Alternative Asset Investments May Help When Stocks Decline

In a Bear Market, Investment Diversification is an Attractive Option

Diversifying your portfolio with alternative asset investments is a necessary step to help cushion your portfolio against stock market volatility. While the last bear market in early 2020 (spurred by the COVID-19 pandemic) was the shortest in Wall Street history, bear markets have lasted as long as 61 months. In order to prevent major losses, it’s important to consider other asset classes, from real estate to precious metals to private equity.

Bear Markets and Diversification

A bear market is one in which market indices such as the S&P 500 and Dow Jones Industrial Average decline at least 20% over a two-month period or longer. Since 1932, bear markets have occurred every 56 months on average, according to Kiplinger.

No one knows, of course, when a bear market will occur. Maybe a pandemic will hit, or stock prices will continue rising short term, but being prepared for a potential drop by diversifying your portfolio could help prevent major losses.

Even in stable years, investors should expect sudden periods of volatility. Pullbacks by as much as 5% are quite normal. Historically, though, the frequency of corrections increases as a bull market ages, so recent market volatility could continue. That’s why the present moment may be a good time to explore diversification opportunities that could offer a way to temper the impact of sudden downdrafts on a portfolio.

Different Alternative Investments for Diversification

Jeffrey Kelley, the senior vice president of Equity Institutional, explains that investors should periodically review their investment diversification.

“To reduce portfolio volatility, the financial advisers I talk to typically encourage their clients to review their portfolios periodically to see if their diversification strategy still aligns with their investment objectives,” Kelley says.

The impact of asset allocation on volatility and returns has been studied for decades. Kelley points to a study that showed how diversifying among a variety of asset classes—and keeping a steady allocation through rebalancing—accounted for more than 90% of the variation in the quarterly returns of the 91 large U.S. pension funds for the period 1974 to 1983.

To guide their clients, Wells Fargo Investment Institute published a bear market action list with five steps:

1. Revisit asset allocation.
2. Rebalance regularly.
3. Broaden exposure to risk-mitigating assets.
4. Look for tactical opportunities late in the business cycle.
5. Be active and smart, particularly when including alternative investments.

As a counterpoint to rising stock prices, they urged investors to better understand the role alternative investments might play in a portfolio. Illustrating the performance of a 50/50 blend of hedge funds and private equity versus a fixed-income portfolio and a developed market equity portfolio. The alternative option helped manage volatility and reduced downside risk while still participating in up markets.

As the current business cycle gradually ages, alternatives with inflation-resistant properties have merit, too. Hedge funds, private equity, and REITs (real estate investment trust) have all demonstrated their capacity to reduce risk and still deliver an attractive level of risk-adjusted return.

According to Forbes’ Javier Estrada, the enduring luster of precious metals like gold can also play a role in buffering a portfolio against downward volatility. Citing his research for the Journal of Wealth Management, Mr. Estrada demonstrated that a 20% portfolio allocation to gold would have substantially lowered risk during both the high-tech sell-off in 2000-2002 and the global crisis of 2007-2009.

For these reasons, alternative assets are becoming more popular. One Preqin report found the following:

• 81% of investors expect their allocation to alternatives to increase by 2025.
• 79% of investors expect to invest more capital into private equity by 2025.
• Public pension funds have been increasing allocations to alternative assets from 18.1% in 2010 to 30.3% in 2020.
• 49% of investors expect to use pooled vehicles to invest in alternatives in coming years.

Investment Diversification Is Almost Always a Winning Strategy

So what is the role of alternative asset investments?

While I’ve already mentioned that historically, asset allocation has helped reduce volatility, a traditional allocation of stocks, bonds, and cash equivalents may not provide the asset diversity needed to manage risk adequately.

Stock and bond prices have generally moved in opposite directions, so a loss in one asset class could be buffered to some degree by a gain in another asset class. However, as investors saw during the global sell-off in 2007-2009, traditional asset classes like stocks and bonds can occasionally move downward simultaneously.

At the same time, different alternative investments have been proven to have either no correlation or little/negative correlation with the price behavior of stocks or bonds. If an asset class has a negative correlation with stocks, it typically will drop in value when stocks rise in value. Conversely, it will likely rise in value when stocks drop.

A Wide Spectrum of Alternative Investments

There are many different alternative assets for investors to consider. By its broadest definition, alternatives include all assets that are neither stocks nor bonds. Private equity, including investments made through crowdfunding platforms, is an example. Many, though, think of alternative assets as hard assets or real assets, tangible items that hold inherent value, such as real estate, currency, and commodities.

Gold is an alternative that people have been investing in for 2,700 years. Corn and grain, farmland, timber, and managed futures are alternative assets. There are also a variety of alternative strategies, which revolve around a specific approach to investment, rather than specific assets. A few examples include long or short, market-neutral, and opportunistic investment strategies.

What Should Investors Do Before Investing in Alternatives?

Kelley says investors interested in alternative investments should speak with a financial professional.

“Because the investments are usually complex, alt-minded investors should speak to their financial professional before making a commitment,” Kelley said. “The custody of alternative assets such as real estate investment trusts, mortgage notes, limited partnerships, limited liability corporations, precious metals, joint ventures and private equity can be substantially different from traditional investments.”

Kelley added that there are also administrative benefits to working with financial professionals.

“Choosing an adviser who works with a custodian that specializes in alternatives can help simplify the administration process, too,” Kelley said. “For the retirement-minded, alternative opportunities can be accessed through individual retirement accounts such as self-directed IRAs.”

To manage expectations, it’s important to have enough knowledge of different alternative asset investments to understand how to use them to diversify. It’s important to recognize that alternative investments can also be volatile—and like other investments, they involve risk, including possible loss of principal.

While no one knows when the next bear market will occur, investing a portion of your portfolio in alternative assets may help tame future bears.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following webinars: PE, VC, and Hedge Funds De-Mystified and All About Asset Allocation. This is an updated version of an article originally published on April 1, 2019.]

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