How to incorporate alternatives into your portfolio
To accomplish any objective, it is essential to have a plan. If you’re interested in alternative investments, following the multi-step process below can help you think about how you may fit these assets into your portfolio:
Define your investment objectives. As I wrote earlier, like stocks and bonds, alternative investments are simply tools investors use in an effort to achieve their investment goals. To this end, it is important for investors to define their investment objectives so they can evaluate whether or not different investments can potentially help them be successful.
Identify those alternatives that are consistent with your objectives. Given the myriad alternatives available, a major challenge for investors is figuring out which ones best fit their current goals. To help investors navigate this challenge, Invesco has created an investment framework that organizes the liquid alternatives universe around common objectives:
Research specific funds. Once investors have decided which strategies they want to incorporate, they need to select the specific funds in which they will invest. Importantly, an investor should invest in a fund only after they understand its unique characteristics (such as expected return and risk), what constitutes a favorable/unfavorable environment, expected performance during different market cycle periods and key drivers of return. To assist their research, investors can find a wealth of information on the websites of the various fund providers, on fund research sites such as Morningstar, and of course from their financial advisor.
Consider management structure and style. Investors should decide if they prefer a single-manager fund or a multi-manager fund. The advantage of a single-manager fund is the investor can be targeted in their approach — single-manager funds usually have a well-defined investment style. The disadvantage of a single-manager fund is the investor is taking on manager risk (i.e., the risk of selecting an underperforming manager). To help mitigate manager risk, the investor can divide assets among multiple managers, thus limiting their exposure to any specific manager.
The advantage of a multi-manager fund is that it allocates across multiple managers (and usually across multiple strategies). The disadvantage of multi-manager funds is the allocation across managers and strategies typically fluctuates, thus limiting an investor’s ability to be targeted in their exposure to a particular strategy.
Decide how much to invest in alternatives. There is no single correct answer as to how much to invest in alternatives. In my experience, investors typically allocate between 5% and 30% of their portfolio to alternatives, which is consistent with what I hear from investment firms. The percentage an investor allocates to alternatives is typically driven by their risk tolerance and comfort level. However, I believe that if an investor does decide to move into alternatives, the amount allocated should be large enough to have an impact on the portfolio. If the allocation is too small, the impact on the portfolio will be negligible, thus defeating the purpose of diversifying into alternatives.
Determine how to fund the investment in alternatives. I am a big believer that asset allocation is as much an art as a science. Furthermore, investors have their own unique investment objectives that will drive asset allocation decisions. As a result, there is no one-size-fits-all answer to the question of how to fund an allocation to alternatives. That said, below are two approaches to consider:
- Allocate proportionately away from stocks and bonds. For example, if an investor wants to allocate 10% of a portfolio to alternatives, they could fund the allocation by reducing their fixed income allocation by 10% and their equity allocation by 10%.
- Allocate based on the return and risk characteristics of the alternative. Under this strategy, if the alternative has predominantly equity-like return and risk characteristics, they would reduce their equity allocation to fund the investment. Similarly, if the alternative has predominantly fixed income-like characteristics, they would take the money from their fixed income allocation.
A final thought
I have one final thought for investors looking to incorporate alternatives into their portfolios: Have a forward-looking perspective and be disciplined. In my experience, a wise approach is forward-looking and builds a portfolio based on what’s on the horizon. Such investors reject a backward-looking approach in which investment decisions are based on the previous market environment. They are also disciplined with regard to their investment approach. Once the decision is made to add alternatives, disciplined investors make alternatives a core holding and allocate based on the long-term expected benefit to the portfolio. As a result, this approach avoids the biggest and most common mistake I see with regard to alternatives — namely, performance chasing.
I hope this “summer school” series has helped you brush up on your alternatives knowledge and prepared you for making decisions in the second half of the year. To learn more about Invesco and our alternative investment options, please visit invesco.com/alternatives.
Read Part 1: What are alternative investments?
Read Part 2: Why invest in alternatives?
Read Part 3: How have alternatives performed?
Alternative products typically hold more nontraditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
There can be no assurance the investments discussed will perform as expected, or that past performance indicates future results.
The PowerShares DB Agriculture Fund (NYSE:DBA) closed at $18.60 on Friday, down $-0.04 (-0.21%). Year-to-date, DBA has declined -6.86%, versus a 11.90% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.