Alternative Investments: An Array of Tools for Diversifying Your Portfolio

The term “alternative investments” denotes a broad category of investment products and strategies that fall outside the traditional purchase and sale of stocks and bonds. Hedge funds, private equity, private credit and real estate are the most familiar examples.

Alternative investments have gained popularity in recent decades as money managers search for new ways to grow and preserve assets for their clients. Their appeal lies in the potential to enhance risk-adjusted performance and help investors achieve additional portfolio diversification.

Alternative investments versus traditional investments: How they differ

Alternative investments vary widely in their objectives, focus, strategies, style and other factors. In general, alternative investment managers employ an array of tools more varied than those used by traditional asset managers, and they pursue different strategies.

For example, traditional managers generally seek to outperform a specific benchmark, while alternative investment managers focus on absolute performance. In addition, while traditional funds are generally fully invested, hedge fund managers often pursue an opportunistic approach. Private equity managers typically call committed capital over time, that is, require investors contribute more as agreed upon.

Correlation is another important differentiator: Unlike traditional investments, alternative investments, such as hedge funds, tend to have a lower degree of correlation with the equity and bond markets. Because alternative investments behave differently from traditional asset classes, including them in your portfolio may add a measure of diversification in various market conditions.

Citi Personal Wealth Management offers clients a wide array of investment opportunities. Citi’s global network allows access to innovative products and strategies from some of the industry’s most accomplished investment professionals.

The alternative investment universe encompasses a broad range of asset classes, styles and strategies. The most common categories include:

Hedge funds

Hedge funds invest in a variety of financial instruments and may use leverage, short positions or other investment techniques as well as instruments such as derivatives and futures.

An allocation to hedge funds may potentially result in reduced portfolio volatility, while offering the potential for downside protection in declining markets. Keep in mind, however, that hedge funds can be illiquid. In addition, they are typically characterized by a lack of transparency and a sensitivity to market volatility, and may not be able to achieve their objectives in all market conditions. Because hedge funds employ leveraging, they may experience greater volatility than traditional investments.

What strategies do hedge fund managers use?

While strategies vary widely, the following are typical:

• Equity long/short. Utilizes a “double-alpha”* strategy by investing in stocks that the manager expects to outperform the market and shorting those the manager expects to underperform.
• Event driven and credit. Seeks to invest in opportunities created by significant transactional events such as spin-offs, mergers and acquisitions, bankruptcies, recapitalizations, and share buybacks.
• Global macro and commodity trading advisor (CTA). Attempts to identify trends based on both fundamental and technical analysis and generate returns by making leveraged trades in liquid markets such as interest rates, currencies, equities, energy, agriculture, metals and other commodity markets.
• Relative value. Seeks to take advantage of specific pricing anomalies and dislocations, while also seeking to maintain minimal exposure to overall market direction.
• Multistrategy. Engages in a variety of investment strategies, including those listed above.
• Hedge fund of funds. Allocates capital to a range of underlying hedge fund managers in an attempt to diversify risk.

^* Alpha: A measure of the excess return on an investment relative to a benchmark. Alpha quantifies a manager’s value added relative to a passive strategy, independent of the market movement.

Private equity

A private equity fund uses investment capital raised from high-net-worth individuals, institutions, or managed funds and others to finance startups, purchase ownership stakes in privately held companies, or buy out mature or private enterprises. Investments can include leveraged buyouts, venture capital, mezzanine funding and other direct investments in companies.

Private equity funds attempt to identify promising companies with growth potential or other desirable attributes. Note, however, that private equity investments are often volatile and illiquid, and managers may employ significant leverage.

Real estate

As a rule, real estate investments are structured as managed funds, clubs and direct deals that invest directly in real estate, including commercial property (for example, offices, retail parks, hotels, health care facilities and industrial buildings) and residential housing. Real estate may exhibit characteristics of both equities and bonds. That is, the cash flow from rental properties can provide income, while capital appreciation is possible. Note, however, that real estate investments are Illiquid, and there is a very limited secondary market for private funds.

Low correlation with traditional asset classes. Not all investments or asset classes are positively correlated. That is, they do not necessarily move in tandem in the same direction. The term “reduced correlation” denotes a relationship between two assets that tend to perform differently under similar market conditions—for example, when one asset declines in value, the other declines less or rises. Because certain alternative investments are designed to have relatively low correlation to traditional investments, such as stocks and bonds, they may provide diversification benefits and potentially reduce overall portfolio volatility if they are able to successfully execute their investment strategies.

Potential for attractive risk-adjusted returns. Alternative managers may use short selling, leverage and derivatives to hedge risk and maximize return— strategies not ordinarily available to traditional fund managers. These strategies are designed to achieve enhanced returns for a given level of risk.

A focus on absolute returns. In most cases, traditional investment managers aim to outperform a market benchmark, such as the S&P 500 or the Russell 2000. Alternative investment managers, in contrast, typically seek consistent, positive returns—absolute returns— regardless of how the markets perform. There can be, however, no guarantee that any given investment strategy will be successful.

Keep in mind alternative investments can be complex and are not suitable for all investors.

Alternative investments are subject to certain risks above and beyond those associated with traditional investments. In particular:

• They often employ leveraging and other speculative or aggressive investment strategies that may result in loss of principal for investors.
• In strong markets, alternative investments may disappoint compared with traditional investments such as equities.
• In extremely poor conditions affecting markets overall, alternative investments may not provide their usual diversification benefits.
• Alternative investments are more complex and less transparent than traditional investments. Managers are not required to provide periodic pricing or valuation information to investors.
• Alternative investment managers may charge high fees.
• The extremely limited secondary market, along with the imposition of extended lockup periods and restrictions on transfers, makes alternative investments highly illiquid.
• Because hedge funds and private equity funds involve complex tax structures, there may be delays in the distribution of important tax information. Please consult with your tax advisor before investing.
• Alternative investments may be subject to less regulatory oversight than traditional investments and can result in significant loss.

Owning alternative investments can be more expensive than investing in traditional assets. In the case of hedge funds, manager compensation is usually based on the performance of the fund as well as assets under management. In addition, administration, placement and redemption fees may apply and vary from fund to fund, so refer to fund documents for specific details. Owning hedge funds may have tax implications. For guidance, talk to your tax advisor.