Investors have likely heard asset allocation specialists advise increasing portfolio exposure to 'alternatives' given the current market conditions. Invesco's Alternatives Investment Strategist, Walter Davis, explores this asset class and suggests 5 alternatives to consider right now.

Alternatives may be an answer to challenging investment environments

Following an idyllic 2017, when equity markets were characterised by strong returns and low volatility, we were reminded in 2018 that markets are often volatile and can go down just as easily as up. In 2019, I believe investors should be preparing themselves for lower equity returns, increased volatility and rising interest rates. Given this outlook, investors may want to consider the addition of alternative investments to their portfolios.

What are alternative investments?

Invesco defines alternatives as investments other than publicly traded, long-only equities and fixed income. Based on this view, investments that have any of the following characteristics would be defined as alternative investments:

• Investments that engage in “shorting” (i.e., seeking to profit from a decline in the value of an asset), such as global macro, market neutral and long/short equity strategies.
• Investments in asset classes other than stocks and bonds, such as commodities, natural resources (i.e. forestry, mining leases), infrastructure, and real estate.
• Investments in illiquid and/or privately traded assets, such as private equity, venture capital and private credit.

Historically, alternative investments were only available for institutional and ultra-high net worth investors, but that is no longer the case. Many alternative investment strategies are currently available to all investors through various investment vehicles.

Alternatives to consider for 2019

Given my outlook for lower equity returns, increased volatility and rising interest rates
in 2019, investors may want to consider the following types of alternative strategies.

Global macro for opportunistic, long/short investing across global markets 

Global macro funds invest opportunistically on a long and short basis across global equity, fixed income, currency and commodity markets. Because these funds can invest long and short, it is possible for investors to earn profits in both rising and falling market environments. For this reason, global macro funds have the potential to outperform traditional stocks, especially during challenging and volatile periods for equity performance.

Market neutral to help preserve principal 

Market neutral funds trade related equities on a long and short basis, such that the funds have close to zero net market exposure. In these funds, the key to generating a positive return is security selection — determining which equities to go long and which to go short. Given the potential for lack of net market exposure, market neutral funds may reduce the impact of market swings, have the potential to generate positive returns in all market environments, and may produce returns that have low correlation to equities and bonds.

Long/short equity for potential upside equity market participation coupled with downside risk mitigation

Long/short equity funds combine both long and short equity positions in a portfolio, while typically being net long to equities. As a result, performance tends to directionally follow the equity market while the short positions seek to cushion performance during periods of stock market decline.

Senior loans to play offense in a rising interest rate environment 

Senior loans (also known as bank loans) are made by banks to non-investment grade companies, commonly in relation to leveraged buyouts, mergers and acquisitions. The loans are called “senior” because they are contractually senior to other debt and equity and are typically secured by collateral. Another key aspect of senior loans
— the interest rate typically floats with a reset every 30 to 90 days. This means that in a rising rate environment, as long as the rate rises above a predetermined minimum level, the payments from the borrower may increase

Multi-alternatives may offer a one-stop shop investment in alternatives 

Multi-alternative funds generally invest across multiple alternative strategies and/or alternative managers. These typically use a combination of alternative strategies, including taking long and short positions in debt and/or equity, alternative assets and futures, among others. Such funds may provide investors with broad exposure to alternatives via a single fund.

A final word

One final word on alternatives: In my opinion, the most common mistake investors make with alternatives is investing on a reactive basis, seeking out alternatives following a period of outperformance by these assets. For this reason, I encourage investors to work with their financial advisor to research and consider an appropriate allocation to alternatives, especially given the current market environment.