Non-vanilla to the rescue: Diversification and the role that alternatives can play in portfolios

Christian Armbruester, Chief Investment Officer at Blu Family Office, explains the vital role of alternatives in portfolio diversification and why private lending should be on your investment radar.

Much has been said and written about stocks and bonds. They are the stalwarts of more than 90% of typical investment portfolios in wealth management and any combination of stocks and bonds would have made you money over the last forty years. You really have to ask yourself, why do anything else?

Because both carry much of the same risk, as both are listed on exchanges. On the one hand, that allows us to buy and sell all of our holdings very easily and whenever we want. On the other hand, that means we are subject to market risk, which means they can both also go down together. Then there is timing, and if we get unlucky and buy when the markets are up, we could sit on huge losses of capital for a very long time. Note, it took more than 26 years to make your money back, if you got your timing wrong and bought just before the crash of 1929.

Achieving true diversification

So, what can we do to diversify ourselves from just holding two asset classes? Easy, invest in “alternatives”. Clearly, when the definition of an entire “asset class” is anything but stocks and bonds, the possible investment universe becomes very large: property, commodities, private equity, venture capital, hedge funds and all the different types of trading strategies there are. There is also fine art, wine, classic cars and nowadays there are even cryptocurrencies and other types of virtual and real assets.

So how to choose which strategies, products and instruments?  First priority: eliminate market risk. That’s pretty easy, in theory. Obviously, any asset that does not trade on an exchange does not carry market risk. But there is a contagion effect and, as we have seen many times in the past, property, commodities, and equities all go down in a crash. The only way to really diversify this type of risk is to invest in assets that go up in value as the markets go down.

There is a contagion effect and, as we have seen many times in the past, property, commodities, and equities all go down in a crash. The only way to really diversify this type of risk is to invest in assets that go up in value as the markets go down

So-called “market neutral” strategies hold assets that benefit from the market going up or down and the risk is in the relative movement of prices of the assets. These type of trading strategies take advantage of short-term mis-pricings between financial securities and protect capital when markets go down. As such, they are essential building blocks of any truly diversified investment portfolio.

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Top Tip

There was a time when a 60/40 split of equities and bonds was considered a good basis for a portfolio, but the investment environment of today calls for far more sophisticated asset allocation strategies. Minimising risk and maximising reward depend on intelligent diversification across asset classes, markets, currencies and instruments in a way that can be very difficult for DIY investors to achieve. Letting a professional look at your portfolio via our free matching service could head off some very expensive mistakes.
Lee Goggin - Co-Founder

Lee Goggin

Co-Founder

Risk realities

Second priority is to make sure the risks we take on are truly different to one another. In essence, stocks are a bet on growth; bonds on the soundness of the global financial system; and market-neutral trading strategies a means to extract inefficiencies in the marketplace. We can also take more idiosyncratic risks by investing in very specific situations, individual assets or borrowing arrangements.

Private lending, for example, whereby loans are extended to borrowers for a specific set of collateral, has existed long before exchanges were invented. Loans are made to term, which means we can’t just buy a bond and then sell it a day later. As a consequence, loans will perform unless there is a default, which is quite rare, as businesses and people that borrow tend to find ways to pay their debts, so they can stay in business or get back their collateral.

Shelter in a storm

Private equity or venture investments tend to be outsized bets on a particular company to grow at an increased rate. With so much of the value placed on a specific situation in an uncertain future, there is very little that will cause people to lose hope for the long term and their investment. As such, unless there are circumstances by which these investments have to be liquidated, most private equity and venture capital investments will be unaffected by short-term market conditions. There tends to be a fairly large illiquidity premium for these types of strategies, which in of itself makes them quite different to everything else.

Unless there are circumstances by which these investments have to be liquidated, most private equity and venture capital investments will be unaffected by short-term market conditions

There is more, much more, and by the time we uncover the intricacies of which painting or vintage of Bordeaux to buy, we will far exceed the capacity of this discussion. But the point is this: alternatives are much broader than stocks or bonds and contain many more different types of risk. As such, they also deserve a much bigger allocation in an efficient investment portfolio. As ever, buyer beware and consult experts before diving in, but one thing is for sure: If you are not diversified with alternatives in your investments, you are taking a very narrow view and very large risk on only two types of assets.

Alternatives are much broader than stocks or bonds and contain many more different types of risk. As such, they also deserve a much bigger allocation in an efficient investment portfolio

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