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.

For example, at Invesco we analyzed the performance of a portfolio of alternatives and compared it to the returns of stocks over a 20-year period.¹  What we found was that across this period, the alternatives portfolio generated annualized returns similar to that of stocks, but with lower volatility and lower maximum decline.  We also found that the portfolio of alternatives lagged equities during bull market periods, while outperforming equities during bear market periods.  All these aspects would need to be taken into consideration when selecting a benchmark and evaluating performance against the benchmark.

Chasing performance: the biggest mistake investors make with alternatives - If there is one consistent mistake I see investors make when using alternatives, it’s that they chase performance and allocate to alternatives only after a period of strong performance for alternatives and/or a period of weak performance for equities. 

Such investors invest by looking in the rear view mirror based on the previous investment environment.  As a result, they often only add alternatives following a period in which they would have helped a portfolio.  While there is an element of better late than never, this is nonetheless the equivalent of buying home insurance after the house has burned down. 

Investors interested in alternatives can consider three things that may help drive success: 1) invest looking through the windshield based on what they see on the horizon, 2) include alternatives as a core part of their portfolios, and 3) have a deep understanding of the alternatives in which they invest.  Given that many alternatives have historically outperformed equities during periods of weak equity performance as discussed in misconception 3.

Over the past eight years, investors have enjoyed a period in which stocks (as measured by the S&P 500) have generated returns well above their historical average accompanied by volatility well below the historical average.  Given this environment, I am concerned that investors have become complacent about equities and various potential risks in the market.  Almost every day I read articles and research papers cautioning that investors should expect lower returns and high volatility going forward. 

Investors that look in the in the rearview mirror risk being caught unprepared should we enter a period of lower returns and higher risk.  Conversely, investors that look through the windshield are busy preparing their portfolios for that environment.  Those investors are actively considering adding alternative investments to their portfolio, if they have not already done so.

1.    Source: StyleADVISOR, January 1997 – June 2016
Alternatives portfolio represented by a portfolio comprising allocations to each of the following alternatives categories: Inflation-hedging assets, represented by 15% FTSE NAREIT All Equity REIT Index and 5% Bloomberg Commodity Index. The 15% / 5% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. Principal preservation strategies, represented by 20% BarclayHedge Equity Market Neutral Index. Portfolio diversification strategies, represented by 12% BarclayHedge Global Macro Index and 8% BarclayHedge Multi-Strategy Index. Multistrategy is underweighted in this example due to its potential overlap with global macro. Equity diversification strategies, represented by 20% BarclayHedge Long/Short Index. Fixed income diversification strategies, represented by 10% S&P/LSTA US Leveraged Loan Index and 10% BarclayHedge Fixed Income Arbitrage Index. The performance of individual alternative investments will differ from that of the index. Traditional 60/40 portfolio represented by 60% S&P 500 Index and 40% Barclays US Aggregate Bond Index. Equities represented by S&P 500 Index. Fixed income represented by Barclays US Aggregate Bond Index.

Walter Davis is alternative investments strategist at Invesco.