For decades, pundits have taken a stab at writing the obituary for the traditional 60/40 portfolio (i.e. 60% stocks/40% bonds).
At first glance, this seems laughable. Over the last 90 years, a traditional 60/40 portfolio returned over 8% per year – like the S&P 500 which returned 9.5% over that period – but… with 40% less volatility!
However, these days, when accounting for historically low interest rates and rising inflation (which may or may not be transitory), the 60/40 bears may have their strongest case in recent memory.
This then begs the question: what now?
For a variety of reasons, there is still plenty of merit to 60/40 portfolios. However, we do appreciate the potential of certain investments to increase portfolio diversification. For investment opportunities beyond that of traditional stocks and bonds, we classify these in the portfolio as Alternative Investments (or, alts).
What are alternative investments?
Alts are essentially a catchall for any investment besides stocks, bonds, and cash (or cash equivalents). They provide an opportunity to gain exposure to areas not traditionally captured in a stock/bond portfolio that may or may not offer above market returns. Some of the more common types of alternative investments include:
- Real Estate – crowdsourced or private commercial/residential property ownership, private/public Real Estate Investment Trusts (REITs)
- Commodities – such as crude oil, corn, soy, wheat, and coffee
- Precious metals – such as gold, silver, and lithium
- Cryptocurrency – purchasing coins, NFTs, or investing in public companies at the fore of crypto/blockchain/web3
- Private Equity – locking up funds with a private equity firm to invest in non-public, private companies often via leveraged buyouts and/or venture capital
- Collectibles – tangible assets such as art, fine wine, and vehicles
What are the benefits of alternative investments?
- Diversification. This is the primary benefit. Alternative investments are typically a counterweight to conventional stock/bond assets and may perform well even if stock/bond returns are poor due to low correlations.
- May have greater upside. Alternative investments, often due to their concentrated positions, can potentially offer outsized returns compared to traditional mutual fund/ETF investments.
- Expertise can be an edge. An example of this would be an experienced real estate fix-and-flipper who can spot an opportunity and has the team/know-how to carry out the vision. Another example might be an art collector that knows how to spot undervalued works of art. All this to say, unique skills/interests in niche areas can set you apart.
What are the drawback of alternative investments?
- Illiquidity. Many alternative investments may be illiquid and difficult to exit. In the case of most non-tradable private REITs, your investment might be tied up for 7+ years before you can access the funds.
- Lack of regulation. Reporting requirements for many alternative investments are minimal compared to those of public companies in the stock market. This can create difficulty when valuing the alt’s underlying assets, which can make pricing and price transparency less straightforward.
- Investment platforms can fail. Many online platforms for alternative investing are start-ups that may or may not succeed. You need to understand how your funds will be handled should the company fail or be acquired.
- Investment minimums may apply. High investments minimums are common and may make certain alts impractical/inaccessible for smaller investors.
- High fees. Alternatives can have many fees that are unique to the investment. Private equity typically charges large asset management fees. Real estate can have many unplanned repair/maintenance/legal expenses. Wine collecting through Vinovest charges 2.5%-2.85% for climate-controlled and insured wine storage! Compare those fees to traditional index funds which have small expense ratios, no purchase fees, no redemption fees, and no 12b-1 fees.
- Complexity. Alternative investments are often complex instruments and may require a higher level of due diligence. If you are considering alternative investments, you also want to be sure that you research and understand the potential tax implications associated with them.
Ultimately, investors need to be aware of both the upside and downside potential of any investment. The suitability of any given alternative investment should be considered against an individual investor’s:
- time horizon
- appetite for risk
- ability/capacity to take on outsized risk, and
- any unique skills/interests that strengthen the odds of making a profitable investment.