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.
Liquid alternatives cover different ways to invest in not only stocks and bonds but also non-standard asset classes like commodities or currencies. 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.
In part one of our article on liquid alternative strategies, we looked at equity-based, non-traditional bond and commodity alternatives. For part two, we’ll turn our attention to multi-currency and derivatives.
Multi-currency alternative investments involve short-term U.S. government debt holdings or various currency futures. These funds typically take a short position on the U.S. dollar like the PowerShares DB US Dollar Index Bearish Fund (UDN), profiting from a fall in the value of the dollar relative to other currencies. Another popular strategy involves carry trades where a long position is taken in a high yield currency and a short position is held in a lower yield currency, such as PowerShares DB G10 Currency Harvest (DBV). Typically, currency mutual funds are diverse investment vehicles that can provide broad exposure, such as the PIMCO Emerging Markets Currency Fund (PLMAX), whereas ETFs generally stick to a single currency index.
Investors looking for diversification into a non-traditional asset class might consider multi-currency investments. They have a risk profile similar to bond funds, making them ideal for aggressive or conservative investors.
The derivatives category of alternative investments can come in multiple forms, ranging from futures to leveraged stocks, making it one of the most diverse alternative categories. There are three main sub-categories: managed futures, volatility and inverse/leveraged funds.
1. Managed Futures
Managed futures in the derivatives category works very much like commodities in the sense that these funds typically hold long or short positions on futures contracts but aren’t limited to just commodities. Because the futures market can have a large investment threshold, such as $50,000 or more, many investors choose managed futures to gain access to this asset class instead. Futures are highly risky, however, and reserved only for investors with a high risk tolerance. One example of a managed futures fund is the Catalyst Multi-Strategy Fund (ACXAX).
The volatility category of derivatives attempts to profit from changing volatility in the markets, typically based on the CBOE VIX Volatility Index. These funds might hold long or short positions on the VIX through futures contracts. Investing in volatility is a good way for investors to hedge their portfolios against risk but should only be done by investors with an aggressive risk tolerance due to the nature of volatility contracts.
Volatility funds are extremely volatile and should only be held by investors with a high risk tolerance. ABR Dynamic Short Volatility Fund (ABRSX) is an example of a volatility fund.
3. Inverse/Leveraged Funds
The last derivatives category is also the largest: inverse/leveraged funds. Inverse funds take a short position in an asset class like stocks and profit from bear markets. They might be very specific, such as ProShares UltraShort Euro ETF (EUO), which takes short positions on the Euro. They can also be quite broad, such as ProShares Short S&P 500 ETF (SH) or the Rydex Inverse S&P 500 Strategy Fund (RYURX) – both of which track the inverse performance of the S&P 500 index. Because inverse funds hold short positions, they are useful only for short-term holdings and not meant for long-term strategies. Only investors with a high risk tolerance seeking a hedge against downside risk should consider this type of derivative investment.
Leveraged funds may or may not be inverse funds. They hold leveraged positions to boost returns relative to an index. For example, Direxion Daily Gold Miners Bull 3X ETF (NUGT) attempts to post triple the returns of the underlying gold miners index. In a similar way, the ProFunds Industrial Ultra Sector Fund (IDPIX) attempts to produce 1.5 times the daily performance of the Dow Jones U.S. Industrial Index. However, these funds are extremely volatile; gains are amplified, but losses are as well. Leveraged funds are suitable only for investors with a very high-risk tolerance.
Want to know about some of the performance questions of Liquid Alternative Strategies? Click here.
The Bottom Line
From bear market equity funds to managed futures, the alternatives market has something for every investor. While alternative investments can help mitigate risk or boost returns, investors should be cautious when considering adding these funds to a portfolio. Fees on alternative funds tend to be higher than other types of funds, which can erode overall returns but add more risk to a portfolio.
Liquid alternatives can be a useful addition for any portfolio whether an investor is seeking a leveraged strategy to boost profits, trying to reduce risk and hedge against downside movement, or trying to gain access to other asset classes like commodities.
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