One potentially powerful dimension of absolute return investing involves alternative asset classes, a broad category that includes investments such as commodities, real estate, equity and fixed-income derivatives, and foreign currencies. Freedom to choose among these investments, when given to an experienced, professional money manager, has the potential to help investment performance in any given market environment.
For example, an absolute return fund manager can determine the periods when it might be beneficial to have broad diversification across a range of asset classes, and at other times focus selectively on a handful of areas while dialing down exposure to others. Adding a range of different investments to more conventional investments can help to diversify the sources of return and potentially improve performance relative to each unit of risk taken by an investment strategy.
Alternative asset types
Among the more prominent alternative asset classes available to absolute return investment managers are commodities and real estate investment trusts (REITs). Commodities can include a range of products, such as gold and other precious metals; natural resources, such as paper and timber; industrial metals; and agricultural products, to name a few. Commodities can provide protection from inflation because commodity prices are strongly linked to the pressures of supply and demand. During periods of economic expansion, demand tends to increase for commodities, which pushes up prices and rewards investors. Conversely, when economies slow or recede, demand for commodities usually falls, and prices decline as well.
Real estate can protect investors from inflation for similar reasons. Demand for real estate usually increases when the economy is strong or strengthening and when inflationary pressures are rising. The utilization of real estate properties typically increases during expansions, which has the potential to lift the cash flow of real-estate-focused companies such as REITs, and if real estate supply is constrained, rental rates can also increase.
Currencies also represent a type of alternative asset class. Unlike most other assets, currencies have no intrinsic value, but they can nevertheless generate a return or loss because of fluctuations in exchange rates. These fluctuations are caused by a host of factors, but for investors who turn to currencies as a source of diversification, the key benefit is that, in many cases, exchange-rate fluctuations are not highly correlated with the performance of other asset classes.