Diversification and defence: A look at alternative investments against traditional assets
Comparing alternative investments against traditional assets, highlighting their roles in creating a resilient, well-diversified portfolio.
Traditional assets like stocks, bonds and direct property ownership have long been the staple of investment portfolios, but alternative investments have gained prominence in recent years.
Understanding traditional assets
Traditional investment assets refer to the main asset classes that investors have historically used to build their portfolios. These traditional investment assets form the foundation of most investment portfolios and are considered relatively well-understood and established investment options. These include:
- Stocks and shares (Equities): Investing in equities offers the potential for significant returns through capital appreciation and dividends. Stocks and shares are known for their growth potential but can also come with higher risk. The share market is known for its volatility often linked to its resemblance to a roller coaster.
- Bonds (Fixed Income): Fixed-income securities like government and corporate bonds provide regular interest payments and return of principal at maturity. Bonds are typically considered safer than stocks but offer lower returns, serving as a stabilising force in a portfolio. Bonds were once considered a suitable hedge against the equities markets due to their low correlation, but in recent times, this relationship has become less reliable as both asset classes have shown increased correlation, reducing the effectiveness of bonds as a diversification tool.
- Cash and cash equivalents: Highly liquid assets such as savings accounts, money market funds, and Treasury bills. These assets provide stability and liquidity but typically offer lower returns.
- Real estate: Direct property ownership can generate income through rent and offer greater potential for capital appreciation but the initial and ongoing costs may be substantial. Additionally, direct ownership occupies the lowest position in the capital stack as it is the last to be repaid in the event of liquidation.
- Commodities: Physical goods like gold, silver, oil, and agricultural products. Commodities can provide diversification and a hedge against inflation but are subject to high volatility and market speculation which can lead to irrational price movements and increased risk for investors. Commodities also do not generate income.
What is the Case for Diversification?
Diversification involves spreading investments across various asset classes to reduce risk. The primary goal is to minimise the impact of poor performance in any single asset on the overall portfolio. Traditional portfolios often use a mix of stocks and bonds to achieve diversification, but alternative investments can further enhance this strategy.
Alternative investments explained
Alternative investment assets are any financial assets that fall outside the traditional categories of stocks, bonds, property and cash. These investments include a wide range of asset classes and strategies, often offering opportunities for diversification and potentially higher returns. Some alternative assets can come with higher risks and lower liquidity. Alternative investments encompass a broad range of asset types including:
- Commercial real estate debt: In these scenarios, the investors are the funders for loans used to finance the purchase, development, improvement or refinancing of commercial real estate assets. Commercial real estate debt offers various opportunities for investors seeking income, diversification, and capital preservation within their investment portfolios. It also has low correlation with the stock and share markets, making it a valuable diversifier.
- Private equity: Involves investing in private companies not listed on public exchanges. These investments can offer substantial returns but come with higher risk and longer investment horizons.
- Hedge funds: Pooled funds managed by professional investors using various strategies to generate returns. Hedge funds aim to achieve positive returns regardless of market conditions, offering potential non-correlation with traditional assets.
- Commodities: Investing in physical assets like gold, silver, oil, and agricultural products can hedge against inflation and market volatility. Commodities often move inversely to stocks and bonds, providing a defensive layer.
- Infrastructure: Investments in public assets like roads, bridges, and utilities can offer stable cash flows and inflation protection. Infrastructure investments are typically less volatile and can be less correlated with other asset classes.
- Venture Capital: Funding early-stage startups with high growth potential. While risky, successful venture capital investments can yield significant returns and offer exposure to innovative industries.
How investing in commercial real estate debt can fortify your investment portfolio
Capital preservation
- Secured by 1st ranking mortgages over real property
- Generally conservative Loan to Value Ratios
Portfolio diversification benefits
- Defensive
- Income generating
- Unique – fits into multiple asset types: fixed income, property, and alternatives
- Credible alternative from other asset classes
Practical considerations for investors
When incorporating alternative investments into a portfolio, investors should consider:
- Risk tolerance: Assessing one’s ability to withstand potential losses and volatility is crucial as alternative investments can vary significantly in risk.
- Investment horizon: Many alternative investments, like private equity and venture capital, require longer investment periods. Investors need to be prepared for illiquidity.
- Expertise and due diligence: Alternative investments often require specialised knowledge and thorough due diligence.
- Regulatory and tax considerations: Different alternative investments may have specific and differing regulatory requirements and tax implications. Investors should be aware of these factors and always seek the appropriate financial and/or legal advice.
A balanced approach
Incorporating alternative investments into a portfolio can significantly enhance diversification and build a defensive, non-correlated layer. While traditional assets like stocks and bonds remain essential components of a portfolio, alternative investing can offer unique benefits and can help mitigate risks associated with market volatility and economic downturns thereby creating a more balanced, more diversified portfolio.
By carefully considering the benefits and attributes of different types of alternative investments, investors can create a more balanced and defensive investment strategy that can withstand market volatility, economic downturns, and unexpected events while aiming for long-term growth and income stability.
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Alan has more than 30 years’ experience in banking and finance, following a short stint as a legal practitioner, with work experience in the UK, South Africa and Australia. His many and diverse roles include C-suite positions in two-listed banking groups in South Africa, CEO of South Africa’s third largest private client wealth manager, Director of a Superannuation Risk and Operations consultancy, a consultant to Westpac, and as MD of a ‘home loan over the phone’ business established for Real Insurance and Macquarie Bank. He has consulted widely to owner-managed businesses across strategy, technology and operations and co-founded Zagga in 2016, where he is a Member of the Zagga Investment Risk Committee, Zagga Credit Oversight Committee, and Zagga Compliance Committee, and a Responsible Manager (AFSL / ACL).
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This article is for information purposes only. It does not take into account your objectives, financial situation or needs. Any opinion expressed in this article are of the author and is subject to change without notice. Readers are reminded to exercise caution and use their own judgment when interpreting and applying the information contained in this article.
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Alan has more than 30 years’ experience in banking and finance, following a short stint as a legal practitioner, with work experience in the UK, South Africa and Australia. His many and diverse roles include C-suite positions in two-listed banking...
Expertise
No areas of expertise
Alan has more than 30 years’ experience in banking and finance, following a short stint as a legal practitioner, with work experience in the UK, South Africa and Australia. His many and diverse roles include C-suite positions in two-listed banking...
Expertise
No areas of expertise
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