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What’s “Hot” On The Financial Runway

Sangita Joshi and Richard Belofsky
11/21/2012

WHAT’S “HOT” ON THE FINANCIAL RUNWAY
(and may eventually catch on with “retail investors”)

Each season, fashion designers present flashy, exaggerated “new styles” that eventually become a trendy look for retail clothing stores to market to the masses. What finally hangs on the rack at the mall is often a dramatically tamed-down version of what first appeared on the runway, but fashionistas in the know can see the connection.

A similar migration of product often occurs in the financial services industry. Strategies and products once designed by creative financial professionals working for large institutions, after some alteration, may eventually become available to “retail investors,” the industry name for individuals and small groups. If you skim the financial press, one of the current hot topics for new financial products is "Alternative Asset Classes.”

Alternative Asset Classes: What are they?

The number of items that might qualify as alternative asset classes is head-spinning. But all alternative assets have one feature in common: their investment performance tends to have “a low level of correlation to fixed-income and equity markets” (from an investopedia.com definition). This means that if the stock market zigs, alternative asset classes might zag. When interest rates go up, income from alternative asset classes might go down – and vice versa. The rationale for alternative assets is fairly simple: since fixed-income and equity markets occasionally go down, it makes sense to find profitable alternatives. Again quoting investopedia.com:

“Combining different types of alternative assets into a portfolio can produce a more optimal asset allocation, and resulting performance benefits that are particularly visible during sustained periods of weak equity market performance.”

There are many investments which might qualify as alternative assets. Some, like real estate, art, collectibles, or precious metals, fit the bill because they are not equities, bonds or other paper assets. Other items qualify as alternative assets because they act as “hedges”; they are structured to provide positive returns when regular paper assets decline. Hedge funds get their name because they typically consist of devices (such as options) or investments (like private equity, or currency futures) chosen for their non-correlation to whatever is happening in the larger stock and bond markets.

Alternative assets tend to be illiquid in comparison to traditional assets, and the minimum purchase price is typically steep – you can’t build an art portfolio with monthly withdrawals from your checking account. In the past, many of these alternative asset classes have been available only to institutions or other “sophisticated investors,” i.e., those who theoretically have either enough money and/or experience to afford the high price points and accept the liquidity and investment risks.

But just as high-end fashions are repackaged for mass consumption, it appears alternative asset products are showing up on the radar screens of retail investors. A July 2012 survey commissioned by a prominent broker of life insurance and investment products found that

“The trend toward alternative asset classes among retail investors has been growing steadily for the past several years…Over the last decade, markets have experienced record volatility. We’re entering a new era of diversification and alternative asset classes are becoming a significant part of that development.”

Part of the repackaging of alternative assets for retail investors is finding ways to lower the price of entry. One of the easier ways to make alternative assets retail-friendly is to package them as funds, which allows for the sales of shares to individual investors. An October 27, 2012, Wall Street Journal article highlighted how some mutual fund companies are changing their tax status to qualify as real-estate investment trusts (REITs). While a typical REIT fund portfolio might own office, industrial and residential properties, some of these new REITs consist of “cloud computing data centers, cell phone towers, prisons, billboards and document-storage facilities” – all chosen because their financial performance is not connected to traditional financial markets.

In a similar way, insurance companies use hedging devices in their indexed annuity products. This combination of opportunity for growth with a guarantee against loss within the format of an annuity allows retail investors to indirectly receive the benefits of alternative asset classes.

Alternative Asset Classes: A Passing Fad or Here to Stay?

No matter how complex they may seem, most financial products are simply different configurations of fundamental economic concepts. At first, their arrangements may seem impossibly difficult to comprehend, but with repeated exposures they make sense. So, as retail investors gain a better understanding of financial products and their applications, it follows that interest in alternative asset classes will increase.

This proliferation of alternative asset classes at the retail level doesn’t mean everyone should own some. There are times when what’s trendy just doesn’t fit. That’s why a team of good financial professionals is helpful. Not only can competent financial professionals be a great resource for explaining alternative assets, they also might be just the right people to say “that doesn’t look good on you.”



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