Alternative investments continue to be one of the fastest growing asset classes as investors seek additional ways to diversify and dampen their portfolios against market volatility. However, with this newfound awareness has also come a wave of misconceptions surrounding this asset class. This article will address and hopefully dispel some pervasive alternative investment myths held by investors.
(1) Alternative Investments Are Too Risky
It is important here to make the distinction between risk and portfolio flexibility. Due to the illiquid nature and longer lockup periods of alternative investments, investors will experience a reduced ability to address cash flow requirements, react to new information, enter and exit investments, and rebalance portfolios.
This does not mean, however, that alternative assets are inherently riskier than traditional investments. Every investment in isolation can be viewed as risky. A discussion of risk should instead involve a holistic view of an investment’s impact on a portfolio. One risk management technique of effective portfolio structuring is diversification, or dividing a portfolio among a variety of assets. Asset classes behave differently under different economic conditions, and a combination of assets featuring low correlation to one another can potentially improve a portfolio’s ability to mitigate against market volatility. Generally speaking, assets that feature low correlation (the extent to which the values of different investments move in tandem with one another) and expose an investor to a variety of risks will produce the best opportunities for diversification. As such, including alternative investments, which exhibit very different risk-return qualities than traditional stocks and bonds, can have an overall beneficial effect on an investor’s portfolio.
The graph below illustrates a Markowitz Efficient Frontier, representing portfolios featuring various risk-return profiles. As one can see, including alternatives in a portfolio can move the efficient frontier up and to the left, adjusting risk and enhancing returns.
(2) It’s Enough to Have Stocks and Bonds for a Diversified Portfolio
Consider the traditional 60/40 (60% stock, 40% bond) portfolio. Over the last 15 years, the correlation of returns between a 60/40 portfolio and a 100% equity portfolio was 0.98, an almost perfect correlation. Despite conventional wisdom and the inclusion of bonds, almost all of the risk in this hypothetical portfolio is dominated by equity risk. A seemingly diverse portfolio from an asset allocation point of view is not necessarily ideal from a risk diversification perspective. This becomes particularly troublesome during times of economic crisis as we begin to see correlation spikes between traditional assets.
What we have learned from the events of 2008 and 2009 is that conventional diversification strategies are not enough to protect against market volatility. A portfolio that incorporates an asset allocation to alternatives can potentially diversify risk exposures, cushion market volatility, and enhance returns. As alternative investments are incorporated, a balancing effect on a portfolio is achieved.
(3) Rely on Past Performance When Choosing Alternative Investments
As the adage goes, “Past performance does not guarantee or indicate future results.” Alternatives are no different from traditional investments in this regard. An investor may be able to glean tremendous insights from a particular opportunity’s past performance. The expertise of the management team and operational prowess can certainly be inferred from a firm’s past results. However, a variety of other factors come into play when shaping the ultimate outcome of an investment decision, and past performance may include unique events that cannot be easily reproduced. At the end of the day, investors should take all of these into account before choosing a particular investment opportunity for portfolio inclusion.
As unfamiliar and exotic alternative investments may seem, it is crucial to dispel misguided notions about these assets before disregarding the possibility of investing in them altogether. Due to the potential of alternatives to enhance the risk-return profile of a portfolio, investors are encouraged to take the time to perform a well-informed examination of the benefits and disadvantages of incorporating alternatives. With the rise of new investment platforms such as DarcMatter and increasing transparency into these assets, alternative investments can be an integral part of any investor’s portfolio.
 The New Diversification: Open Your Eyes to Alternatives, BlackRock 2014
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