Why to Invest in Alternative Investments

Over the last 2 to 3 years the percentage of our client portfolios invested in alternative investments has increased from 10 percent to around 30 percent.

First, as the definition of alternative investments is somewhat open for interpretation we define the following assets as alternatives:

* Real Estate

* Commodities

* Insurance Linked Securities

* All Asset Variance Risk Premium Option Strategy

Most investors are familiar with real estate and commodities, but few are familiar with the latter two investment categories.

Insurance Linked Securities is essentially an investment that puts an investor in the same position as an insurance company without the equity risk. The investment makes money by collecting premiums and losses money when there is a major insurable event (hurricane, earthquake, etc.).

Our variance risk premium strategy continually sells options on 25-30 different non-correlated asset classes on both sides of the market. Over the long term most of these options sold will expire worthless and we get to keep the premium. We lose if the underlying asset moves in price by a large percentage in a short period of time.

Both of these strategies are unique in the fact that they should produce durable ‘equity-like’ rates of returns over the long term and have little or no correlation to the stock or bond markets.

An equally important point is why we have steadily increased exposure in the alternative area over the past several years. There are three main reasons for the move highlighted below:

1. Lower Expected future total returns in US Stocks/Bonds: As the stock market has increased in value over 200% since 2009 the trailing P/E of the S&P 500 now stands at about 18. In addition the ‘Schiller P/E’, a more accurate and predictive measure of valuation, is much higher (27 or so). These valuation levels along with slow earnings/revenue growth seem to indicate the future returns on the domestic stock market will be much lower over the next decade.  High quality US bonds, with yields anywhere from 1.9 to 3.5 percent also have much lower than historical return potential.

2. Possible Lower Diversification/Risk Reduction Benefits From Bonds: Because bonds have very low yields and the risk/return equation is quite different then much of the last century the benefits of holding these investments has decreased substantially. To be sure most investors still need some exposure in this area to hedge against an equity position, but you have to be very careful in constructing portfolios with traditional assumptions.

3. Availability of more liquid/beta-driven ‘True’ Alternatives:  Recently alternative forms of risk/return have become accessible to traditional investors. The strategies mentioned above are BETA driven forms of returns and risk that are not correlated to any other financial asset class. The returns are not dependent on the managers picking winning stocks, trends, etc., but simply getting us access to another form of return ‘passively’.

Because of lower expected returns and risk reduction benefits in traditional asset classes we feel the move into viable alternatives is necessary in keeping risk in line with our mandate and maximizing our client future returns.

To learn more about Eric Mancini, view his Paladin Registry profile.

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