Alternative investments typically have a low correlation to more traditional asset classes. Alternative assets, therefore, provide an opportunity for portfolio diversification, reducing overall risk exposure across investments. Many alternative assets also provide a hedge against inflation.
Investors have been drawn to the potential returns offered by alternatives throughout history. While returns cannot be guaranteed, alternative assets have the potential to offer much higher returns than their traditional counterparts. The caveat: capital is tied up for much longer periods of time and alternative investments are subject to a higher level of risk.
Returns are measured in a variety of ways, including relative and absolute returns.
· Relative returns are compared to a benchmark since returns are expected to follow market movements.
· Absolute returns are measured relative to zero, as investments are expected to perform independently of market movements.
Alternative assets can be categorized as either ‘return enhancers’ or ‘return diversifiers’:
· A return enhancer refers to an asset added to a portfolio with the expectation of a higher average return.
· A return diversifier refers to an asset added to a portfolio because of its low correlation to other assets, with the aim of reducing risk across the overall portfolio.
Low Correlation to the Public Market
Investors who want to diversify their portfolios seek low correlations. Many institutional investors rely on a target return that must be achieved each year (i.e., a pension fund must pay out yearly from investment gains). These investors want to safeguard their asset pool, so do not want to expose too much capital to the same risks. If one market (security, asset, investment strategy, etc.) falls, investing in another market with different drivers can offset those losses and provide a more reliable stream of returns.
MANAGING RISKS AND RETURNS
High risk and high minimum investments mean that alternative assets typically appeal to long-term investors, rather than those that prefer to use short-term investments to profit from the volatility in stock markets. That said, more and more investors are choosing to add alternatives exposure to their portfolios to take advantage of the benefits outlined above.
The correlation between alternatives and traditional assets can fluctuate as business cycles move from contraction to expansion, but they rarely fully converge. The risk to reward ratio is therefore preferential for investors that incorporate alternatives within their portfolio to spread risk.
Reasons for investing in alternatives vary across asset classes.
Diversification is stated as a key benefit across all asset classes, while the various types of returns available mean certain asset classes are more suited to certain investors.
How can alternatives complement a traditional portfolio?
For long-term investors able to forego some liquidity, a strategic allocation to alternatives assets can help to improve the overall risk/return profile of their portfolio. The exact weight of the alternative bucket within a diversified portfolio will depend on individual return objectives, investment horizons, and liquidity constraints.