Alternative Investments: When To Diversify Your Portfolio

Alternative investments are a crucial component of portfolio diversification, offering investors access to unique opportunities beyond traditional stocks, bonds, and cash. These investments, including private equity, hedge funds, real estate, and commodities, provide a differentiated source of returns and serve as an effective inflation hedge. While they carry higher risks and fees, alternative investments can enhance long-term returns and reduce overall portfolio risk when incorporated strategically. This decision depends on various factors such as an investor's wealth, spending needs, risk tolerance, and time horizon.

Private equity

When deciding whether to include private equity in your portfolio, it is important to consider your overall wealth, spending needs, risk tolerance, and time horizon. Private equity investments are generally considered long-term investments, and they are less liquid than traditional investments. Therefore, it is often recommended to start with a smaller allocation and gradually increase your investment over time.

In summary, private equity can be a valuable component of a well-diversified portfolio, but it is important to carefully consider your investment goals and risk tolerance before including it in your portfolio.

Hedge funds

When investing in hedge funds, strategy and manager selection are crucial due to the significant differences in fund performance. Hedge funds are considered high-risk investments and are not suitable for all investors. They often engage in speculative practices, are highly illiquid, may employ complex tax structures, and charge high fees.

For investors new to alternative investments, it is generally recommended to start with a smaller allocation and gradually increase exposure over a period of three to five years. This helps to diversify sources of return and manage the risk associated with the less liquid alternative investments market.

Real assets

Real estate, in particular, is an interesting category because it combines characteristics of both bonds and equity. Like bonds, real estate owners receive current cash flow from tenants in the form of rent. At the same time, real estate investments aim to increase the long-term value of the property, a characteristic more akin to equity investments.

Other types of real assets include commodities, which are mostly natural resources such as agricultural products, oil, natural gas, and precious and industrial metals. Commodities are also considered a hedge against inflation as their value tends to rise and fall with supply and demand.

Infrastructure is another type of real asset that provides diversification and inflation mitigation while contributing to overall returns.

When considering including real assets in your portfolio, it is important to keep in mind that these investments are generally less liquid than traditional investments and may be more suitable for investors with a longer time horizon. Additionally, the valuation of real assets, particularly real estate, can be challenging and requires strong valuation skills to be successful.

Private credit

When considering private credit as an alternative investment, it is important to keep in mind that these funds are generally more complex and less frequently traded than public stocks and bonds. They are also more lightly regulated by the U.S. Securities and Exchange Commission (SEC) and are considered high-risk investments. As such, private credit funds are more suitable for sophisticated investors with a strong governance program in place.

In terms of portfolio allocation, it is recommended that investors who are new to alternative investments start with a relatively smaller allocation and gradually increase their exposure over a period of three to five years. This helps to diversify sources of return and manage liquidity risk. For private markets as a whole, it is typical to devote between 15% and 30% of investable funds to alternatives and other long-term illiquid assets.

Overall, private credit can be a valuable addition to an investment portfolio, particularly for investors seeking to boost their income and diversify their sources of return. However, due to the high-risk and complex nature of private credit funds, it is important for investors to conduct thorough due diligence and ensure they have the necessary expertise and resources to build a successful alternative investment program.

Inflation hedge

Alternative investments can be used to hedge against inflation. Real assets such as commodities, farmland, timber, energy, and infrastructure assets are generally perceived to provide a hedge against inflation. Commodities, in particular, are considered a hedge against inflation as they are not sensitive to public equity markets. The value of commodities rises and falls with supply and demand, and higher demand for commodities results in higher prices and investor profit. Timber investments provide both growth and inflation-hedging properties.

Real estate strategies are also believed to provide protection against unanticipated increases in inflation. Core real estate strategies are more income-oriented, while opportunistic strategies rely more heavily on capital appreciation.

Private credit strategies, such as direct lending and asset-based lending, can also help hedge against rising rates due to the floating-rate nature of most direct loans.

In addition, certain commodity investments serve as safe havens in times of crisis.

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