees.

A graphic featuring five sets of two bars each, which show how hedge funds have performed, compared with the S&P 500, in the five largest drawdown periods since January 2011. The first set of bars is for 5/2011 to 9/2011. It shows the S&P 500 dropping by 16%, hedge funds by 9%. The second set of bars is for 4/2012 to 5/2012. It shows the S&P 500 dropping by 7%, hedge funds by 3%. The third set of bars is for 8/2015 to 9/2105. It shows the S&P 500 dropping by 8%, hedge funds by 4%. The fourth set of bars is for 10/2018 to 12/2018. It shows the S&P 500 dropping by 14%, hedge funds by 6%. The fifth set of bars is for 1/2020 to 3/2020. It shows the S&P 500 dropping by 20%, hedge funds by 11%. The data is from Bloomberg, as of May 2020.

Potential benefits for investors: Nevertheless, adding hedge funds to a portfolio may be worth considering, because they can help provide a buffer for market downturns and assist with capital preservation, Sharma notes. Although hedge-fund strategies can also lead to losses, the performance of hedge funds over the past decade suggests how resilient they can be. During each of the 10 biggest market drawdowns since 2011, hedge funds have held up better than stocks. (See how hedge funds performed in the 5 biggest market drawdowns since 2011 above.)

Private Equity: Buying and Selling Companies

Private-equity funds aim to acquire private and some public companies with the ultimate goal of selling them at a substantial profit and returning capital to investors. They invest in companies that might benefit from an infusion of capital and shifts in business strategies and then work with them to change management, reduce costs, refine product lines or enter new markets before the sale. Investors should be aware that in some cases, they may have to wait up to a decade before realizing returns.

Potential benefits for investors: Historically, private equity has outperformed public markets1 and may also help manage portfolio volatility. “Some of the best-performing private-equity funds are the ones that operate during or shortly after recessions,” says Sharma. “This makes sense because dislocations and market volatility can create favorable entry points.”

Real Assets: In a Category All Their Own

Real assets, sometimes also known as tangible assets, have an intrinsic value and usually a physical form. They cover a wide range of investments, from gold and other precious metals and commodities to commercial and residential real estate, infrastructure funds, agricultural land and natural resources. Such assets tend to behave differently than stocks and bonds and even than other alternative investments. Some may be less liquid than traditional investments, and like private equity, can require an investment horizon of more than a decade.

Potential benefits for investors: Real assets’ low correlation with the performance of traditional investments makes them especially suited to increasing diversification, and because they often gain value when consumer prices rise, they may also provide a hedge against inflation. “Many of these assets don’t have much of a relationship to the business cycle, and that’s the point,” says Sharma.

A Mix of Alternatives May Be Appropriate

Alternative investments can be mixed, matched and calibrated to pursue specific goals. For example, with interest rates currently stuck near historic lows, defensive alternative investments might use options strategies to provide a better source of income than bonds. Diversifying alternative strategies, such as a global macro strategy, seek to generate returns that depend less on market direction and may help reduce volatility in portfolios during dislocations. For investors who are willing to accept higher risks and greater exposure to market turbulence, growth-focused alternative investment strategies may use concentrated positions, leverage and other approaches that could potentially generate compelling total returns.

“These three outcomes—defense, diversification and growth—aren’t mutually exclusive,” says Sharma. “They can be used in combination within your portfolio, and the right mix will depend on your goals, risk tolerance, liquidity needs and the time you have to pursue your goals.”

Finding an Allocation That’s Right for You

“Private equity, real estate and other alternatives typically require an investment horizon of more than a decade,” Sharma says. Weighing your need for liquidity and other considerations can help you and your advisor determine what kind of allocation to alternative investments you might consider if you are a qualified investor. In most cases, you’ll want to diversify not only across stocks, bonds and alternative investments, but also within those asset classes, with a broad range of hedge-fund strategies, private-equity holdings and real assets.

Of course, even the addition of alternative investments doesn’t change the need for a disciplined approach to investing that looks past current market conditions.

“Remembering why you’re investing and sticking with an asset allocation aligned with your goals is almost always the best course,” Sharma says.