An Introduction to Alternative Asset Classes Richard D. Landsberg, JD, LLM, MA, CLU, CPM, ChFC, RFC, AIF Director Advanced Consulting Nationwide Financial Abstract Alternative investments, which have been used by large institutions and endowments for quite some time, have become more main stream in recent years. Not only are they more popular among individual investors, but there are also more products available, making investing in alternatives possible for a much broader universe of investors. This is understandable: The power of alternative investments to reduce risk and enhance returns in traditional portfolios has long been recognized by institutional investors. A modest allocation to alternatives may be prudent for more investors than previously was thought. This paper will define alternatives and discuss the unique attributes and benefits of alternatives as an asset class. It will also explore the key considerations associated with implementing alternatives in client portfolios. What are alternative asset classes? Beyond the three primary asset classes--stocks, bonds, and cash-- many other types of investments can be used to diversify investment portfolios. The term "alternative assets" is highly flexible. It may include specific physical assets, such as natural resources or real estate, or methods of investing, such as hedge funds or private equity. In some cases, even geographic regions, such as emerging global markets, are considered alternative assets. Alternative investments utilize a different approach to investing than do traditional equity or fixed income investments. This approach may involve holding both long and short positions in securities and holding private securities instead of publicly traded investments, and there may be derivatives or hedging strategies as well. Investors using alternatives may also have a goal of achieving a particular level of absolute return as opposed to relative performance versus an index. Why should advisors and investors consider alternative asset classes? Alternative investments have the potential to enhance the risk and/or return characteristics of an investment portfolio. Given their low correlation to traditional investments, they may potentially 1
enhance diversification and reduce risk; with their ability to be more flexible and invest in a wider opportunity set, they may potentially enhance return; and they can be used to hedge certain portfolio exposures, thereby reducing concentration risk. The successful implementation of an alternative investment strategy relies largely on investment manager experience and skill due to the broad range of investment opportunities. This is in contrast to managers specializing in specific asset classes such as commodities, real estate, emerging markets equity and high-yield fixed income. These non-traditional, or satellite, asset classes provide portfolio diversification due to low correlation with traditional asset classes, but like traditional investments, performance is primarily driven by asset class exposure as well as manager skill. Many alternative investments attempt to achieve their returns not from the activity of the market but by using unique investing strategies to exploit market inefficiencies that the markets haven't perceived. As a result, alternative assets can provide an additional layer of diversification and complement more traditional asset classes. However, diversification alone cannot guarantee a profit or ensure against a loss. While alternative assets offer potential for returns that aren't highly correlated with other markets, their unique properties also mean that they can involve a high degree of risk. Grouping Alternative Investments A Summary Hedge funds Hedge funds are private investment vehicles that manage money for institutions and wealthy individuals. They generally are organized as limited partnerships, with the fund managers as general partners and the investors as limited partners. The general partner may receive a percentage of the assets, additional fees based on performance, or both. Hedge funds originally derived their name from their ability to hedge against a market downturn by selling short. Though they may invest in stocks and bonds, hedge funds are typically considered an alternative asset class because of their ability to implement complex investing strategies that involve many other asset classes and investments. Private equity Like stock shares, private equity represents an ownership interest in a company. However, unlike stocks, private equity investments are not listed or traded on a public market or exchange, and private equity firms often are more directly involved with management of the business than the average shareholder. Private equity often requires a long-term focus before investments begin to produce any meaningful cash flow--if indeed they ever do. Private equity also typically 2
requires a relatively large investment and is available only to qualified investors such as pension funds, institutional investors and wealthy individuals. Private equity can take many forms. Angel investors are individual investors who provide capital to startup companies and may have a personal stake in the venture, providing business expertise, industry experience and contacts as well as capital. Venture capital funds invest in companies that are in the early to mid-growth stages of their development and may not yet have a meaningful cash flow. In exchange, the venture capital fund receives a stake in the company. Mezzanine financing occurs when private investors agree to lend money to an established company in exchange for a stake in the company if the debt is not completely repaid on time. It is often used to finance expansion or acquisitions and is typically subordinated to other