Updated July 2017 — Diversity is a good thing — especially in a time of volatility. Knowledgeable investors may want to explore alternative routes to traditional equity and bond choices as one way to help manage potential risk to their portfolios.
But even the sharpest minds may have difficulty sorting through some of the terminology associated with alternative investments. Here, Adam Taback, Deputy Chief Investment Officer, Wells Fargo Private Bank, and Head of Global Alternative Investments for Wells Fargo Investment Institute, talks about four alternative investment strategies — equity hedge, relative value, event driven, and macro — that may help unlock value or complement traditional equity and fixed income allocations.
"These four strategies have historically helped to generate superior risk-adjusted returns," says Taback, adding that these strategies often have lower correlation to traditional investments, meaning they have shown the ability to potentially produce greater returns with less volatility. "The potential benefit is being able to participate in upward-moving markets while being strategic in challenging markets, and being able to utilize additional tools, which are not readily available with traditional equity and fixed-income investments, to help achieve those objectives."
Overview: Identifies opportunities in the investable equity universe through a combination of traditional purchases and short sales.
Equity hedge strategy, explains Taback, maintains long and short positions in primarily equity and equity-derivative securities. It's also known as long/short equity for this reason — investors can buy long equities, expecting their value to increase, or sell short equities, expecting their value to decrease. Typically, these strategies focus on the potential gains of the long-term play, says Taback, "with that long exposure slightly offset by the exposure on the short."
- Net exposure: The difference between a fund's long position and its short position. If 60 percent of a fund is in long positions and 40 percent is short, for example, then the fund's net exposure is 20 percent.
- Short selling: The selling of a security that the seller does not own, or any sale that's completed by the delivery of a security borrowed by the seller. Short sellers assume that they'll be able to buy the stock in the future at a lower price than the price at which they sold short.
Overview: More conservative than equity hedge; focuses on fixed income and loan markets.
"This strategy is predicated on the realization of a small valuation discrepancy between multiple securities," says Taback. Similar to an equity hedge, investors typically hold both long and short positions in an attempt to avoid exposure to volatility.
- Arbitrage: Let's say you buy apples at Sally's Farmers Market for $1 a pound, and then resell them at Sam's Farmers Market for $2 a pound — that's the basic premise of relative value arbitrage, or simultaneously selling one instrument while buying another to take advantage of price differentials.
- Investing in pairs: Purchasing two securities in the same sector, with a long position in one and a short position in the other, hoping that the long position will provide gains to offset any losses in the short position.
Overview: Investing with a focus toward "catalyst" events, such as company spinoffs, mergers and acquisitions, or security issuance. For example, you might invest in a security with the expectation of influencing the management or strategy of a company.
Often, investors see opportunities to use their experience to help a company succeed. The typical event-driven move, according to Taback, is to purchase a large position in a company's stock. By gaining a voice with management or the board of directors, the investor can recommend ways to better position the company for growth and stock price appreciation.
- Shareholder value: A firm's proven performance – growing earnings, earning dividends, and increasing share price.
- Intrinsic value (true value): This valuation of a company or an asset takes into account both tangible and intangible factors – including talent and potential for growth.
- Exploiting price inefficiencies: Due to market fluctuations, stocks may be undervalued or overvalued at any given point. Investors generally have a very short timeframe to act on any price inefficiencies.
Overview: Strategy based on economic fundamentals and historical performance; adds diversification.
The macro strategy tends to perform particularly well in highly volatile environments. It tracks upward and downward movements in underlying economic variables and the impact these have on equity, fixed income, credit, hard currency, and commodity markets around the world. For example, if an investor sees economic data suggesting a country is going into recession, he or she may adjust investments to underweight securities in that country.
- Directional trading: Making long or short plays depending on the investor's idea of where the market or security is heading in the short term.
- Non-directional trading: Investing based on relative value principles rather than market shifts.
The takeaway: Why your investment professional may suggest exploring alternative strategies
- Greater potential for diversification to help "smooth the ride" for investors especially during periods of market volatility
- Historically low or non-correlation to traditional investments
- Potential to minimize market cycle peaks and troughs
- Exposure to a broader range of investment opportunities and strategies not broadly available
- Potential for improved risk-adjusted returns
- Diversified income streams (for investors seeking income)
"It's important for investors to work with their investment professionals to understand alternative investments and how they can complement their long-term goals," says Taback.
"There are also considerations that investors will need to understand before deciding if alternative strategies are right for their portfolios, such as different investment risk considerations, liquidity considerations, and, depending on the strategies/funds used, potentially tax-reporting considerations."