In my role as Alternatives Investment Strategist at Invesco, I spend a great deal of time talking to investors about alternative investments. Based on those conversations, it’s clear to me that there is great deal of confusion about alternatives. In order to help reduce some of this confusion, I’d like to discuss three common misconceptions about alternatives and the biggest mistake I see investors make with regard to alternatives:
Misconception #1: Alternatives are just hedge funds – While hedge funds clearly comprise a significant portion of the alternative investment universe, alternative investments extend beyond hedge funds into alternative asset classes such as commodities, and illiquid strategies such as private equity.
At Invesco, we define alternatives as investments in things other than publicly traded, long-only stock and bonds. When an investment is made into assets other than stocks and bonds, you have entered the world of alternatives. When a fund “shorts” (e.g. attempts to make money from the decline in price of an asset), you have entered the world of alternatives. And, when a fund invests in an illiquid, privately traded asset, such as private equity, you have entered the world of alternatives.
At Invesco, we divide the alternatives universe into two baskets: alternative asset classes and alternative investment strategies. Alternative asset classes comprise assets other than stocks and bonds. Real estate, commodities, infrastructure and master limited partnerships are all examples of alternative asset classes.
Alternative investment strategies are comprised of common hedge fund strategies, such as global macro, equity long/short, market neutral, managed futures, banks loans and unconstrained fixed income. Private equity is also an example of an alternative investment strategy.
Misconception #2: Alternatives are designed to outperform stocks – The universe of alternative investments is quite broad, and the various types of alternatives have their own unique return objectives. When looking at the different types of alternatives, it is important for investors to understand that return and risk objectives vary widely from strategy to strategy and manager to manager. For this reason, it is imperative that the investor understand the return and risk objective of the strategy and manager they are using.
In doing so, investors will find that some alternatives, such as private equity, seek to outperform stocks. They will also find that some alternatives seek equity-like returns and lower volatility and downside risks than stocks. There are also some alternatives that are more bond-like in nature, both in terms or return and risk.
Misconception #3: Alternatives should be benchmarked against stocks – Alternative investments are called “alternative” because they invest and perform in a way that is different and unique than stocks and bonds. Given the unique nature of alternatives, and the wide range of return objectives across strategies and managers, stocks may or may not be an appropriate benchmark for alternatives.
Before selecting a benchmark for an alternative, investors need to first understand the unique characteristics of the strategy and manager in which they are investing. To this end, they should focus on characteristics such as expected return and risk, expected performance during different parts of the market cycle and key drivers of return. Only after understanding these factors can an appropriate benchmark be selected.