debt. As a result, from an investor's standpoint, mezzanine financing can be rewarding because the interest paid on the loan can be high. Buyouts occur when private investors--often part of a private equity fund-- purchase all or part of a public company and take it private, believing that either the company is undervalued or that they can improve the company's profitability and sell it later at a higher price. In some cases, the private investors are the company's executives, and the buyout is known as a management buyout ( MBO ). A leveraged buyout ( LBO ) is financed not only with investor capital but with bonds issued by the private equity group to pay for purchase of the outstanding stock. Real estate You may make either direct or indirect investments in buildings--either commercial or residential- -and/or land. Direct investment involves the purchase, improvement, and/or rental of property; indirect investments are made through an entity that invests in property, such as a real estate investment trust ( REIT ). Real estate has a relatively low correlation with the behavior of the stock market and is often viewed as a hedge against inflation. Natural resources Most investments in natural resources such as timber, oil or natural gas are done through limited partnerships. In some cases, such as timber, the resource replenishes itself; in other cases, such as oil or natural gas, the resource may be depleted over time. Timberland produces income from the trees harvested, but may also grow in value and be converted for use as a real estate development. Art, antiques, gems and collectibles Some investors are drawn to investment-grade collectibles because they may retain their value or even appreciate as inflation rises. If you are a knowledgeable collector or have expert advice, they may generate high returns. However, their value can be unpredictable and can be affected by supply and demand, economic conditions, and the condition of an individual piece or collection. 3
Gold and precious metals Investors have traditionally purchased precious metals such as gold, silver, platinum, and palladium because they believe that precious metals provide security in times of economic and social upheaval. Gold, for instance, has historically been seen as an alternative to paper currency and therefore a hedge against inflation and currency fluctuations. If paper currency becomes worth less and less because of inflation, investors perceive that gold will retain its value. As a result, gold prices often rise when investors are worried that the dollar is losing value. However, the price of gold is volatile; its value may rise and then fall quickly. In recent years, the price of gold has been particularly difficult to predict and has shown little correlation with inflation. There are many ways to invest in precious metals. In addition to buying bullion or coins, you can also invest in futures, shares in mining companies, sector funds, and exchangetraded funds. Commodities and financial futures Commodities are physical substances that are fundamental to the creation of other products or to commerce generally. Unlike most other products that are bought and sold, a commodity is basically indistinguishable from any other commodity of the same type. Examples of commodities include oil and natural gas; agricultural products such as corn, wheat, and soybeans; livestock such as cattle and hogs; and metals such as copper, nickel and zinc. Commodities are typically traded through futures contracts. Futures are contractual agreements that promise future delivery of something upon a certain date, at a specified price. For example, a commodities futures contract might involve wheat, corn, oil or natural gas, among others. Futures contracts also are available for financial instruments, such as a stock index or a currency. Futures contracts are standardized and are traded on organized exchanges. Although the futures market was originally created to facilitate trading among individuals and companies who produce, own, or use commodities in their businesses, the market has expanded to include individuals and companies that buy and sell futures contracts as a way of investing. Like options, futures are considered derivatives because their value is based on some other security. Futures allow an investor to leverage a relatively small amount of capital. However, they can be highly speculative and are not suitable for all investors. Risks of Alternative Investments There are several risks associated with alternative investments above and beyond the typical risks associated with traditional investments. Higher fees. Alternative investments can have higher fees. For example, fees can include an annual management fee (1 2%) and an additional incentive fee (10 20%). Fund of funds may 4
also charge yet another management fee. While higher than traditional investments, these fees may or may not be justified when comparing returns net of fees. More complicated. Alternative managers may invest in a wide variety of investments, including derivatives, and utilize short selling. Understanding complicated investment strategies requires more upfront and ongoing due diligence. Additionally, an investor may not have access to a given investment unless they meet suitability requirements for investing, including income level and minimum investment. Less transparent. There can be limited transparency into the underlying holdings of these investments. Additionally, many manager evaluation tools are not as well suited for alternative investments, making a manager s investment ability more difficult to assess. Also, some alternative investments are largely unregulated. Finally, accurately assessing values and risks may be difficult. The performance of an alternative asset can be