Alternative investments can help diversify a traditional portfolio for improved risk-adjusted returns.
Certain alternative investment strategies are now available to all investors, though it's key to understand risk and reward.
Hedge funds offer the potential to protect against volatility, while private capital may provide access to new markets.
We believe investors should consider diversifying portfolios with alternative Investments.
Helping investors understand alternative investments
Over the long term, traditional asset classes have performed well. Yet, in an uncertain world, risks in the economic and geopolitical landscape can negatively impact your portfolio. By incorporating alternative strategies we believe investors can build a portfolio that offers greater diversification in an effort to withstand challenging market environments.
Pensions, endowments, and institutional investors have long incorporated alternative investments, including hedge funds and private capital funds, in their asset allocation framework.
Alternative investments may improve portfolio results
History has shown that diversification — putting money into a variety of different types of investments or asset classes — generally has been an effective strategy to help manage a portfolio’s risk and return profile. True diversification, however, is more than a mix of traditional long-only stock, bond, and cash holdings.
Alternative investments can help diversify or complement a traditional portfolio through the types of investments owned or the techniques employed. Types of alternative investments include alternative mutual funds (liquid alternatives); private funds (hedge funds, managed futures, private equity, and private debt); and certain real assets, such as private real estate.
What alternative investments may deliver
Exposure to a broader range of investment opportunities and strategies
Potential for improved risk-adjusted returns
Less-extreme market cycle peaks and troughs
Access to less-efficient markets, which can create investment opportunities
Historically lower correlation — that is, they may respond differently to market conditions — versus traditional investments
Alternative mutual funds open the door to more investors
Until the relatively recent introduction of alternative mutual funds, the availability of alternative investment strategies was limited. With alternative mutual funds, or liquid alternatives, a broader range of investors now have access to certain alternative investment strategies. Alternative mutual funds attempt to employ many of the same investment strategies typically followed by hedge funds, which aim to further diversify a portfolio and lower its overall risk level.
Alternative mutual funds and private placements have some overlapping portfolio benefits but also significant differences that are important to understand before considering investing:
Alternative mutual funds
Greater flexibility and investment techniques than traditional stock and bond mutual funds
Broadest security and investment technique flexibility
Able to sell short securities and use leverage within regulatory limitations
Able to sell short securities and use leverage without regulatory limitations
Limited ability to invest in illiquid securities and strategies (including private equity and private debt) due to regulatory constraints
Can invest in illiquid securities and strategies (including private equity and private debt)
Daily liquidity and pricing
Less frequent liquidity and pricing
Simplified tax reporting
More complex tax reporting
Typically lower investment minimums
Typically higher investment minimums
Generally lower fees and expenses
Generally higher fees and expenses
There is no assurance traditional mutual funds or alternative mutual funds will achieve their investment objectives. All investing involves risks, including the possible loss of principal.
For important risk information related to these funds, please see the end of this report.
Hedge funds can add another dimension to portfolios
Hedge funds are private, pooled investments that generally are available only to qualified investors. Fund managers typically do not rely on the general movement of the equity or fixed-income markets as a key driver of returns. Instead, most have the flexibility to construct portfolios that seek to dampen market risk.
Months with significant negative returnsSource: MPI Stylus. Numbers indicate months with returns of less than -3%. Data based on historical performance from January 1, 1990, through December 31, 2022.
Helping investors win by not losing
Hedge funds have been able to help preserve capital during negative equity markets by experiencing only 21% of equity losses while maintaining participation in up markets by capturing 51% of positive equity returns.1
Looking at it another way, hedge funds have helped investors navigate difficult markets over the long term by experiencing significantly fewer negative months than equities.
Equities have experienced a much bumpier ride than hedge funds.
1 Source: MPI Stylus. Data as of June 30, 2021. Data since January 1, 1990, the inception of the HFRI Fund Weighted Composite Index. Up/down capture ratios are a measure of investment performance in up and down markets relative to the market itself. A down market is one in which the index’s quarterly return is less than zero.
Private capital may unlock significant opportunity
Many businesses today are choosing to remain private longer. In 1999, the average U.S. technology firm transitioned to the public markets after four years of operating history, and by 2019 that figure increased to 11 years.2 The additional seven years (on average) that the companies remained private meant that much of the value accrued during the early, faster growth phase of a firm’s lifecycle benefited private market investors.
Companies that remain private can avoid the burden and cost of regulatory requirements and focus on longer-term strategic plans, compared with public market entities that pay greater attention to shorter-term financial results. While there are advantages and disadvantages to each side, investors that can allocate across private and public markets may be able to capitalize on the broadest array of opportunities to reach their financial goals.
2 Source: UF Warrington College of Business website
Our strategic moderate growth and income allocation that includes alternative investments
Our belief is that many investors can benefit from alternative investments.
Alternative investments and real assets
Source: Wells Fargo Investment Institute. Allocations are current as of July 18, 2022.
This chart is for illustrative and information purposes only and does not constitute advice or a recommendation of any investment strategy, including strategies that allocate to alternative investments.
Diversification cannot eliminate the risk of fluctuating prices and uncertain returns.
