Sunday, February 9, 2020

An alternative investment matrix - Determine weights for each box


Defining the alternative investment universe is actually not easy.  It is more than just hedge funds. There is a spectrum of different choices for investors and there is often confusion on what choice is best for a given objective or environment. However, an alternative matrix that uses a grid on two dimensions, income/volatility versus asset characteristics (fixed income/equities) can be a help. Given this matrix approach, first developed by JP Morgan, investors will choose core, complements, or return enhancers. 

Investors need to think about the choice of asset characteristics, fixed income or equities and volatility. Do you want more carry or total return? Do you want more or less risk? Investors can develop a core satellite approach for alternatives.

This can also be viewed as a pyramid of choices with traditional assets on the bottom as a core. Upon the core will be a set of similar alternatives. In the case of fixed income, it could be core private credit. In the case of equities, it could be smart beta or style specific beta choices. The next level will include hedge funds which should be able to provide added diversification to the core portfolio. Upon the top of the pyramid will be alternative choices that will be situational, have higher risk, and the opportunity for higher returns. Each box or level will have its own return and risk characteristics. Investors will have to look at the trade-off of moving from one box or level to another.

How the alternative investment matrix can be used can be based on where we are in the business cycle, what is an investor's tolerance for risk, liquidity needs, and current valuation. For example, being late in the business cycle may require a move from illiquid to more liquid alternatives and a move away from things like distressed credit.

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