Concerned about extreme market shocks? Consider Alternatives

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Preparing for the unexpected is an essential element of any successful investment strategy. Alternative assets can prove valuable shock absorbers when mainstream markets suddenly prove challenging.

Financial markets don’t respond well to sudden shocks—and sell-offs can be highly contagious, spreading quickly to infect lots of different kinds of investments.

This has been abundantly clear over the last 18 months. The popping of China’s stock-market bubble last summer quickly triggered a sharp sell-off in risk assets worldwide. China-related concerns resurfaced again early this year: worries about the health of China’s economy, and the knock-on impact on demand for commodities, saw a repeat spike in global market volatility. And just when markets were beginning to regain their poise, they’ve been hit by another unwelcome surprise—the UK’s vote to leave the European Union (EU). Once more, the shockwaves have been far-reaching.

As mainstream markets have grown more turbulent, many investors are thinking about whether their portfolios incorporate approaches to weather volatility spikes and to withstand contagion risks.

Holding a mix of traditional investments like stocks and bonds has become a much less effective way to handle stressed markets. That’s because correlations between stocks and bonds have more than doubled in the last 20 years.

How do Alternatives handle stress?
Alternative investments often derive a lower proportion of their returns from basic market movements—what’s known as beta—than either stocks or bonds. Since they tend not to mimic mainstream markets’ moves, they can lose less money when equity and fixed-income markets are falling (as shown in the Display). As a result, allocating to alternatives can potentially enhance a portfolio’s long-term returns, while also reducing its vulnerability to mainstream market risks.

In the past, investing in alternatives was really only an option for big institutional investors. Today, private investors can access the very same institutional investment capabilities through a number of widely available investment vehicles.

But some people remain wary about allocating to alternatives. This nervousness is particularly pronounced in Europe. Indeed, only around 11% of European institutional investors hold alternatives allocations, whereas more than 25% of their US counterparts are invested in alternatives.

We think this is largely because some aspects of the asset class are still poorly understood—and it has tended to attract negative press attention, particularly in the wake of the global financial crisis.

Common myths and misconceptions
Some people fear that alternative investments are inherently riskier and less well-regulated than mutual funds investing in stocks and bonds. This isn’t the case now that investors can access alternatives in the very same investment vehicles that have traditionally focused on more mainstream investable assets. Many alternatives funds are regulated under European law and private investors can access them in Ucits funds registered for public distribution and, therefore, benefit from daily liquidity requirements.

People also worry that investing in alternatives could prove prohibitively expensive. That’s largely because some alternatives strategies charge performance-related fees—higher returns come at a higher price. But not all strategies take this approach. Some charge investors a flat fee no matter what they deliver.

Worries also arise because the “alternative investments” label covers such a broad range of different things. Some people associate alternatives with hedge funds and private equity strategies. For others, alternatives are real estate or wind turbines or gold and other commodities. And the performance of some of these things can be pretty volatile—in the case of commodities, sometimes even more volatile than equity or fixed-income markets. That said, several alternative investments are less volatile than traditional equities.

We think it’s important to recognize that many alternatives strategies deliver returns driven more by investment manager skill in decision making than by broad movements in investable alternative assets’ prices.

Some alternatives strategies can emphasize traditional asset classes (equities, bonds and currency), but they’ll tend to approach them in highly innovative and flexible ways. For example, they may decide opportunistically to move into a wider investment universe that incorporates macroeconomic views across asset classes or includes commodities. Or they may incorporate derivatives or hedging techniques in a bid to temper overall strategy volatility.

Finding the Right Fit
The alternatives universe is very broad and features diverse investment styles and strategies—each with its own expected risk/return profile. As a result, investors need carefully to consider what kind of strategy would likely best fit their specific investment objectives. This might be increasing portfolio diversification, for example, or perhaps reducing exposure to mainstream market volatility.

Christine Johnson, head of Alternatives Product Management at AB