Whiteboard Video Series: Alternatives 101
Watch this short 5-minute educational video for a brief overview on alternative investments.
As part of our ongoing University of Alts content library, today we're going to cover an introduction to alternative investments.
So, before we do that let's take a quick step back and think about the landscape of investments. As an investor, essentially every investment you ever make will be comprised of one of these followings things, or perhaps a combination, and that would be equity, debt, or currency. So, in the world of company investing, think stocks, bonds, and cash. In real estate, think real estate equity, real estate debt – you could be the lender on a property – or cash reserves once again.
In the world of alternatives, we like to really bifurcate the world in two different sections. You have alternative investments on, let's say, an x-axis here. But along a y-axis, to make a quadrant, we have alternative strategies. And the further towards the bottom of the y-axis we go, the more dynamic the strategy. The further to the right we go on the alternative investment scale, the more alternative to your traditional stock, bond, and cash we get from an investment.
So, for example, let's just handle this upper right-hand quadrant first. So, with the upper right-hand quadrant, what we like to think about this bucket is rather than just a common equity and a tradeable security that you may find in the left-hand quadrant, you find private equity, you find real estate, perhaps commodities. So, in this case, these are long-only investments in which an investor buys with the intent to hold for sale at some point in the future.
As you move down the y-axis and into alternative strategies, suddenly you're able to take some of these instruments that's in the upper left-hand corner – equity, debt, and currency – and manage them in a unique way to create a unique return stream; for instance, long/short equity, market-neutral. These strategies take common securities such as stocks, but manage them in a way that creates a return stream unique to holding those same securities in a long-only fashion.
Finally on this quadrant, we have alternative investments that are managed with an alternative strategy in mind. Popular investments here include managed futures. They're using derivatives, where maybe the root market is a commodities market, but they're doing it in a way that is inconsistent with just owning the investment long. What that allows is, once again, the potential for a unique return stream.
When looking at the reasons why an investor may invest in alternative investments, this includes return, risk control, or perhaps overall diversification to a portfolio. When thinking about this in the context of the quadrants that we just discussed, perhaps private equity, long-only real estate would be return drivers. Maybe an investor would invest there because they feel the prospects for returns are greater than that of the broad public markets. Whereas a long/short equity investment is clearly made to reduce risk, while managed futures are made with the purpose of increasing diversification.
Many investors make this decision based on their forward-looking assumptions of the markets. So, for instance, if you feel that fixed income or debt investments could face a challenging time because of rising interest rates, you may want to consider using alternatives in your portfolio to control risk levels without subjecting the portfolio to unwanted duration risk.
Oftentimes, the world of alternative investments may seem confusing at first to new investors. But if you remember that all investments are comprised of some component of equity, some component of debt, and some component of currency and it's how those investments are put together and perhaps the structure of those investments that determine whether they're "alternative" or not will make the process of analyzing a particular investment easier.