Alternative investments, such as hedge funds, private capital, and private debt funds, are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws. They are speculative and involve a high degree of risk that is appropriate only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. Some of the risks associated with these funds include loss of all or a substantial portion of the investment due to leverage, short selling, or other speculative practices; lack of liquidity in that there may be no secondary market for a fund; volatility of returns; restrictions on transferring interests; potential lack of diversification and resulting higher risk due to concentration of trading authority when a single advisor is utilized; absence of information regarding valuations and pricing; complex tax structures and delays in tax reporting; less regulation and higher fees than mutual funds; and risks associated with the operations, personnel, and processes of the manager. An investor’s ability to withdraw capital from funds or partnerships may be subject to specific limitations, including initial “lock-up” periods, advance notification requirements, and predetermined “windows” for redemptions. Private debt strategies seek to actively improve the capital structure of a company often through debt restructuring and deleveraging measures. In private debt investments, an investor acts as a lender to private companies and loans have specific contractual interest rate terms and repayment schedules. Such investments are subject to potential default, limited liquidity, the creditworthiness of the private company, and the infrequent availability of independent credit ratings for them. Because of their distressed situation, private debt funds may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks. An investor should review the private placement memorandum, subscription agreement, and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.
Alternative mutual funds (liquid alternatives)
There is no assurance that traditional mutual funds or alternative mutual funds will achieve their investment objectives. All investing involves risks, including the possible loss of principal. Mutual funds that invest using alternative strategies are more complex investment vehicles. Relative to broad, long-only traditional asset class mutual funds, alternative mutual funds may employ more complex strategies, investments, and portfolio structures. Some of these risks include short selling, leverage, and the use of derivatives. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the fund. In addition, taking short positions in securities is a form of leverage, which may cause a portfolio to be more volatile. Leverage increases a fund’s sensitivity to market movements. The use of leverage in a portfolio varies by investment strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivative prices depend on the performance of an underlying asset. A small movement in the price of the underlying asset may produce a disproportionate large movement, whether favorable or unfavorable, in the price of the derivative instrument. Derivatives generally have implied leverage, which can magnify volatility and may entail other risks such as market, interest rate, credit, liquidity, counterparty, and management risks. Alternative mutual funds may hold investments that may be difficult to value. At times, the fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks may apply as well, depending on the specific fund. Before considering, investors should carefully read the investment fund prospectus.
Each asset class has its own risk and return characteristics, which should be evaluated carefully before making any investment decision. Both stocks and bonds involve risk, and their returns and risk levels can vary depending on prevailing market and economic conditions. Stocks are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Small-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to interest rate, credit/default, liquidity, inflation, and other risks. Bond prices fluctuate inversely to changes in interest rates. Foreign investing entails risks not typically associated with investing domestically, such as currency, political, economic, and different accounting risks. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.
Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.
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Hedge funds: The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in U.S. dollars and have a minimum of $50 million under management or a 12-month track record of active performance. The HFRI Fund Weighted Composite Index does not include funds of hedge funds.
Note: HFRI indexes have limitations (some of which are typical of other widely used indexes). These limitations include survivorship bias (the returns of the indexes may not be representative of all the hedge funds in the universe because of the tendency of lower-performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another, and the index may not accurately reflect the performance of a described style); and limited data (many hedge funds do not report to indexes, and, therefore, the index may omit funds, the inclusion of which might significantly affect the performance shown. The HFRI indexes are based on information self-reported by hedge fund managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, L.L.C. Results for funds that go out of business are included in the index until the date that they cease operations.
Therefore, these indexes may not be complete or accurate representations of the hedge fund universe and may be biased in several ways. Returns of the underlying hedge funds are net of fees and are denominated in USD.
Private equity: Cambridge Associates LLC U.S. Private Equity Index uses a horizon calculation based on data compiled from more than 1,400 institutional-quality buyout, growth equity, private equity energy, and subordinated capital funds formed between 1986 and 2017. The index uses a modified private market equivalent (mPME) calculation as a way to replicate private investment performance under public market conditions. While traditional public market indexes calculate an average annual compounded return (time weighted over specified time periods), private indexes measure performance using internal rates of return and multiples based on cash flows (money-weighted returns). The funds included in the index report their performance voluntarily, and therefore the index may reflect a bias toward funds with records of success. Funds report unaudited quarterly data to Cambridge Associates when calculating the index. The index is not transparent and cannot be independently verified because Cambridge Associates does not identify the funds included in the index. Because Cambridge Associates recalculates the index each time a new fund is added, the historical performance of the indexes shown are net of fees, expenses, and carried interest. Index returns do not represent fund performance.
The Bloomberg U.S. Aggregate Bond Index is a broad-based index that measures the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market, including Treasuries, government- related and corporate securities, MBS, ABS, and CMBS.
The Bloomberg U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt.
The Bloomberg Commodity Index is a broadly diversified index comprised of 23 exchange-traded futures on physical commodities and represents 20 commodities weighted to account for economic significance and market liquidity.
The FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real estate companies and REITs in developed countries worldwide.
Bloomberg Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. It is comprised of the U.S. Aggregate, Pan-European Aggregate, and the Asian-Pacific Aggregate Indexes. It also includes a wide range of standard and customized subindices by liquidity constraint, sector, quality and maturity.
The JPM EMBI Global Index is a U.S.-dollar-denominated, investable, market-cap-weighted index representing a broad universe of emerging market sovereign and quasi-sovereign debt.
The MSCI EAFE Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of 21 developed markets, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure equity market performance of 23 emerging market countries. The MSCI World Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of 23 global developed markets.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.
Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
The S&P 500 Index is a market-capitalization-weighted index composed of 500 widely held common stocks that are generally considered representative of the U.S. stock market. Returns assume reinvestment of dividends and capital gain distributions.
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Global Alternative Investments (GAI) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo & Company.
The information in this report was prepared by Wells Fargo Investment Institute (WFII). Opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector, or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
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