As market churns, take a fresh look at diversification

When evaluating your investment strategy, it is advisable to look beyond standard, low-cost investments such as mutual funds and exchange traded funds (ETFs), and broaden your investment perspective to include less-traditional investment options such as commercial paper, hedge funds, REITs and others. Of course, the fees of these various investment types must also be considered since high fees can negatively impact portfolio growth (especially if performance is less than stellar).

One of the best ways for investors to mitigate the effects of volatility is to ensure that they have clearly defined long-term goals and align their investment strategy with those goals. It goes without saying that a young executive with little debt and high earning potential should be guided to invest differently from an older, retired investor with fixed income. Alternative investments could be considered in both scenarios and are most often accessible by working with a financial adviser.

Likewise, in both scenarios, the financial adviser must ask, “What is the maximum downside my client can tolerate?” By diversifying beyond investments that are highly correlated to stocks and bonds, advisers can help investors reduce risk without compromising return potential.

Mutual funds are generally a safer and relatively low-cost investment option, but investors should be aware that they may be subject to several types of fees over the course of their investment. Mutual fund fees include front-end sales charges (or loads), redemption fees, short-term trading fees and service fees. Index ETFs are an even more cost-effective way to invest in the market. Most of the time, there are still fees associated with these investments – but there are fewer of them – and mutual fund fees are generally higher than those of index ETFs.

Investing in commercial paper (CP) is a fairly low-risk way to diversify a portfolio. Corporations issue this form of short-term debt security as a promissory note to obtain ready cash. Despite being uninsured by the federal government, CP is less risky than many investments because of its short-term nature; it is issued with a fixed interest rate and a maturity date of one to 270 days. Individual investors can purchase CP, but it is usually issued in denominations of $100,000 or more. Returns are typically a bit higher than the rate of inflation and justify the payment of the low fees.

Originally designed to reduce or eliminate the risk of volatility’s downside, hedge funds are another investment type for wealthy investors to consider. (Typically, only qualified purchasers with liquid net worth of over $5 million have access to hedge funds, and the minimum investment amount can range from $100,000 to as high as $25,000,000) During the 2008 recession, the S&P 500 lost 38 percent of its value, but the average hedge fund was down only 18 percent.

The downside is that fees for investing in hedge funds are extremely high (for example, 2 percent of assets under management, plus a performance fee of 20 percent of gains). In recent years, those high fees have become tougher to justify since between 2009 and 2018 hedge-fund returns have been less than half of the S&P 500. Another issue with hedge funds is liquidity – they can have extended lock-up periods when funds cannot be withdrawn.

Purchasing direct real estate or investing in private equity are additional ways to diversify a portfolio. While these investment types are less correlated with stocks and bonds, they are also illiquid, meaning it’s challenging to divest oneself of the investment.

Individual real estate investment trusts (REITs), on the other hand, are public companies, traded like stocks, and are liquid investments. Liquid alternatives (liquid alts) are mutual funds that invest in an alternative strategy, such as managed futures or long/short equity strategies. Because of their fund structure, and as their name implies, they are liquid investments, but their strategies often have high trading costs that lead to high expense ratios, making them less attractive.

By broadening their perspective so that not all investments are highly correlated with one another and by adding investments beyond mutual funds and ETFs (such as commercial paper, hedge funds, direct real estate, private equity and REITs), investors can reduce the impact of volatility on their portfolios.

Michael Joyce is founder and President of Agili in Bethlehem and Richmond, Virginia, and is responsible for overall invest¬ment strategy, management of investment portfo¬lios and financial counseling services. He can be reached at mjoyce@agilipersonalcfo.com.

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