Thursday, March 20, 2014

Alternative Investments

There is considerable talk these days about “alternative investments.” The portfolios of large universities and pension plans frequently contain a significant percentage of their assets in such investments. What are alternative investments? Are they truly different investments from the traditional stocks, bonds, and cash; or, or they different tactical methods of managing those traditional asset classes? The answer: both!  Some portfolio managers specialize in types of securities that the “average” investor has not utilized (think “derivatives,” “futures,” “commodities,” etc.). Other portfolio managers specialize in using different tactics involving the traditional asset classes (think “long-short,” “quantitative,” “mergers and acquisitions,” etc.). Our purpose here is not to discuss the alternative universe in detail; it is instead to discuss whether such things might now be beneficial in the “average” investor’s portfolio.

Alternative investments/strategies have historically been used by large, sophisticated investors or institutions (pension plans, endowments, etc.) Why haven’t smaller investors been involved? The characteristics of this type of investing usually did not fit the goals/needs of the average investor. Alternative investments historically have been:

  1. Less liquid-thus not allowing easy access to the investor’s money in case the need arose,
  2. Less transparent in value-since many of the investments traded outside traditional markets making the determination of portfolio values more subjective,
  3. More risky-since many of these assets could lose a significant (all) portion of the investment, and,
  4. Long time frame-some investments (private equity) are designed to have life spans of 7-10 years.
Given these factors, why are we discussing such investing? Because some things have changed. Prior to the financial crisis, there were only a few dozen mutual funds that used such investments. Now there are over 400 such funds-funds which basically use hedge fund strategies but are done in a mutual fund wrapper. Such mutual funds are desirable for the smaller investor because they provide the ability to buy/sell small investment amounts on a daily basis. In addition, we face some “interesting times” in the investment markets. Interest rates are at historic lows and investors realize that increasing interest rates are going to result in the loss of bond investment principle. The stock market is at an all-time high—are we due for a significant correction with a resulting loss in stock investments?

Do alternative investments/strategies have a place in individual portfolios? Possibly-it depends on the goals/objectives of the individual. The biggest advantage is to diversify the portfolio. Alternative investments usually don’t provide the same level of return on the upside of the markets, but they also don’t lose as much in down markets. Therefore, using alternative investments can dampen the risk of the portfolio. We at Paragon Financial Advisors have investigated some alternative investment mutual funds and back-tested their use in integrated portfolios. Please call us and let’s discuss whether or not alternative investing has a place in your portfolio. Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

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