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Consider the Alternatives—Beyond Stocks & Bonds

Hedge funds, private equity and real assets could help you manage volatility as you pursue your goals, but they carry some risk. Here’s what you need to know.

YOU’VE HEARD IT BEFORE: Diversification is a key to managing risk. When stocks go down, bonds are likely to rise in value. Owning both can help you minimize losses in a down market. But in today’s volatile market environment, many people are wondering: Is there anything else investors can consider to increase their diversification?

“Some alternative investments are insulated from market ups and downs. Others take advantage of volatility in targeted ways.”—Anshul Sharma, head of alternative investment strategy for the Chief Investment Office for Merrill and Bank of America Private Bank

Well, yes. Though they may not be right for everyone, “alternative investments are strategies that can help complement traditional stock and bond investments,” says Anshul Sharma, head of alternative investment strategy for the Chief Investment Office for Merrill and Bank of America Private Bank. “They take advantage of techniques such as hedging, concentration of assets and leverage in ways that increase diversification while addressing specific goals.”

Alternative investments are particularly useful during volatile markets, notes Sharma, because unlike traditional investments, “some are insulated from the business cycle and market ups and downs. Others take advantage of volatility in targeted ways.”  While all come with risks and costs (including, often, high minimum investments), and they can be less liquid than traditional investments, they are increasingly viewed as a valuable addition to a truly diversified portfolio, with the potential to help enhance both returns and income.

Below, Sharma highlights three alternative investment strategies for qualified investors to consider. “Ask your financial advisor whether one or more might make sense for you.”

Hedge Funds: A Variety of Approaches

Hedge fund managers engage in a wide variety of trading strategies not generally available to traditional asset managers, says Sharma. Equity long/short funds, for example, position themselves to extract gains from stocks that may perform well over the long term, as well as those that may lose value. Global macro funds are designed to benefit from broad macroeconomic trends, and event-driven funds focus on corporate restructurings and mergers and acquisitions. These are sophisticated strategies, Sharma cautions, and hedge-fund managers may make frequent trades and use leverage, derivatives, short-selling and concentrated positions to achieve their goals. They may also provide less transparency to investors and charge higher fixed fees.

Potential benefits for investors: Nevertheless, adding hedge funds to a portfolio may be worth considering, because they can help provide a buffer for market downturns and assist with capital preservation, Sharma notes. Although hedge-fund strategies can also lead to losses, the performance of hedge funds over the past decade suggests how resilient they can be. During each of the 10 biggest market drawdowns since 2011, hedge funds have held up better than stocks. (See how hedge funds performed in the 5 biggest market drawdowns since 2011 above.)

Private Equity: Buying and Selling Companies

Private-equity funds aim to acquire private and some public companies with the ultimate goal of selling them at a substantial profit and returning capital to investors. They invest in companies that might benefit from an infusion of capital and shifts in business strategies and then work with them to change management, reduce costs, refine product lines or enter new markets before the sale. Investors should be aware that in some cases, they may have to wait up to a decade before realizing returns.

Potential benefits for investors: Historically, private equity has outperformed public markets1 and may also help manage portfolio volatility. “Some of the best-performing private-equity funds are the ones that operate during or shortly after recessions,” says Sharma. “This makes sense because dislocations and market volatility can create favorable entry points.”

Real Assets: In a Category All Their Own

Real assets, sometimes also known as tangible assets, have an intrinsic value and usually a physical form. They cover a wide range of investments, from gold and other precious metals and commodities to commercial and residential real estate, infrastructure funds, agricultural land and natural resources. Such assets tend to behave differently than stocks and bonds and even than other alternative investments. Some may be less liquid than traditional investments, and like private equity, can require an investment horizon of more than a decade.

Potential benefits for investors: Real assets’ low correlation with the performance of traditional investments makes them especially suited to increasing diversification, and because they often gain value when consumer prices rise, they may also provide a hedge against inflation. “Many of these assets don’t have much of a relationship to the business cycle, and that’s the point,” says Sharma.

A Mix of Alternatives May Be Appropriate

Alternative investments can be mixed, matched and calibrated to pursue specific goals. For example, with interest rates currently stuck near historic lows, defensive alternative investments might use options strategies to provide a better source of income than bonds. Diversifying alternative strategies, such as a global macro strategy, seek to generate returns that depend less on market direction and may help reduce volatility in portfolios during dislocations. For investors who are willing to accept higher risks and greater exposure to market turbulence, growth-focused alternative investment strategies may use concentrated positions, leverage and other approaches that could potentially generate compelling total returns.

“These three outcomes—defense, diversification and growth—aren’t mutually exclusive,” says Sharma. “They can be used in combination within your portfolio, and the right mix will depend on your goals, risk tolerance ,liquidity needs and the time you have to pursue your goals.”

Finding an Allocation That’s Right for You

“Private equity, real estate and other alternatives typically require an investment horizon of more than a decade,” Sharma says. Weighing your need for liquidity and other considerations can help you and your advisor determine what kind of allocation to alternative investments you might consider if you are a qualified investor. In most cases, you’ll want to diversify not only across stocks, bonds and alternative investments, but also within those asset classes, with a broad range of hedge-fund strategies, private-equity holdings and real assets.

Of course, even the addition of alternative investments doesn’t change the need for a disciplined approach to investing that looks past current market conditions.

“Remembering why you’re investing and sticking with an asset allocation aligned with your goals is almost always the best course,” Sharma says.

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Based on data from December 2000 to June 2019. Indices used are S&P 500 Total Return Index (stock) and  Cambridge Associates U.S. Private Equity Index (private equity).

Information is as of 07/01/2020

Opinions are those of the author(s), as of the date of this document and are subject to change.

Investing involves risk, including the possible loss of principal.

Past performance is no guarantee of future results.

The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., (“Bank of America”) and Merrill Lynch, Pierce, Fenner & Smith Incorporated (“MLPF&S” or “Merrill”), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation.

Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Securities indexes assume reinvestment of all distributions and interest payments. Indexes are unmanaged and do not take into account fees or expenses. It is not possible to invest directly in an index. Indexes are all based in dollars. 

S&P 500 is a stock market index that tracks the stocks of 500 large-cap U.S. companies. It represents the stock market's performance by reporting the risks and returns of the biggest companies. 

HFRI Fund Weighted Composite Index - A global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in U.S. Dollar and have a minimum of $50 Million under management or a twelve month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.

The Cambridge Associates U.S. Private Equity index and benchmark statistics are based on data compiled from more than 1,400 institutional-quality buyout, growth equity, private equity energy, and subordinated capital funds.

Alternative investments such as derivatives, hedge funds, private equity funds, and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk. Alternative investments are speculative and involve a high degree of risk. An investor could lose all or a substantial amount of his or her investment. There is no secondary market nor is one expected to develop and there may be restrictions on transferring fund investments. Alternative investments may be leveraged and performance may be volatile. Alternative investments have high fees and expenses that reduce returns and are generally subject to less regulation than the public markets. The information provided does not constitute an offer to purchase any security or investment or any other advice.

Nonfinancial assets, such as closely held businesses, real estate, oil, gas and mineral properties, and timber, farm and ranch land, are complex in nature and involve risks including total loss of value. Special risk considerations include natural events (for example, earthquakes or fires), complex tax considerations, and lack of liquidity.  Nonfinancial assets are not appropriate for all investors.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Bonds are subject to interest rate, inflation and credit risks.

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