Inflation, rising interest rates, and a potential recession have more investors seeking diversification. One possible answer: alternative investments.
There has been no shortage of market uncertainty in 2023, thanks to rising interest rates, elevated inflation, and the threat of a potential recession on the horizon. Among these factors, Adam Taback, the head of private wealth investments for Wells Fargo Wealth & Investment Management, sees the seismic transition from decades of cheap money to a higher-interest rate environment as the key driver of markets going forward.
“We believe that big change has led to assets being mispriced,” Taback says, noting that Wells Fargo Investment Institute views recent earnings forecasts as too high for the current environment. “The more things are mispriced, the harder it becomes to navigate the market and find opportunities.” As a result, Taback believes 2023 is a perfect time to look closely at your portfolio’s asset allocation and consider repositioning your assets to defend against heightened volatility and uncertainty.
One particular asset class worth considering: alternative investments. “Alternative investments can zig when markets zag,” Taback says. “We think it’s a good time to be a little more defense-oriented, and alternatives can play a large role in that.”
Here, Taback answers common questions about alternatives and offers ideas for how they may benefit an investment portfolio.
What are alternative investments?
Alternatives fall outside the traditional asset classes of stocks, bonds, and cash.
“They are a fourth asset class, and they offer a lot of flexibility,” Taback says. “They have tended to respond differently to market conditions than more traditional investments, and as part of a diversified portfolio, that can be a really good thing.”
Alternative investments allow for different kinds of strategies and structures than conventional investments. For example, alternative investments include investment options such as private equity, private debt, and real estate. Hedge funds, which tend to offer flexibility and aren’t always connected to traditional markets, may be the best-known alternative vehicle. Alternative investments also include publicly traded alternative mutual funds, known as “liquid alts.”
What are the potential risks?
These funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. Some alternatives can be speculative, highly illiquid, and are designed for long-term investment. Alternative investments often have higher expenses than conventional investments, may have higher risk, and may take longer to sell. These investments are not appropriate for all investors.
What can alternatives do for an investor’s portfolio?
One of the biggest potential benefits is diversification. History tells us that diversification tends to help manage investment risk and improve investing outcomes over the long term, and alternatives can help you do that by offering access to private markets and differentiated investment strategies. One example of a differentiated strategy would be the use of both long and short positions — longs gain when an asset appreciates, while shorts profit from declining values — and other strategies. They may also offer higher potential returns and protection against inflation.
“To be truly diversified, we believe you need to go beyond long-only strategies and public markets. This includes looking at investments that provide access to private markets, like private equity, and also investments that allow for both long and short investing.” Taback says. “To us, it’s the best way, over the long haul, to mitigate risk and still capture potential market increases.”
How does an investor access alternatives?
Alternatives are widely available to a wide range of investors (though that wasn’t always the case). That said, certain alternatives can carry higher risk, so be sure to seek professional advice before deciding to pursue an alternative strategy.
“Speak to your advisor about how alternatives can fit as a part of your overall asset allocation,” Taback says, “and see what’s appropriate for you.” Part of that discussion, he says, should be about making sure you know what investments you own, why you own them, and the role they play in your portfolio.
For any new investment — alternative or otherwise — Taback notes that it’s important to ask about, and understand, the liquidity expectations and fee structures, and to plan for cash flow needs.
Where are the opportunities?
Every investor is different, and it’s important to match your portfolio to your time horizon and risk tolerance level. Still, Taback believes that, broadly speaking, the current market environment points to three primary considerations for investors looking at alternative investments:
- “The markets are dislocated,” Taback says, “and selected alternative investments can allow you to buy into areas of the market that are potentially undervalued, at depressed prices,” he explains. “And when things are overpriced, you can tactically allocate for that too.”
- Private equity investors raise capital to buy a stake in companies, while private debt investors raise capital to lend to companies. When it’s hard for companies to get money, as it is now, terms and illiquidity premiums improve, meaning investors may benefit from tying up their capital while diversifying risks within their portfolio. Taback especially likes secondary private equity markets. “I think there are a lot of excellent opportunities out there in secondary investing with attractive valuation resets, as a result of forced selling by investors, especially in sectors like growth and technology,” Taback says.
- Likewise, new private debt funds being launched with fresh capital should be well positioned as access to capital becomes more difficult. “You can get good lending terms and yields,” Taback explains, “which may help lower the risk level and may help ensure that you’ll get a good stream of income.”
What else do I need to know?
Working with your advisor is key. You and you advisor should thoroughly research potential strategies and develop a thorough understanding of their methods, risks, and goals.
It’s also important to manage expectations. For example, Taback says that sophisticated investors have the idea that hedge funds should outperform equities or fixed income, even when markets rally. “That’s not a hedge fund’s role,” he says. “In bull markets, they’re probably not going to keep up. But when markets are down, or through periods of volatility, they have the potential to outperform.”
Wells Fargo Wealth & Investment Management (WIM) is a division within Wells Fargo & Company. WIM provides financial products and services through various bank and brokerage affiliates of Wells Fargo & Company.
Alternative investments, such as hedge funds, funds of hedge funds, managed futures, private capital, real assets and real estate funds, are not appropriate for all investors. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicle. These funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing. An investment in a fund of funds carries additional risks including asset-based fees and expenses at the fund level and indirect fees, expenses and asset-based compensation of investment funds in which these funds invest. An investor should review the private placement memorandum, subscription agreement and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.
Liquid alternative mutual funds (liquid alts) are designed to provide retail investors access to strategies utilized by hedge funds and provide investors an “alternative” way to invest in asset classes or strategies less correlated to traditional assets such as stock, bonds and cash and potentially improve diversification. Relative to broad, long-only traditional asset class mutual funds, liquid alternatives may employ more complex strategies including hedging and leveraging through short selling and derivatives and might invest in assets such as global real estate, commodities, leveraged loans, start-up companies and unlisted securities. Although liquid alternatives may seek to mimic hedge fund strategies, these funds cannot fully duplicate the broad hedge fund industry and differ substantially from hedge funds and other private investments in a number of ways. Because these funds are registered under the Investment Company Act of 1940, they must hold a certain percentage of their assets in liquid securities and are limited in their use of leverage, among other requirements that are not present for hedge funds and other private investments.
Liquid alternative mutual funds are subject to market and investment specific risks and are not appropriate for all investors. They generally have higher costs and employ more aggressive techniques not generally employed by traditional stock and bond mutual funds. There is no guarantee an alternative investment strategy will be successful and not incur loss for the fund. All investing involves risk including the possible loss of principal.