What’s the Alternative?

As an investor, I remain cautiously optimistic about the long-term prospects for stocks, though in the next few years we could see moderate overall returns and patches of high volatility. 

December, 2021

What’s the Alternative?
As an investor, I remain cautiously optimistic about the long-term prospects for stocks, though in the next few years we could see moderate overall returns and patches of high volatility.  At the same time, bond investments are likely to face pressure as interest rates begin to rise.  I’ll say more about these macro issues in my upcoming year-end review letter.  But it is quite possible that the “easy money” has been made in stocks and we will have to work harder to find decent returns in the next few years.  What is an investor to do? 

They say that the primary drivers of long-term account performance are investor behavior and asset allocation.  Behavior can be impacted by many things (what Keynes called “animal spirits”).  Asset allocation should involve careful decision making about how much of a portfolio is invested in stocks, bonds, cash, etc.  In the years ahead, there is growing evidence that individual investors are likely to benefit by adding another category called alternative investments to their overall allocation pie. 

Introducing Alternative Investments
Alternative investments have been used for years in university endowments and pension funds.  More recently, access to these investments has been democratized to where they are becoming more available to individual investors.  Not many individual investors have had a lot of experience dealing with this space and it is now time to learn more about these important categories of investment.

There are several different subcategories of alternative investments, but in essence each seeks to provide growth and/or income with low correlation to stocks and bonds.  In other words, investors using alternatives are seeking performance from allocations that might do well regardless of what happens to traditional assets classes.  Of course everything in the economy is eventually interrelated, so it might be impossible to find investments that have zero correlation to one another.  Nevertheless, assets with low correlation do exist and it’s time to start working them into portfolios.

Liquidity
Liquidity is one of the more important concepts to understand about alternative investments.  In this context, liquidity refers to how readily an investment can be turned into cash.  For example, stocks have relatively high liquidity because they can be sold quickly at low cost.  There is a vast, active, and highly liquid market for stocks in which millions of trades happen throughout the day.

Other assets are less liquid.  Take houses for example.  The market for house sales involves appraisers and lenders and inspections and the stressy closing date.  It’s a slower more cumbersome process, which means it is less liquid.  And while there are companies looking to automate this process, it is nowhere near as frictionless or liquid as the market for stocks.

Liquidity (or illiquidity) of an asset can be a good or bad thing, depending upon circumstances.  There can be times when low liquidity is a problem.  For example, when the residential real estate market turned bad in 2007 -2008, many people struggled to sell their homes and during the ensuing months, their house values often declined greatly. 

But there are other times when illiquidity is a good thing.  Some people (like yours truly) think it is far too easy for investors to make trades in the stock market.  Short-term price swings can cause investors to sometimes overreact and sell stocks that they maybe should have held.  There have been many investments that have gone through a tough month or year only to later go on to decades of dramatic growth.  Oftentimes it’s better if you don’t, or can’t, sell. 

From the perspective of diversification and portfolio design, high versus low liquidity can lead to both opportunities and challenges.  This is a good segue into another key point to understand about alternative investments: correlation of investments.

Correlation 
For those of you who studied words more than numbers in school, let’s do a quick review of the concept of correlation.  Basically, correlation is a mutual relationship between two things (variables that are co-related).  Close cousin causation is when the action of one thing causes an impact on another.  Correlation doesn’t require causation, but causation always implies correlation.  Two variables can be positively correlated, meaning that when one goes up, the other also tends to rise.  Variables can also be negatively correlated (one goes up, the other goes down).  The numerical measure of perfectly positive correlation is 1, and perfectly negative correlation is -1.  When things have a correlation factor of zero, they are said to be mutually exclusive of one another.

It can be fun to come up with examples of things with positive or negative correlations, and when they are mutually exclusive.  But don’t get too lost in these definitions.  For our purposes, just understand that the concept of correlation, the interrelationships that different investments have to one another, is important in designing investment portfolios.

