For decades, alternative investments were not readily available to the average investor. Instead, they were reserved for institutional investors and high net-worth individuals — mainly due to complexity and lack of regulation.
But now, soaring inflation concerns and rising market volatility are driving the popularity of alternative investments as a recommended wealth-building strategy. A variety of alternatives, including real estate (particularly multifamily), have often performed well under challenging market conditions, just as they are now. Let’s look at the history, characteristics, and importance of alternative investments in managing exposure and stabilizing returns.
History of Alternative Investments
In the ’50s and ‘60s, Modern Portfolio Theory established the mechanics and benefits of diversification. This framework highlighted risk as a function of a portfolio, formalizing the idea that exposure can be reduced by holding a wide range of investments.
President Eisenhower signed legislation in 1960 that blended the features of real estate and stock-based investing to establish a new means of generating income.
Following the 1974 stock market crash, the Employee Retirement Income Security Act (ERISA) allowed pension funds to adopt riskier asset allocation strategies, which further paved the way for alternative investments.
Since the 2008 crisis, markets have been increasingly moving in tandem. According to a recent study by Wells Fargo, large-cap stocks (U.S. and non-U.S.) are highly correlated. Traditional asset allocation strategies began to underperform and present higher overall risk exposure. Consequently, global investors steadily sought out non-correlated, attractive, customized investment products.
Alternatives are now an essential component of investment portfolios. Global alternatives under management have risen from $7.9 trillion in 2013 to over $10 trillion in 2020. The volume is expected to reach $14 trillion by 2023.
Alternative Investments: Characteristics and Methods
Alternative investments tend to have a low correlation with traditional asset classes. The correlation value between two investments is, in theory, mostly determined by their sources of returns. In the real estate market, for instance, performance is virtually independent of the equity market.
Alternative and traditional investments have differing return characteristics. And unlike traditional investments, alternative assets typically lack a well-established history of analysis. Thus, the methods for analyzing traditional investments are often not appropriate for alternatives.
Risks Involved in Alternative Investments
Risk in alternative investments can manifest in various ways and is mostly determined by the type of underlying asset. To illustrate, “concentration risk” exists when all assets are invested in the same sector, geographic location, or kind of investment instrument.
Illiquidity — or the inability to sell an asset at a specified time and at a fair market price — is also one of the main concerns in alternative investments. Similarly, alternatives are frequently constrained by a lack of market data and history. Evaluating the asset’s performance before making an investment decision can therefore be challenging.
Alternative Investment Allocation Today
Alternative investments provide an additional layer of diversification and are virtually unaffected by market turbulence, making them powerful risk management instruments. These financial assets are slowly becoming an irreplaceable tool for institutional investors.
Nowadays, institutional investors allocate between 10% and 20% of their portfolios to alternatives. Furthermore, a recent report from Price Waterhouse Coopers indicates that even sovereign and public pension funds are shifting to alternative investing.
The Future of Alternative Investments
Considering the rapid growth of alternative investments over the past decade, their weighting in portfolios is likely to grow in the coming years. Already, according to a survey conducted by Prequin in 2018, 84% of investors plan to increase their capital commitments to alternative assets over the next five years. And this trend will likely continue well into the future.
In the aftermath of Covid-19’s significant impact on the investment landscape, alternative asset classes have been gaining even greater traction as a tool to diversify portfolios and hedge against inflation while offering attractive return profiles.
Given the current environment, it is crucial to adapt and develop financial products and strategies to align with clients’ objectives and risk tolerance. In an era of heightened market movements, long periods of high inflation, and low yields, alternative investments can provide an excellent hedge against risk and a stable source of returns.
An Alternative to the Alternatives
Of all the alternative asset classes that fall under the broad heading of “Alternative,” one asset class stands alone. A life settlement is the only investment where its yield payment to the investor is driven by the execution of a contract triggered only by the mortality of an individual policyholder. All the other offerings in the marketplace will ultimately derive their value from the market price action that can be affected by more than one variable.
As a pure buy-and-hold risk hedging instrument, only life settlements have a differentiated mechanism for creating yield for investors that will remain unaffected by markets, geopolitics, mass events, and virtually any other risk that comes down the pike.