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Demystifying Alternative Investments

Many investors consider alternatives to be too risky or volatile. But the truth about these increasingly popular investments may surprise you.

For many investors, there is a great deal of mystery surrounding alternative investments. They’re described as exotic, for the ultra-wealthy or too volatile.

The reality is, alternative investments cover a broad range of vehicles with the goal of helping to enhance returns, add diversification, and provide an overall portfolio with some downside protection. So it’s worth taking a look at some of the most common misconceptions

Alternatives are Nothing New

One lingering misunderstanding about alternatives is that they are new, exotic investment vehicles without long-term track records. Lisa Shalett, Head of Investment and Portfolio Strategies for Morgan Stanley Wealth Management, says this is a common misconception. “Alternative investments have existed for decades. For example, hedge funds have been around since the 1940s, and began experiencing rapid growth starting in the 1980s.”

Of course, alternatives include much more than hedge funds. Alternatives encompass a wide variety of investments such as private equity, managed futures, real estate and exchange funds.

The Daredevils of Finance?

Another major misconception is that alternatives are excessively risky. While it’s certainly true that they have unique and sometimes considerable risks, alternatives are actually designed to mitigate risk and manage volatility over time when used as a component of a diversified portfolio.

“Alternative asset classes often employ unique strategies and exposures, like leverage, shorting and derivatives,” says Shalett. “While these nontraditional investment options and strategies may be complex and involve higher risk, by their very nature they are designed to provide better risk-adjusted performance than traditional long-only products.”

The graph below provides a look at risk and return over the last 25 years. As you can see, having an allocation to alternatives both enhanced returns and reduced volatility for investors.

Fears of Increased Volatility

A third misconception is that alternative investments will actually magnify the overall volatility of a portfolio. But again, a closer look reveals the whole story. Alternatives possess historically low to moderate correlation of returns to traditional investments. Diversifying a traditional investment portfolio with the appropriate alternatives may help reduce overall volatility.

During times of increased volatility for stocks and bonds, the low correlation between those two asset classes and alternative investments comes even sharper into focus, meaning that a strategy of heterogeneous diversification becomes more attractive. This leaves room for an investor to think of ushering in an array of alternative investments such as equity hedge assets, equity return assets and opportunistic assets, such as private equity, and direct lending.

The Illiquidity Issue

Often investors may hold the belief that all alternative investments are illiquid—which adds to the perception of alternatives being risky. “While some strategies do tend to have longer investment horizons, some equity managers have much shorter lock ups,” says Shalett.

However, while alternatives have varying levels of liquidity, this is usually balanced by improved returns. This is often called an “illiquidity premium.”

The chart below takes a look at a comparison of the returns between private equity and public equity over a twenty-five year period. Private equity has historically offered attractive long-term returns vs public equity with the understanding that investors have been rewarded for taking on less liquidity.

A final misconception about alternatives is that they are only accessible to institutional investors. While that may have been true years ago, today these investments are available to retail investors, when suitable, who meet certain eligibility criteria such as income or net worth.

Morgan Stanley Wealth Management’s goal has been to provide eligible clients with access to some of the industry’s best global alternatives managers and investment opportunities.

Morgan Stanley has a seasoned team dedicated to Alternative Investments, including due diligence professionals with extensive industry and product experience. As an example, our Hedge Fund platform has a strong record of choosing top ranked funds, with 94% outperforming their 5-year peer benchmarks.4

Morgan Stanley offers an array of proprietary and third-party Alternative Investments products including: Single Manager Hedge Funds, Funds of Hedge Funds, Managed Futures, Real Estate, Private Equity and Exchange Funds.

To start the conversation about alternative investments, talk with your Morgan Stanley Financial Advisor or Private Wealth Advisor.

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