Asset Allocation
When constructing a portfolio, investors seek returns while trying to mitigate risk.  I like taking a top-down approach to this.  First, determine how much risk someone wants to take on, then allocate across major asset classes in a way that fits with their desired level of risk.  In each category and subcategory of these allocations, factors like potential for growth and income are important considerations.  Also, as discussed above, the way the different pieces interact with one another, their correlation, is important.  In order to manage risk, if investments are too highly correlated with one another, then they could all go down at the same time = bad.  In good times, high correlation can go unnoticed because everything’s growing, so what’s the problem?  This may be where many portfolios are today: if asset classes are too highly correlated, investors may have more risk than they realize or understand.

Liquid vs. Nontraded
Alternative investments can often be purchased through traditional means such as mutual funds and ETFs.  These are sometimes referred to as “liquid alts.”  Also, many alternatives can be bought in less liquid formats often called “nontraded” investments.  These don’t trade on an exchange like the NYSE and the investor usually commits to a holding period of at least one, three, seven years, even more.  Illiquidity can be unnerving to new investors in the space.  But it is really not that big a deal if you think about how long you hold other more liquid investments.  If you hold a stock or index fund for several years, it’s liquidity never mattered to you, it’s just that you could have sold it if you wanted to.

With both liquid and nontraded access to alternative asset classes, why would an investor choose the less liquid version?  A central advantage to nontraded investments is that lower liquidity can reinforce the low correlation to traditional asset classes.  If an investment is sequestered from the major exchanges, then it has a chance to rise or fall on its own merits and not due to the mass greed and fear (the “animal spirits”) of the overall markets. 

There are several subcategories of alternative investments.  And there are liquid and non-traded/illiquid versions of each.  Several different strategies could be combined to play a role in a portfolio.  Here are high-level descriptions of several of the most important alternatives.

• REITs.  Real estate investment trusts are a way for investors to allocate to a diversified portfolio of real estate assets.  REITs can have high potential income and also a low correlation with stocks.  They come in many different types, such as broadly diversified or narrowly sector focused.  REITs often invest in an array of assets such as malls, hotels, residential developments, stadiums, hospitals, and warehouses.  A sector REIT might focus on just one of these.  Geographic diversification is also important.  REIT taxation must be understood by investors and discussed with their CPA because of potential benefits (single taxation) and potential drawbacks (distributions taxed as income).
• Private Equity and Credit.  While the total number of publicly traded companies has declined in the past decade, the universe of privately owned companies has expanded greatly.  This area includes many well-known mature companies in various industries, as well as venture capital and massive infrastructure projects.  Shielded from the scrutiny faced by publicly traded companies can in theory allow private companies to implement strategies that may take many years to decades to play out.  This long-term focus can reduce correlation to public markets and offer potential for long term returns.  On the credit side of the private market, many private companies issue bonds (they borrow) in order to finance their often very large endeavors. 
• Commodities.  There are many categories of commodities which represent early stage inputs or hard goods used in production and manufacturing.  These can be very volatile and can be seen as good investments during times of growth and inflation.  Blended diversified commodity funds are often used to manage high potential volatility.  Examples include agricultural produce (like wheat, corn, soy), raw materials (steel, lumber, copper, lithium, cobalt), energy (oil, natural gas, coal).   Many investors are considering whether crypto or digital investments belong in this category.
• Precious Metals.  Seen as among the oldest forms of money, these have been used by investors for centuries.  Gold and silver have uses as jewelry/ornamentation, as inputs in manufacturing, and by speculative investors.  When assessing whether to allocate here, it is important to consider which investor segment might be driving movements in price.  Investors typically access these through funds and/or ETFs that track spot prices.  Some investors allocate to physical coins and bars, or to futures.

Conclusion
The portfolio allocations of individual investors may change in coming years.  Traditional asset classes such as stocks, bonds, and cash are likely to continue as important building blocks.  Alternative investments which seek noncorrelated gains and income through liquid and nontraded approaches may become important additions to the overall mix.  This means that individual investor portfolios may evolve to resemble allocations used by institutional investors such as endowments and pension funds.  This evolution will require some education and willingness to change, but will I believe lead to superior long-term outcomes.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. 

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.  Asset allocation does not ensure a profit or protect against a loss.