Searching for a Common Definition of Alternatives

By Stephen Scott

July 29, 2016

Let’s be honest. We’ve talked about “alternatives strategies” for decades without a clear consensus about what that actually means.

What’s more, many investors use the terms “hedge funds” and “alternatives” interchangeably, adding to the confusion.

Are alternatives an asset class, an investment strategy or an investment structure? An internet search only leaves you more baffled:

Investopedia: “Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors.” “Alternative: one of the two or more ways of achieving the same desired end or goal.”

Wikipedia: “An alternative investment is an investment in asset classes other than stocks, bonds, and cash.”

The agonizing search for quality

It’s no wonder that advisors are frustrated by the lack of quality options available in the alternative investment space. How can we define what quality looks like, and how to properly structure your portfolio to make the most of it, if we can’t agree on what alternatives are in the first place?

There’s a clearer path forward, and it’s not as complicated as you might think. Bear with me for a minute as we go back to the basics.

An alternative to what?
What are most investors seeking? Better performance through properly diversified portfolios. Most of us can agree that “better performance” means making more money.

But what about diversification? According to Investopedia: “Diversification is a risk management technique that mixes a wide variety of investments within a portfolio.”

So, let’s agree that investors are looking for any investment they make to deliver both performance (returns) and diversification (risk management).

Most investors today have 60/40 stocks and bonds portfolios, so they’re currently taking two types of risk:

  1. Equity risk: the ownership risk tied to the change in stock prices
  2. Bond risk: the lending risk tied to the credit worthiness of the borrower and interest rate environment

If the point of adding something “alternative” to your portfolio is for it to accomplish these same two goals (returns + risk management) in a “different” way, then alternatives should help investors take a different type of risk.

By doing so, investors add more diversification, which has the potential to increase portfolio performance. Mission accomplished, right? So, following that line of logic, by definition alternatives should offer investors a different type of risk—one that’s alternative to that of stocks and bonds. Or put more simply: alternative strategies produce returns by taking risk other than equity and bond risk.

Searching for a Common Definition of Alternatives

The role of alternatives in a portfolio
This simple definition can help clear up confusion. But savvy investors who want a deeper understanding will ask: why do we need an alternative source of risk in our portfolios in the first place?

Seeking an alternative source of risk increases the likelihood that an asset may remain uncorrelated to stocks and bonds, especially in challenging environments. This is because alternatives are tapping into fundamentally different economic principles.

Quality alternative investments are not just different to be different. They’re different with an expressed purpose: to deliver diversification and give investors a real rate of return.

That’s a meaningful benefit that any investor can understand.