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Categorization Confusion—The ‘Alternatives’ Problem

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In recent years, I’ve noticed that the number of music genres on my iPod has continued to expand. What used to be “rock” is now subdivided into alternative rock, indie rock, indie pop, pop rock, industrial rock, country rock, rockabilly—and the list goes on.

While some of these categorizations are useful in understanding what I should expect from my listening experience, many of the descriptors are fairly useless. Specifically, while the majority of artists that I follow fall under the “alternative rock” category, I’m at a loss as to how to describe what that means to someone who has no contextual background—say, my mom, for example.

What I do know is that most of the music I listen to consists of combinations of vocals, guitars and drums. The components are the same, they’re just mixed in different amounts, volumes and patterns, and my mom can understand that.

As I think about this, I can’t help but see a parallel with the investment industry and the amorphous group of strategies labeled as “alternative investments.” How do you explain “alternative investments” to the typical investor who doesn’t live and breathe the markets?

You start by recognizing that all investments consist of the same components—asset classes—and that everything we invest in is either exclusively, or in part, equity (guitars), debt (drums), commodity (bass guitars) or currency (vocals).

So where does the confusion come from? It’s partly an “asset classes” versus “strategies” issue. Asset classes are what you invest in, whereas strategies consist of the ways in which you invest in asset classes. A traditional, long-only value manager is investing in equities (the asset class) by evaluating the valuation characteristics of each company and buying the cheaper ones (the strategy).

Private equity, emerging market bonds and REITs, to name a few, are often cited as “alternative investments,” but they are just subcategories of the primary asset classes. Private equity is equity; it’s just a non-liquid form of equity. Emerging markets debt is debt. REITs are equity, and so on.

It doesn’t help when mainstream reference sources even propagate the inaccurate. Look up “alternative investments” on Wikipedia and it says, “An alternative investment is an investment in asset classes [emphasis mine] other than stocks, bonds and cash.” Wrong!

It’s not that alternative investments represent different asset classes; alternatives such as long-short equity, managed futures or global macro are simply different ways to invest in or trade equities, debt, commodities and currencies. They have the flexibility to go long or short, they may employ leverage and they may gain exposure to these asset classes through the use of derivatives. However, at the end of the day, investors in alternative strategies have exposure to equities, debt, commodities and currencies. Those asset classes are just mixed in different proportions, with varying directional exposures, in order to expand the opportunity set and to fine-tune risk.

We frequently hear people say, “Oh, I don’t invest in alternatives,” and I don’t get that. Why would someone not want to take advantage of a larger opportunity set with the ability to manage risk much more precisely? I think it’s because of the fear of the unknown or the difficulty of explaining to clients what they are seeing on their statement.

To my client—Mom—I say, don’t get caught up in the fact that your statement indicates an investment in the Global Macro Absolute Return Alpha Opportunity Fund; you’re just invested in equities, debt, commodities and currencies. Let me worry about the rest.