What is an alternative investment? Find out if they’re right for you

In most investment portfolios, increased wealth means increased complexity, as well as the investors' desire to build and maintain their existing capital. As volatility continues in global markets, many high-net-worth investors are looking to reduce their exposure to traditional stocks and bonds in an effort to generate absolute returns.

Some sophisticated investors are turning to alternative investments — such as private equity, real estate, infrastructure and hedge funds — as a way to diversify and stabilize their portfolios. Alternative assets may provide higher yields than bonds and more stability than stocks.

“Alternative assets give investors the ability to add value in a portfolio in a way they don't have in the public markets with traditional stocks and bonds,” says Michael Kitt, head of real estate equity investments at RBC Global Asset Management.

According to research by The Economist Intelligence Unit (EIU), commissioned by RBC Wealth Management, 34 percent of high-net-worth (HNW) investors in Canada say they prefer to invest in real estate and 64 percent specifically invest in alternatives, such as hedge funds.

The New wealth rising survey targets high-net-worth individuals (HNWIs), adult children of HNWIs, and high-earning professionals across Canada, the U.S., UK, China, Hong Kong, Singapore and Taiwan. It looks at the shifting landscape of global wealth, where wealth will be, what it will be invested in, how it will be invested and who is investing.

Alternatives can provide diversified asset classes with a low correlation to stocks and bonds. "The result is they reduce the volatility of your overall portfolio which, in turn, can lead to better risk-adjusted returns," says Kitt, who has extensive experience in the global real estate sector.

“Alternatives can positively contribute to your portfolio in many different ways,” Kitt says.

Some alternative assets also provide steady cash flow and are linked to inflation, which Kitt says provides some protection to the real value of portfolios. These are all critical factors for investors seeking to build more stable returns over the long term.

Alternatives no longer just for institutional investors

Alternative assets have traditionally been the domain of large institutional investors, such as pension funds, due to their complex financial structures. Changing technology and regulations have opened up the space to other types of investors including smaller institutions, accredited investors and HNWIs, and ultra-high-net-worth (UHNW) families.

These investors often have investable assets equal to some institutional clients, and Hermann Leiningen, managing director, international family office investments in the Enterprise Strategic Client Group at Royal Bank of Canada, says this allows them to diversify into other asset classes.

He says alternative assets become more interesting late in a market cycle as investors anticipate a rise in volatility across parts of their portfolio. “The higher stocks go, the more investors look to diversify in anticipation of when volatility comes back.” Investors should hedge away – and prepare for — some additional risk in a stock portfolio, adds Leiningen.

He notes that more investors began inquiring about alternative assets, such as real estate, private equity and hedge funds, in the years following the 2008-09 global recession.

For clients around the world who want to move beyond stocks, bonds and cash, alternative investments can be “a great addition to their portfolio,” Leiningen adds.

According to the New wealth rising survey, most respondents expect their investment strategy to change in the next five years, with limiting risk and diversification as key drivers.

Characteristics of alternative assets

While alternative assets have many upsides, investors must also be comfortable with some of the drawbacks, including limited liquidity when compared to traditional investments such as stocks, mutual funds and exchange-traded funds. With these complex asset classes comes higher management fees too, which should also be taken into consideration.

While alternatives can be one way of diversifying your portfolio, investors should seek the guidance of a professional to ensure a broad range of asset classes are being utilized.

“It's important that a client is aware of the risk, as well as how the alternative assets work, and how they perform,” Leiningen says.

Alternative investments may also be more difficult to access than traditional investments, says Kitt.

“It's one thing to build a do-it-yourself stock portfolio online. You can't do that with alternative investments,” he adds. “There isn't a long list of ways for individuals to invest in the private markets. Access remains challenging.”

Seek professional advice when investing in alternatives

Investors looking to add alternatives to their portfolio should have a clear understanding of the products, which can be best offered through professional managers who specialize in the asset class. “You need to understand what you're buying, why, and how it will fit into your portfolio,” Kitt says.

Professional advisors can also help determine if a particular asset class, such as private real estate or infrastructure, is the right fit for your overall portfolio. For instance, if an investor already owns a lot of real estate they may wish to explore private equity or another alternative asset class outside of the real estate sector to ensure better diversification. Kitt recommends the alternative investment and asset class be aligned with the investor's financial plan, including their risk tolerance, asset allocation, values and longer-term investment goals.

Kitt says investors may also want to distinguish between privately-managed alternative assets, such as public-private infrastructure funds or private multi-family residential holdings, and similar-style assets offered in the public markets, such as a real estate investment trust (REIT) or an infrastructure-based mutual fund.

The publicly-traded funds are often correlated to the stock markets which, Kitt says, means they may not offer the same diversification as a privately-managed alternative asset. “The kind of products you put in your portfolio, with a goal of diversification or lowering volatility in the portfolio, that's what really matters,” Kitt says.

Kitt also cautions due diligence when selecting where to make private alternative investments. He recommends choosing reputable firms with professionals who have experience and a successful track record of managing alternative assets.

As the investing world becomes more complex and private investments grow more important, the value of professional management and experience “has never been greater,” adds Kitt.