The Role of Alternative Investments in a Multi-asset Portfolio

When considering adding alternative investments to a portfolio, investors need to know what benefits to expect. Alternative investments span the spectrum between risk-reducing and return-enhancing. This lack of consistency is a familiar theme with alternative investments. Each one will be discussed in further detail here. Investors often categorize an asset class based on the role it is expected to play in the overall portfolio. The roles and their relative importance will vary among investors, but it is common to identify the following functional roles:

• Capital growth.
• Income generation.
• Risk diversification.
• Safety.

The Role of Private Equity in a Multi-asset Portfolio

In multi-asset portfolios, private equity is typically employed to boost returns. Both public and private companies face similar risk factors, meaning that introducing a private equity investment into a multi-asset portfolio doesn’t necessarily provide significant diversification. The illiquidity premium is the primary driver of increased returns when investing in private equity versus public equities.

It’s worth noting that private equity indices may not always fully reflect the heightened volatility associated with such investments. This discrepancy arises due to infrequent valuations of underlying assets. Consequently, many market participants prefer to use public equities with a liquidity premium as a proxy for estimating private equity volatility.

The Role of Hedge Funds in a Multi-asset Portfolio

Hedge funds are incredibly diverse among alternative investments. Their impact on a portfolio, whether reducing risk or enhancing returns, depends on their specific strategy:

• Long/short equity strategies provide equity-like returns with less exposure to equity market risk due to the manager’s ability to short stocks.
• Short-biased equity trading reduces portfolio equity beta and can generate alpha.
• Arbitrage and event-driven strategies exploit market inefficiencies and aim for low correlation with traditional assets.
• Opportunistic strategies, although volatile on their own, offer unique exposures not found in traditional portfolios, thus reducing risk.

The Role of Real Assets in a Multi-asset Portfolio

Real assets encompass timber, commodities, farmland, energy, and infrastructure assets. These investments share a strong correlation with inflation, serving as an effective hedge against rising prices, which improves portfolio risk.

Commodities can be categorized into:

• Metals (gold, silver, platinum, copper).
• Energy (crude oil, natural gas, heating oil, gasoline).
• Livestock and Meat (hogs, pork bellies, live cattle).
• Agricultural (corn, soybeans, wheat, rice, cocoa, coffee, cotton, sugar).

Direct ownership of commodities involves complexities and costs, leading many investors to prefer derivatives. Commodities primarily serve as an inflation hedge and source of diversified risk rather than enhanced returns.

Farmland investment can be approached in two ways:

• Direct ownership: Higher risk and reward with ownership and product sales.
• Leasing to farmers: Lower risk and reward, with farmers responsible for operations, resembling real estate investing.

Energy investments focus on exploration, development, transportation, and sale of energy sources like oil and gas, including wind, hydroelectricity, and solar. These investments serve as an inflation hedge and source of diversified risk.

Infrastructure investments involve assets like bridges, toll roads, and airports, typically requiring construction and maintenance. They offer an illiquidity premium but carry regulatory risks due to government involvement in price-setting in certain cases.

The Role of Commercial Real Estate in a Multi-asset Portfolio

Commercial real estate can boost returns and reduce risk while introducing new risk factors not common in traditional investments. It’s considered an inflation hedge because rising prices can lead to higher rents and property values.

However, investing in commercial real estate can be challenging due to sourcing, analyzing, closing deals, and property management complexities. Illiquidity in large commercial deals can provide an opportunity for earning a return premium.

The Role of Private Credit in a Multi-asset Portfolio

Private credit can be invested in two ways: direct lending and distressed investing.

Direct lending involves providing capital to individuals and small businesses at interest rates higher than traditional public markets. This strategy offers access to a high-yield, albeit riskier, debt market segment. It also comes with a liquidity premium and some correlation with the traditional bond market.

Distressed investing focuses on companies facing financial turmoil. Accessible mainly to experienced investors, distressed investments often come with substantial discounts. Despite being bonds, they have low sensitivity to traditional bond risks, primarily due to the dominance of idiosyncratic company risk. This offers the potential for return enhancement and risk reduction.

Question

Which of the following is least likely to provide inflation-hedging benefits when included in a traditional portfolio of 60% stocks and 40% bonds?

1. Private equity.
2. Commercial real estate.
3. Investments in real assets.

Solution

The correct answer is A.

Private equity investments often involve taking ownership stakes in private companies. While they can offer potential for capital appreciation, they may not provide as direct or immediate inflation-hedging benefits as some other asset classes. The relationship between private equity and inflation is often less direct, making it the least likely to provide immediate inflation protection in this portfolio context.

B is incorrect. Commercial real estate, such as office buildings, shopping centers, and rental properties, is often considered a strong hedge against inflation. As inflation rises, property values and rental income tend to increase, providing a direct and effective means of hedging against inflation. So, commercial real estate is likely to provide inflation-hedging benefits.

C is incorrect. Investments in real assets often include commodities, infrastructure, and natural resources. Many of these assets are known for their ability to provide inflation protection. Commodities, for instance, tend to see price increases during periods of inflation. Therefore, investments in real assets are typically chosen as a way to hedge against inflation.

Portfolio Construction: Learning Module 3: Asset Allocation to Alternative Investments; Los 3(a) Explain the roles that alternative investments play in multi-asset portfolios