Advanced Investment Strategies
Knowledgeable investors seeking aggressive portfolio returns often diversify through advanced investment strategies. This includes investing in private equity and hedge funds, fixed-income bonds, options, futures and collateralized debt obligations (CDOs). While above-average returns from sophisticated strategies are alluring, they come with above-average risks. Before chasing returns, learn more about your investment options below, and discuss with your Safe harbor Fiduciary representative the best way to reduce portfolio risks while increasing returns.
Private Equity (PE)
PE firms are generally separated by strategy: venture capital and buyout funds. Venture capital funds take investor money and invest in small start-ups with high upside potential. Buyout funds are geared toward larger, more established companies that may already be publicly traded. Investors looking to allocate capital to higher risk-reward propositions may choose to invest in venture capital firms. Both fund structures require significant due diligence, may cause liquidity issues due to lockup periods, and can result in significant volatility and price-performance measurement problems.
Investing in PE is an indirect way an investor can gain access to sophisticated investment techniques. These funds generally have clearly stated investment approaches, and focus specifically on individual sectors or industries such as hotels, real estate, industrial companies and many others. The fund executives may be able to find undervalued opportunities because of prior expertise in these areas.
The benefits of PE investing can be numerous—primarily due to enhanced returns via the experts that can find hidden returns. Because PE risk and return drivers can be different from general investment classes, they can have a positive diversification effect on a portfolio. However, some PE funds use leverage, thus increasing possible losses, the lockup periods that funds have (can be different by each fund) and long-term timeframe for returns to be generated.
Investing in hedge funds has similar risks to PE funds, which also offer access to investment strategies that add diversification potential to a portfolio. Some funds can add value for investors by taking advantage of market inefficiencies, investing in struggling companies, performing high-frequency trades, using quantitative techniques and more. While these methods increase average returns, they have different risks. Hedge funds can be ideal for investors eager for the diversification benefits that another investment strategy can add.
As with PE funds, hedge funds have stated strategies prospective investors can review before allocating capital. Investors can gain access to macro-economic shifts, distressed companies, emerging markets, special situations, and other strategies that can add value and reduce portfolio risk through diversification
In general, indirect investment strategies have additional costs that can significantly reduce return. Depending on the size of a portfolio, this cost may be higher or lower than the transaction costs that are associated with direct investing strategies. Indirectly investing through managers may be necessary as few individuals have the expertise or resources to take advantage of advanced techniques. For investors that have the time, knowledge and resources to directly invest in alternative asset classes or engage in advanced strategies, there can be significant benefits for an investment portfolio’s performance.
Collateralized debt obligations (CDOs) made headlines in the 2008 Financial Crisis when they were pointed to as a contributing factor of the economic destabilization. Like all investments, CDOs are risky because there is a potential loss of principal. However, they are not more “intrinsically” risky than other investments as portrayed in news reports. The magnified losses from CDO investments occurred in 2008-2009 because risk was not adequately managed. CDOs are packages of consumer debt (mortgages) or corporate bonds that can be publicly bought and sold. Investors can gain exposure to CDOs through mutual or hedge funds (many times unaware they are in the fund portfolio) or may purchase them directly. CDOs typically have “tranches,” with more expensive tranches having better credit ratings and receiving priority distribution for dividend payments. Investing in different tranches and betting against others based on the outlook for a particular credit rating is just one of many ways investors can use advanced investment strategies in this asset class. The main risk when investing in this asset class is a lack of understanding all of the underlying assets that constitute these investments.
Fixed income, generally available to retail investors in the form of corporate-issued bonds, provides more opportunity than the strategies listed above. By investing in bonds with a particular credit rating, duration, maturity or other characteristics, an investor can turn a vanilla bond portfolio into one that derives value from a changing market outlook, economic events, interest rate movements, foreign political developments and more.
Options provide investors with the opportunity to voluntarily purchase or sell an asset at a fixed price. Traditionally used for stocks, options now exist for just about every tradable asset. By using multiple options simultaneously, investors can profit from not only the direction of a stock, but how long it takes to get to a specific value, changes in the volatility of the stock and many other factors. Individuals can buy existing options or sell ones they’ve created (referred to as writing an option). Depending on the strategy, options can increase or reduce risk. By purchasing an option, you limit your loss to the initial option price, but by writing an option, you become liable to produce the underlying stock if that option is exercised. A non-exhaustive list of options strategies includes: call and put spreads, collars, butterfly spreads, ladder spreads, covered calls, straddles and strangles. Before engaging in any strategy, be sure to understand the risks before focusing on potential returns, as all of these strategies pose the potential for full equity loss and possibly more.
A futures contract is similar to an option with the important addition that it is required for both parties. Futures trading can be done directly, but it can also be accessed through firms that offer “managed futures” accounts. Futures (particularly those that deal with commodity trading) have become popular for their ability to increase a portfolio’s diversification. Futures trades use a margin system, allowing investors to leverage trades for increased returns and losses. This can be particularly risky for investors with a minimal equity investment.
Benefits and Drawbacks of Using Advanced Strategies
Advanced strategies are not necessary for successful portfolio returns. They require considerably more effort, cost and attention than standard methods. In direct methods, each transaction usually is accompanied by a transaction cost, and indirect methods of private equity and hedge funds have significant management fees and other constraints. Funds that partake in leveraged strategies increase the possibility for losses as well as gains. It is paramount to not overlook the potential for losses in search of gains. On the whole, the biggest risk posed by advanced strategies is the risk of not knowing what it is you’re investing in (i.e. how returns are generated, potential risks, mispricing those risks, return correlation with other investments, etc.)
Used properly, advanced investment strategies can provide both diversification benefits and above-average market returns to a portfolio. These two features make advanced strategies appealing to those who have the capital to access them. When carefully analyzed, planned and controlled within a portfolio, advanced investments can help investors reach their goals.
Always consult your financial advisor before considering advanced market strategies. Also, remember that taxes play an important role in the final return realized from an investment and need to be a factor when deciding how to invest.
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