It wasn’t so long ago that the idea of adding more than just stocks and bonds to an investment portfolio was considered solely the realm of professionals and institutional investors. Lately though, more and more alternative investments are being added to portfolios for reasons ranging from risk mitigation to leveraging holdings.

Alternative investments can be either liquid or illiquid. Examples of illiquid alternatives include things like private equity or private debt holdings – investments that aren’t easy to sell. Liquid alternatives, on the other hand, are relatively easy to sell and can be traded easily.

While alternative investments can include stocks and bonds, they could also include non-standard asset classes like commodities or currencies. Or they might include a non-traditional way of investing, such as shorting the market or hedge strategies aimed at profiting from a lack of volatility.

It’s a growing market, with more than $300 billion invested in alternative ETFs and mutual funds as of 2012. For investors, the attraction of alternatives is easy to see. They allow them to invest in assets that are normally out of reach, such as futures contracts or currency trades, and engage in complex strategies to take advantage of down or neutral markets or leverage bullish ones.

Liquid alternative investment strategies can be broadly broken into the following categories:

• Equity-based
• Non-traditional bond
• Commodities
• Multi-currency
• Derivatives

In the first part of our two-part article, we’ll focus on equity-based, non-traditional bond and commodity alternative investments.

Check here to know where liquid alternatives can fit into a portfolio.

Equity-based alternatives can come in multiple forms but all of them deal with different ways of investing in stocks. There are three main sub-categories: bear market, long/short equity and market neutral.

Bear market funds take a net short position in stocks to profit from downside movement. They can help investors hedge against corrections in the market or take advantage of full-blown bear markets. However, because they are considered ‘tail-hedges,’ they are meant only for short-term investments and shouldn’t be held for a long-term strategy. One example of a bear market fund is the ProShares Short S&P 500 ETF (SH), which takes a net short position against the S&P 500 index.

Long/short equity funds take a hedged net long position on stocks, which reduces volatility. It’s the largest category of alternative funds with $36 billion in assets as well. This type of fund allows investors to take advantage of long-term growth while hedging against downside movement in the markets. The main risk with long/short funds is the opportunity cost since they typically come with a low beta and might not be able to keep pace with the broader averages. Boston Partners Long/Short Research Fund (BPIRX) is an example of a long/short mutual fund.

Market neutral funds seek to eliminate risk in a portfolio altogether by averaging a beta somewhere between -0.3 and 0.3. There are three different types: equity market neutral, merger arbitrage and convertible arbitrage. Equity market neutral funds offset short and long positions to remove risk from the investment process. Merger arbitrage funds hold a long position in target stocks while shorting the acquiring company profiting from the difference. Convertible arbitrage holds long positions in convertible bonds while shorting the stock of the underlying company.

All market neutral funds offer risk reduction strategies but come with a high degree of opportunity cost – returns are generally on par with bond funds. Examples include JP Morgan Research Market Neutral Fund (JMNAX), Touchstone Merger Arbitrage Fund (TMGAX) and Calamos Market Neutral Income Fund (CMNIX).

Moving on to non-traditional bond funds, this type of alternative asset class invests in debt holdings but seeks to hedge duration and/or credit risk.

This type of alternative investment can help boost a bond portfolio’s returns while reducing risk typically found in ‘junk’ bonds. As an aggressive bond strategy, it is recommended only for those with a high risk tolerance. One of the largest funds of this type is the PIMCO Unconstrained Bond (PUBAX).

Commodities are the last type of liquid alternatives, which can be classified under the ‘managed futures’ category.

These funds invest in futures contracts and can be long or short on commodities, currencies or stock/bond indices. Investors seeking exposure to commodities should consider managed futures but should be aware that the futures market is highly risky. Only investors with a high risk tolerance should consider managed futures. AQR Managed Futures Strategy Fund (AQMIX) is an example of this type of alternative investment.

Want to know about some of the performance questions of Liquid Alternative Strategies? Click here.

Liquid alternatives can be a useful addition to any portfolio whether an investor is seeking a leveraged strategy to boost profits, a way to reduce risk and hedge against downside movement, or gain access to other assets like commodities. In part two, we’ll explore multi-currency and derivative funds and their value in an investment portfolio.

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