Should You Invest in Alternative Investments?
Sarah H. from Stockton, CA asks: I’ve been reading more and more that many financial advisors are adding “alternative investments” to their list of offerings. My basic understanding is that these are non-traditional investments (not stocks or bonds) that potentially offer a higher return for similar or maybe slightly higher risk. Is this correct, and does Zacks offer these kinds of investments? Thanks!
Mitch’s Response: Thanks for writing, Sarah. Before I dive in, let me first offer a quick explanation to readers who may not be familiar with “alternative investments.” You correctly point out that these are non-traditional assets, outside of the realm of stocks and bonds. Alternative investments generally involve private equity, hedge funds, real estate transactions, futures, derivatives, and/or commodities. I think investors are starting to hear more about alternatives because stock valuations are creeping higher and fixed income yields have remained stubbornly low.
The very first thing I’ll say on this topic is really just an age-old piece of investment advice: if you do not thoroughly understand an investment product or asset, then you should probably not invest in it. That should be the starting point for most investors and readers.
In my opinion, alternative investments are not inherently bad. Like any risk asset, there is the potential for a solid positive return if properly researched and managed. But for me, it is not a question of whether alternative investments are good or bad – it is whether they are worth it. Generally speaking, alternative investments require high minimum investments, have higher fees, and are less liquid than traditional stocks, bonds, and ETFs. Those three things generally do not match what retirees ultimately need in managing their nest eggs.
What’s more, there is not great evidence that alternatives are even boosting overall returns as hyped. In fact, recent empirical data suggests just the opposite. The National Association of College and University Business Officers (NACUBO) conducted a study last year of 805 U.S. endowments that manage $515.1 billion in assets, with an average allocation of 53% to alternative strategies. These endowments/institutions have some of the most ‘qualified’ investment professionals overseeing decision-making and investment allocations, so one would expect that the results would be inspiring as it relates to the positive contribution of alternative investments, right?
Far from it. Through June 30, 2016, the 10-year average annual return for endowments was 5%, while the 10-year return from the Russell 3000 Index was 7.4%. Even a blended portfolio of 60% stocks and 40% bonds would have outperformed the average endowment over the 10-year period, with a return of 5.4%.
So again, this brings me back to my central point of, are alternative investments really worth it? With generally higher fees, less liquidity, more complex structures, more volatile returns, and so on, it is difficult for me to make the case for allocating to alternative investments when we can generate similar – if not oftentimes better – returns with the traditional approach of stocks and bonds. As the saying goes, “if it ain’t broke, don’t fix it.”
At Zacks Investment Management, we have been able to deliver strong, positive long-term returns through our equity and fixed income based strategies. Our view simply corresponds with what history has shown us time and again – that companies build businesses to grow and create value over time. By investing in the stocks and bonds of these companies, an investor can participate in that value creation over time. Simple. Our view has been, and remains, that investors who invest in stocks and bonds over long periods of time can grow their net worth in a risk-controlled environment, with highly competitive rates of return. In my view, alternatives just aren’t needed to make that growth a reality.
Now I know what you are thinking – “if alternatives are not the best way to go then how should you position you portfolio?”
A good start to answering this question would be to review the core tenants of “Modern Portfolio Theory.” One of the keys to modern portfolio theory is diversification across non-correlated asset classes, which can help investors control for risk and potentially smooth out returns. There are other features of Modern Portfolio Theory that could help investors navigate the markets as conditions start to change. I would encourage you to brush up on some of these concepts, or if they’re new concepts to you, to learn them with our newly released guide, “Making Sense of Modern Portfolio Theory.” Click on the link below for more details!
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