challenging to research, price, and understand. Less liquid. Alternative assets often are less liquid than stock or bonds. Depending on the alternative asset, you may or may not be able to find a willing buyer when you're ready to sell. Also, some hedge funds may require investors to stay invested for a certain period of time. Less tax-friendly. Most alternative investment strategies have little to no focus on minimizing taxes. Also, those whose legal structure is a partnership issue a K-1 statement rather than a 1099. May disappoint in strong up markets. Investments that seek to generate an absolute return often use short selling strategies, and as such tend to lag long only strategies in strong up markets, which may discourage some investors. May not diversify risk in extreme down markets. In periods of dislocation, the correlations of many types of investments, including alternatives, may increase significantly, as was the case in the extreme down market of 2008. Credit risk. For some structured products, notes in particular, principal protection guarantees are limited to the credit worthiness of the issuer. Often clients and their financial advisors come to the conclusion that the benefits of alternatives warrant the added risk. Greater investing freedom can increase potential for mismanagement or loss from sector exposure. Because they are subject to less regulation than many other investments, there are fewer constraints to prevent potential manipulation or to limit risk from highly concentrated positions in a single investment. Also, hard assets such as bullion, antiques, art or gems are subject to physical risk and may involve special considerations such as storage and insurance, while timberland may be subject to natural disasters. 5
Incorporating Alternatives into Portfolios Alternative investments lack of correlation with other types of investments may help increase or stabilize portfolio return. Part of sound portfolio management is diversifying investments so that if one type of investment is performing poorly, another may be doing well. Both institutional and individual investors have increasingly begun to explore alternative assets in recent years as a way of trying to increase returns and/or diversify risk. In a global economy, traditional asset classes such as stock and bonds are increasingly linked. However, in many cases, an alternative asset's performance is often highly dependent on the qualities of the individual investment, as opposed to being highly correlated to an overall market. In other cases, such as precious metals, the asset class as a whole may behave differently from stocks and bonds. There are two main considerations to keep in mind when incorporating alternatives into an investment strategy. Conservative approach. By definition, alternative investments use a nontraditional approach to investing. Additionally, performance is largely dependent on manager skill, unlike traditional investments, in which much of the performance is driven by asset class exposure. Therefore, it is prudent to take a conservative approach, opting for those strategies with a proven track record and stable investment team and process. With new products being offered regularly in this fastgrowing space, it is wise to exercise caution, having a bias toward offerings with demonstrated success, as opposed to paper portfolios or back-tested track records. Appropriate allocation. Generally allocating 10 20% of a portfolio to alternative investments is most appropriate, although the allocation can be higher in unique situations. This is a large enough allocation to be impactful in terms of enhancing returns or helping to reduce risk, without being so large that it dominates the overall portfolio. Typically alternatives can be funded proportionately from the equity and fixed income portions of an investment portfolio. For example, in a portfolio consisting of 60% equity and 40% fixed income, to add a 20% allocation to alternative investments, 12% could come from traditional equity (includes satellite asset classes) and 8% from traditional fixed income. Conclusion The foregoing has shown there are many different types of alternative investments. One commonality among them is that they provide a unique return stream when compared to traditional portfolios. Alternatives hold tremendous potential for investors. Although there is a potential for risk or loss of principal, when implemented correctly, alternatives offer expanded opportunities for diversification, reduced risk and increased return. Consequently, an increasing number of 6
advisers and their clients will want to benefit from the power of alternative investments going forward. Federal income tax laws are complex and subject to change. The information in this brochure is based on current interpretations of the law and is not guaranteed. Neither the company nor its agents/representatives gives legal or tax advice. You should consult your attorney or tax adviser for answers to your specific tax questions. The use of asset allocation does not guarantee returns or insulate you from potential losses. Diversification does not assure a profit and does not guarantee against loss in a declining market. The opinions expressed are being provided for informational purposes only and are not intended to provide specific advice or recommendations for any individual. For specific guidance on how to apply this information to your particular circumstances, you should contact your insurance, legal, tax or financial professional. Nationwide and the Nationwide framemark are registered service marks of Nationwide Mutual Insurance Company. Nationwide Financial Services, Inc. All rights reserved. Nationwide Investment Services Corporation, Columbus, Ohio, member FINRA. NFM-11576AO (03/13) 7