I’ve written previously about market volatility and how severe volatility can hurt overall portfolio return.
It should always be understood, when in the market, that volatility comes with the territory. Still, investors can manage the impacts of volatility through portfolio diversification. Diversification doesn’t assure a profit or protect against a loss in a market decline, but it can help to smooth the shocks in an investment portfolio.
To realize the benefits of diversification, a portfolio’s assets must behave differently under different market conditions; this is measured by correlation, how investments move in relation to each other. Famed economist Harry Markowitz showed that by combining assets with a low correlation to one another — i.e., assets move more independently of each other — an investor may reduce the overall risk of a portfolio without sacrificing return.
Enter alternative asset classes and alternative strategies. Simply put, alternative asset classes fall outside the traditional asset classes of stocks, bonds, and cash, with strategies that allow investment in traditional and alternative asset classes (such as real estate and commodities). Alternative strategies fall outside of the typical long-only buy and hold strategies, and are not constrained to an investment style or benchmark. Because alternatives don’t always move in tandem with the equity and fixed-income markets, they may provide diversification properties different from traditional investments.
Once limited to institutions and high-net-worth investors, alternative strategies are available to retail investors through a class of mutual funds sometimes called liquid alternatives. They may offer the potential for risk reduction, enhanced returns, and more complete diversification, along with the advantages of mutual funds including: lower investment minimums and fees, and daily liquidity.
If an investor’s goal is to secure higher returns at a lower level of risk (volatility) over the long term, then adding alternative investment strategies to a portfolio of traditional assets could be a worthwhile option.
Asset allocation/diversification does not guarantee a profit or protect against a loss.
Investment risk may be magnified with the use of alternative strategies; liquid alternatives are subject to market risk. When using hedging strategies investors should not expect significant outperformance during market rallies. It is possible to lose money when investing in mutual funds.
Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.