In my last post I discussed the primary asset classes (stocks and bonds) and their various subdivisions. In this post I will give an overview of some “alternative” investments. First we should define what an alternative investment actually is. There isn’t a precise definition, but broadly speaking it is an investment that is not one of the ones mentioned above (stocks and bonds). As noted previously, common stocks can be large-cap, mid-cap, small-cap, or micro-cap; growth or value or blend; domestic or international; and represent companies located in developed countries or emerging markets; nonetheless those would all generally be considered traditional investments. Similarly, investment grade bonds can be short term or long term; inflation adjusted or not; callable, putable, or neither; and taxable or non-taxable (i.e. municipals or “munis”) with none of those categories considered “alternative.”
A number of alternative investments are illiquid and don’t trade regularly so the prices are merely estimates. This leads to two statistical artifacts of note. First, the standard deviation (volatility) appears lower than it really is, and second, the correlation with other investments (generally the correlation being reported is with stocks) appears lower than it really is. The investments that are prone to having this issue (and having salespeople present what is in fact bad data as a purported advantage to the investment) include many types of hedge funds, non-traded REITs, timber investments, and directly owned real estate.
Another difference between traditional investments in stocks or bonds and alternative investments is the source of returns. Companies sell products or services and most of the time make a profit which investors then receive as a dividend, interest, or growth (in the case of government bonds, taxes pay the interest). Many alternative investments don’t have that tailwind, but rather depend on three things. First, that some investments are mispriced by enough to yield risk-adjusted excess returns even after transaction costs, search costs (the cost of finding the mispricing), overhead, etc. Second, that the manager can identify those mispriced securities in advance. Third, that the market will then recognize the “true” value of the investment and move it to that value over a reasonable period of time.
In addition, these types of investments frequently come with high risk, high correlations with stocks, and a great deal of illiquidity – though none of these may become apparent until there is market stress. Further, the distributions of returns are typically leptokurtic (extreme events happen more frequently than you would expect) and negatively skewed (those extreme events tend to be the bad ones, not the good ones).
With that out of the way, over the next few posts I will review various alternatives.