One question that frequently comes up in meetings with clients is, "What do you consider an alternative investment and how does it fit into my portfolio?" This is a great question because there are many investments that fall under the alternative category. Some are more straightforward than others, but understanding why certain funds are included in a portfolio is every client's right. This article should shed some light on the benefits that alternatives can provide to an investment portfolio.
While we do not believe alternatives should be an overwhelming part of your investment portfolio, ignoring the category altogether would be a mistake. The main goal of including alternatives is to reduce overall volatility while still providing a reasonable return. To achieve this goal, the Bremer investment committee chooses alternative investments that have a low correlation to the equity and bond markets. Currently, these categories include real estate, global infrastructure, and a multi-strategy hedge fund. All of the current investment vehicles that Bremer uses are operated under a standard mutual fund structure.
This is important because some alternative investments can be very illiquid. The funds in the Bremer strategic portfolios are all bought and sold in the same manner as an S&P 500 Index fund, at daily closing prices.
The chart below provides index performance information for the three alternative categories where Bremer currently allocates client money, along with the S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index. The return information looks at three periods of extreme market moves and then at the last 17 years, which includes most of all three of the extreme periods.
The first period to consider is the technology bubble of the early 2000s. Over the three-and-a-half-year period indicated on the graph, bonds and U.S. real estate performed the best. This is easily explained by the Federal Reserve’s move to reduce interest rates from 6.5% down to 1%. An interest rate reduction of that magnitude will always help the general bond market and in most cases cause real estate prices to increase due to the availability of cheap financing. Stocks were led downward by investor over-exuberance for technology companies. Global infrastructure and multi-strategy hedge funds ended in the middle of the group.
The second period to examine is the most recent financial crisis. The category performance during this period has a similar tone to the tech bubble period, with a twist. Once again, the Federal Reserve drastically reduced interest rates from 5.25% to 0% and implemented quantitative easing to soak up the excess assets in the financial system. Bonds did well again, but real estate did not. The explanation is that this time, real estate replaced technology stocks as the asset subject to investor exuberance. Global infrastructure was hurt in a similar manner due to government money being used to bail out banks and keep the financial system afloat. On a global basis, investments in bridges, roads and airports declined dramatically during this time. Stocks ended up negative during the period, with multi-strategy hedge managing to create a small gain.
The third period is the current bull market. One thing to point out is that the time period analyzed only runs through March 2017. This is due to limited data for the global infrastructure index. Most of the time period is captured and provides a reasonable comparison. Stocks and real estate have performed the best by a wide margin due to the Federal Reserve’s cautiousness in raising interest rates. The Fed has had a dovish stance since the financial crisis with the intent of averting another recession. Multi-strategy hedge comes in a respectable third, with bonds and global infrastructure plodding along.
Looking at the final period from 2001 through 2017, you will see that real estate and multi-strategy hedge funds performed the best, followed by stocks, bonds and global infrastructure. Now that the history lesson is done, the question remains: "Why would someone want to invest in alternative asset classes?" As we walked through the different time periods, one thing to notice is only two categories were positive in every time frame – bonds and multi-strategy hedge funds. Neither category obtained returns above 10% on an annual basis, but neither category went below about 1.5% annually. Real estate and stocks were rather volatile, with global infrastructure a little less so.
To completely answer the "why" question, consider the viewpoints of the Bremer investment committee.
- We include multi-strategy hedge in our strategic portfolios to provide a less volatile return over the long term. (One thing to note is that you cannot directly invest in the index used in the graph, so the fund that we have chosen will not behave exactly like Credit Suisse Index, but we believe it is a reasonable approximation.)
- Real estate is considered to be a better opportunity because of pent-up demand due to the lack of new housing coming out of the financial crisis. The unemployment rate was near 10% entering 2010. Currently, the unemployment rate is 4.1%. It has taken a long time to get to this point, but now millennials who have been graduating from college are finding employment, building wealth, buying homes and starting families. This dynamic can be a solid driver for real estate in the U.S. going forward.
- Global dynamics will eventually lead to huge infrastructure projects. For example, there are countries in the Middle East with the goal of moving their economies from being oil dependent to being driven by tourism. Traffic in India, a country of more than one billion people, is horrendous. Electric vehicles are replacing those that run on internal combustion engines, and they need a place to recharge. These are just a few of the global dynamics that will lead to huge infrastructure projects.