Why Alternatives: The Investment Rationale

 

Two variables are paramount in the world of investing: risk and return. Minimizing risk while maximizing return is the central pursuit of portfolio management. To generate more return, however, one generally must take on more risk (defined as volatility of returns).

 

There are, however, two well-known workarounds to this fundamental tradeoff: one is diversification, and the other is generating alpha. This is where alternative investments really shine, offering more diversification and more alpha potential than what’s available from just stocks and bonds. In short, alternatives provide investors with the opportunity for higher returns with lower volatility. This simple statement has profound implications for the long-term compounding of portfolio value.

 

There are tangible, structural drivers of enhanced diversification and excess returns (alpha) within alternatives that collectively lead to a reliable improvement in portfolio results over time.

 

The key implication of those structural advantages is that by simply participating, investors should expect to realize the benefits of investing in alternatives. This does not diminish the importance of thorough due diligence on the asset managers we ultimately select, but it does instill a higher level of conviction in the broader decision to participate in alternatives in the first place.

 

Diversification is achieved through owning assets whose returns are uncorrelated, and the result is lower portfolio volatility.

 

While stock and bond returns are, indeed, uncorrelated over meaningful time horizons, that traditional portfolio is limited to long positions (buying and holding) in these two types of financial assets – there are no other means for further diversification.

 

Alternative investments include differentiated assets (natural resources, real estate, options, futures, etc.) and introduce the ability to hedge market risk through short selling and/or the use of derivatives. Most asset managers within alternatives specialize in a certain asset type and specific investment strategy. A diversified portfolio of alternatives will include many of these distinct and uncorrelated sources of return.

 

Alpha is generated when highly skilled asset managers identify and exploit inefficiencies that arise within capital markets. Alpha refers to investment returns greater than what you would expect to earn, given the amount of risk taken to earn them, and must be measured relative to benchmark returns using statistical techniques. Alpha is easier to come by within alternatives because of an abundance of investment skill and extreme market inefficiency.

 

Many of the drawbacks that are often cited as reasons not to invest in alternatives, such as high fees and illiquidity, can also be understood as structural drivers of long-term returns. High fees often provide access to top investment talent with expertise in private asset classes. A lack of liquidity means (among other things) that assets aren’t priced daily on public exchanges, and can thus be bought for less than they are worth by discerning investors. Investors’ restricted ability to withdraw funds from private investment vehicles also means that asset managers can hold investments for long periods without pressure to sell until the greatest amount of upside is captured.

 

Private markets are broader and deeper than public markets.

 

Bolstering both the diversification potential of a portfolio as well as the opportunity for excess return is another striking structural advantage within alternative investments. Today, private companies represent the majority of investible businesses around the world. The number of publicly traded companies in the U.S. and abroad has been trending downward over time. This trend is not limited to just the very smallest companies. As of 2023, only about 14% of businesses globally with revenues above $250 million were publicly traded companies¹, meaning most businesses, even excluding small businesses, are private companies.

 

The opportunity for risk-adjusted outperformance through exposure to alternatives is significant but complex. This article is intended to be a starting point. There are nuances to alternative assets not explored in this article that should be considered and discussed before investing. 1834 is here to help determine whether an investment in alternatives is right for you.

 

¹ Blackstone; Capital IQ, August 2023.