When constructing an investment portfolio, it is important to consider how much exposure should be given to ‘alternatives’.
Away from the mainstream asset classes – typically regarded as cash, fixed interest securities and equities – alternative investments should offer the potential for higher growth and/or risk reduction through greater diversification.
With relatively low returns forecast for mainstream investment types, it is understandable why investors might consider alternative investments within their portfolios.
Some new research from Architas, reported in Portfolio Adviser, has found that alternatives make up 12% of the value of the funds within the IMA mixed investment sectors, what used to be referred to as cautious or balanced managed funds.
Of this 12%, commodities made up 22% and hedge funds made up 20%. There was also 17% in absolute returns, 14% in property and 8% in private equity.
Investing in alternatives can introduce risk to a portfolio. There is also the danger of duplicating exposure.
For example, investors with exposure to the UK stock market would already have indirect investments in commodities through the shares of mining companies, which make up as much as a third of the market capitalisation of the FTSE 100 index of leading UK company shares.
Making a separate commodities investment could dramatically increase the risk profile of such a portfolio.
Exposure to alternatives also requires a much higher level of due diligence. Whilst mainstream asset classes are relatively easy to understand, the broad descriptions of an alternative asset class (such as ‘absolute return’) can cover a multitude of different investment strategies.
Where alternatives are used for genuine performance enhancing or risk mitigation reasons, they can have a valid place in a wider investment portfolio.
Where they are being used to increase the remuneration of the fund manager or mask a riskier than necessary investment strategy, alternatives must be treated with real caution.
Photo credit: Flickr/Martin Deutsch
