You’ve likely already heard of alternative investments, which represent a set of diverse strategies with risk and return characteristics that are notably different from those of traditional asset classes you’re familiar with, like stocks and bonds.
A new world of opportunity
Today, the total alternative investments universe is just under $6.5 trillion dollars globally,1 presenting investors with a sizable investment opportunity. They include investments such as commodities, non-Canadian small-capitalization equities, infrastructure, real estate and more.
Sophisticated investors, including institutional investors, have known for years about the importance of investing in asset classes—like alternative investments—that are uncorrelated or exhibit low correlation to traditional asset classes.
Correlation is simply a measure of how the direction and magnitude of movement of one asset class matches up to another. The lower the correlation, the more probable that the asset classes you are comparing will behave differently through various parts of a market cycle. Having less correlated assets helps to diversify your portfolio and “smooth out” returns and gain higher return potential while reducing portfolio risk over time.
What is investment correlation?
The degree of correlation between two assets can be measured on a scale from “minus one” through to “one.” A correlation of “one” signifies a lock-step move, while “minus one” signifies opposite movement. When correlation between two assets is positive (anywhere between zero and one), the assets are moving in the same direction. When the two assets are negatively correlated (anywhere between zero and minus one), they are moving in opposite directions.
How do traditional assets correlate with alternative investments?
Alternative assets can be combined with conventional assets in your portfolio, like stocks and bonds, to help achieve portfolio diversification. The benefit of combining assets that have low or negative correlations is that portfolio risk is potentially reduced over all possible levels of return.
The significance of a lower correlation
Alternatives often have low correlation with most traditional investments—and in some cases, there’s even a negative correlation. A negative correlation means that two asset classes don’t “behave” alike. This low to negative correlation is attractive as it offers a greater level of diversification than positively correlated assets.
For example, based on the table above, Canadian equities pair well with global bonds (a common alternative asset) because their correlation is -0.4. Based solely on correlation, this is a more attractive pairing than Canadian equities with emerging market equities as those two categories have a +0.6 correlation, meaning they’re more likely to behave similarly and cause greater portfolio swings.
An advisor can help you navigate the alternatives
When implemented as part of a properly diversified portfolio, alternative investments can play an important role in a physician’s investment strategy. Your MD Advisor can help you discover whether alternatives have a place in your total wealth management strategy.
1 Wills Towers Watson, Global Alternatives Survey, June 2017.