Consider the Alternatives (Part 1)

What are alternative investments?

Duck-billed platypus, an egg-laying mammal. Photo: Klaus. Source: Wikipedia

Alternative investments are assets that don’t fit into the normal asset-class categories of stocks, bonds, or cash. They include private equity, hedge funds, managed futures, collectables, commodities, and so on. They’re related to the standard asset types, but they have a slightly different twist. So physical gold is an alternative investment, while gold mining company stocks are not. Real estate is an alternative investment; Real estate investment trusts that trade on an exchange are not.

Alternatives are hard to value and are less liquid than conventional assets. It’s a lot more work to buy or sell an apartment building or a 200-year old bottle of wine than it is to move 1000 shares of Apple stock. There aren’t as many buyers and sellers, each asset is distinctive, and there are high transaction costs. But because they’re so unique, their prices aren’t so closely correlated with stock and bond markets. As a result, many institutional investors have begun to use them as tools to diversify their holdings.

Stock Market, Gold, and Fine Wine Indices. Source: Bloomberg

But the goals of institutional investors—like endowments or large retirement plans—aren’t the same as individuals. These investors want to maximize their returns, like everyone else, but they also have ongoing liquidity needs. They need to pay cash to current pension beneficiaries, or fund current operations, at the same time that they try to maximize growth. Individuals who are saving for retirement 20 years out can “set it and forget it.” It doesn’t matter to them if the market zigs and zags along the way. As long the market is there for them at the end, they’re in good shape.

If an institution with current cash flow needs has to sell something to fund their commitments, though, they risk turning temporary fluctuations into permanent losses. They don’t just need to maximize their returns—they need to do this with as little variability as possible. The destination matters, but how rough the road is along the way matters almost as much. Because a big pothole could make the transmission drop out.

There’s no magic to the markets. Assets grow in value because they participate in the economy—and represent different claims on the economy’s cash flow. There are really only three types of economic assets: stocks, bonds, and real estate. Bonds are a senior claim on cash flow; stocks are a junior claim; real estate comes in between. Alternatives are some form of derivative—either a different way to manage the assets, like hedge funds, or a way to capitalize on household wealth, like old master paintings or antique cars. But everything still depends on how much wealth the economy is producing.

Alternative assets are a way for managers to try to reduce the volatility of their portfolios. Investors should be aware of them, but should also be very careful how they use them. Anything with limited liquidity and not-very-transparent prices that suddenly becomes trendy is likely to be abused. And as bees are drawn to honey, crooks are drawn to money.

Douglas R. Tengdin, CFA

Chief Investment Officer

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