Cindy Rapponotti, CFA®, CAIA®, Senior Vice President, Senior Portfolio Manager
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Key Highlights
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Interest in alternative investments, a category of assets that are managed differently from traditional investments like stocks, bonds, or cash that investors buy or sell on publicly traded markets, has gained popularity in recent years among investors. Depending on their investment goals, investors may seek to invest in alternative investments, or alternatives, to complement opportunities available to them through traditional investments, potentially achieving objectives like diversification, enhanced returns, or income potential.
Alternatives historically were an asset class exclusive to institutional clients and high-net-worth individuals or family office investors. Today, a wider group of investors can gain exposure to a variety of alternatives through investment strategies like mutual funds and exchange-traded funds, along with other private investment vehicles.
However, alternatives are not suitable for all investors. These complex assets carry higher risks and may have more stringent eligibility requirements than traditional investments. It’s important for investors interested in alternatives to consult their wealth management team to determine if these assets are an appropriate fit for their investment portfolio and wealth plan.
Commerce Trust views alternatives in the context of how these strategies align with a client’s investment strategy, risk tolerance, wealth plan, and overall financial situation. Any alternatives strategy we may employ in a client’s portfolio is customized to that client’s specific needs.
Types of Alternative Strategies
Examples of alternatives include commodities, hedge funds, private investments (both private equity and private credit), collectibles, cryptocurrency, and real estate.
Commodities today are broadly categorized into four areas: energy, metals, livestock, and agricultural products. These often act independently from other major asset classes like equities and fixed income through both bull and bear markets. Commodities have performed positively year-to-date, with the Bloomberg Commodity Index returning approximately 5% through April 2024.1 Oil and metals have been the main drivers of year-to-date performance as demand in commodities continues to be strong in the U.S. economy.
Hedge funds are investments that pool money from multiple investors to invest in a variety of asset classes. They are designed to achieve returns by “hedging” against market movements. Hedge funds can be employed for diversification or to mitigate risk in an investment portfolio, especially during down markets. For example, when both equity and fixed income markets delivered negative returns in 2022, the HFRI Fund of Funds Conservative Index, an index of multiple hedge funds designed to show consistent performance regardless of market conditions, outperformed the broader stock market, as represented by the S&P 500 Index. The HFRI Fund of Funds Index returned 0.1% for 2022 in comparison to the S&P 500, which returned -18.1% over the same period. (Figure 1)
Figure 1 - Volatility Comparison - 2022 (HFRI Funds Conservative Index vs. S&P 500 Index)
Private equity can offer investors ownership in privately held companies not available in the publicly traded markets. While the types of private equity investments can vary, we define them in two broad categories of venture capital and buyouts for illustrative purposes. Venture capital is funding that a new or growing company may seek in the various stages of business development. A buyout, which can take different forms, refers to the majority acquisition of a mature business.
Typically, there are two groups of investors involved in private equity investments: general and limited partners. The general partners are individuals who manage the day-to-day operations and make the investment decisions for the funds. Limited partners are individuals or institutions that provide capital to invest in the funds.
Within the private equity space, a growing area of interest for investors is the secondaries market, which allows a limited partner to sell their position to a buyer outside of the partnership. The seller gets to reduce or eliminate their position while the buyer gains access to the private equity investment, often after the early stages of the investment when profitability is not always realized.
Private credit is a private investment vehicle where non-bank lenders provide debt financing services outside of the publicly traded markets. In the current higher interest-rate environment where bank lending activity has slowed, more companies are engaging private credit firms for their debt needs. Two areas of opportunities in private credit are distressed debt and “special situation” investments. Within distressed debt, investors may acquire the debt of a struggling company in the hopes of receiving an equity stake after a restructuring of the company takes place. Special situations may take the form of a variety of investment opportunities. For example, a private credit fund can provide short-term debt solutions to a company with liquidity needs, which could deliver returns to investors.
Unique Risk Considerations
Due to their complexity and illiquidity, alternatives have inherent risks far different from a traditional stock and bond portfolio. Examples of these risks include:
Time horizon. Alternative investments, like collectibles and real estate, typically are not driven by market movements. Their value tends to appreciate slowly over time. Private investments can often deliver negative returns in the initial stages before positive returns are realized as the investments mature. In addition, private investment managers may not deploy capital all at once but rather invest funds over time, sometimes years, to acquire assets.
Lack of liquidity. Alternatives are often illiquid. For example, hedge funds and private equity investments may have minimum investment levels or time requirements that limit or prohibit the ability for investors to make withdrawals.
Less regulatory oversight. Unlike traditional assets, not all alternatives are registered by the Securities and Exchange Commission. Information like historical performance and benchmarking that investors would seek from publicly traded investments may not be readily available. Meanwhile, investments like cryptocurrency lack consistent regulatory oversight. (Commerce Trust views investing in cryptocurrency as highly speculative and does not currently offer direct investment in the asset class.)
Manager risk. Manager selection with any private investment opportunity is an important consideration. At Commerce Trust, for any opportunity we engage on behalf of our clients, our due diligence in evaluating outside managers starts with a performance review, but also includes getting to know their people, processes, and philosophy.
Eligibility Considerations
Federal regulation requires potential investors to be accredited investors or qualified purchasers to invest in certain alternatives, such as private investments or hedge funds. The requirements for accredited investor and qualified purchaser differ slightly with the thresholds to be considered a qualified purchaser being slightly more stringent. Generally, to qualify investors must meet certain minimum thresholds of asset holdings and any trust or organizational investor cannot be formed for the purpose of purchasing the investment.
It is important for any potential investor to talk with a financial professional about the complexities, risk and return profile, and associated fees related to alternative investments. Your team of investment professionals at Commerce Trust can help you to understand the various aspects to alternative investments.
[1] "Market Tracker," Commerce Trust, April 30, 2024; www.commercetrustcompany.com.
The Chartered Financial Analyst® (CFA®) Charter is a designation granted by CFA Institute to individuals who have satisfied certain requirements, including completion of the CFA Program, and required years of acceptable work experience. Registered marks are the property of CFA Institute.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of May 23, 2024. This summary is not intended to provide general information only and is reflective of the opinions of Commerce Trust. This material is not a recommendation of any particular security, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.
Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Incorporating alternative investments, including derivatives, hedge funds, private equity, REITs, and commodities, into a portfolio presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk. Additionally, certain alternative investments may require investors to be accredited or qualified investors, which have defined minimum asset requirements.
Commerce Trust is a division of Commerce Bank.
Investment Products: Not FDIC Insured | May Lose Value | No Bank Guarantee
