The term “alternative investments” conjures up images of esoteric investment vehicles that seem riskier than skydiving in a hurricane. Perhaps it’s the word “alternative” that’s the issue since it is sometimes used as a synonym for radical, avant-garde or even revolutionary. But interestingly, perhaps even ironically, alternative investments actually have the capacity to do the opposite of what you might think – that is, they can serve to reduce risk in an investment portfolio.
WHAT IS AN ALTERNATIVE INVESTMENT?
Quite simply, an alternative investment is an investment product other than traditional investments such as equities, bonds or cash. Although this definition of alternatives could include tangible assets like art, antiques, coins or stamps, in the financial context, an alternative investment usually means assets like real estate, commodities, private equity, hedge funds and other financial derivatives. Some of these definitions (like hedge funds that are eloquently explained in Peter Klein’s accompanying article) are complicated, while others, like real estate, are fairly straightforward.
WHY ARE ALTERNATIVE INVESTMENTS PERCEIVED TO BE RISKY?
So why are alternatives seen as risky? I think it’s because, out of context, some alternative investments can, in fact, be quite risky. But as part of a holistic investment portfolio, alternatives can actually reduce risk. While it’s unlikely that most investment professionals would recommend alternatives compose a significant part of a charity’s portfolio, alternatives should be considered precisely because they help charities succeed in what they are trying to do – achieve stable returns with less volatility.
“As part of a holistic investment portfolio, alternatives can actually reduce risk.”
WHY SHOULD ALTERNATIVE INVESTMENTS BE CONSIDERED BY CHARITIES?
Alternative investments actually help charities achieve the three things they value most from their portfolio – limited risk exposure; more stable returns and lower volatility. Equities and bonds are asset classes that are well known to most investors, but it is important to keep in mind that these are only two asset classes, albeit large and important ones. If equity and/or bond markets are volatile, so too will be the portfolio composed of them (at least, a long-only portfolio). Alternative asset classes (such as real estate or commodities) are often not correlated to traditional equities and bonds, and can therefore smooth out the volatility in addition to providing more stable rates of return.
Let’s say I offer a 7% rate of return for the next decade with no volatility to a charity’s Chief Financial Officer (or, for that matter, to a charity’s Board of Directors). My sense is that most charities would eagerly accept the offer, even knowing that they might be able to achieve more in a traditional stock-bond portfolio. Why? Because even though the traditional portfolio might do better in the long run, the road to better returns is likely a rough and bumpy one. CFOs don’t like bumpy roads.
Alternative investments, coupled with a portfolio that includes traditional asset classes, can actually provide a charity with exactly the kind of stable returns they are seeking. In fact, I would suggest that, in many ways, they are actually tailor-made for a charity’s investment portfolio. Of course, as with all investment decisions, the decision to introduce alternative investments into a portfolio should be supported by sound professional advice.