Importance of Alternative Investments in Portfolio Diversification

Alternative investments, which have been used by large institutions for quite some time, have become more mainstream in recent years. Individual investors are more attracted towards Alternative investments in the recent past.

An alternative investment collectively refers to many asset classes that fall outside the traditional asset classes like Stock, bond and cash. Category includes Hedge Funds, Private equity (Venture Capital and Leveraged Buyout), Real Estate, Commodities (Managed Futures), structured products and Collectibles.  Given their non-traditional approach and their ability to invest in areas and ways traditional investments cannot, and their low correlation to traditional investments they have the potential to improve the overall risk-return characteristics of a portfolio and enhance the portfolio diversification.

Some of the Strategies and approaches in Alternative Investment includes, Holding both Long and Short position in the security, Holding private securities instead of publicly traded securities, Using Derivative products and Leverages, Exploiting Pricing Discrepancies between different asset classes, Real Estate investments includes Residential and Commercial property and REIT’s( Real Estate Investment Trusts ) and Investments in Commodities. Some Wealthy Investors even consider investing is collectibles like Stamps, Wine, Antiques, and valuable Arts.

Benefits of Alternative Investments:

There is evidence that over the last 20 years, returns on Alternative Investments have been higher than the return on traditional asset classes. Despite unique and higher risks considerations, alternative investments can be useful tools to improve the risk-return characteristics of an investment portfolio. They can increase diversification and reduce volatility, given low correlations to more traditional investments. They can offer the potential for enhanced returns due to the wider investment opportunity set. And they can hedge certain portfolio exposures, thereby reducing concentration risk.

Disadvantages of Alternative Investments:

Some of the Disadvantages and Risks associated with investment in Alternative investments are, Higher Fees structures, more complicated strategies which the layman cannot understand, less transparency and Liquidity, Credit risk, disappointing  returns during strong up markets and most importantly no diversification during down market trends.    

To Conclude, with increased investment knowledge of modern investors and readily available information on Alternative Investments, these products looks more attractive to the common investors. Considerations one has to keep in mind before incorporating alternative investments are their approach towards it and appropriate asset allocation. Some of the due diligence one has to consider before investing is, Product’s Investment Strategy and Process, Historical return and Valuation, AUM, Management style, Reputation and System of Risk Management. 

An ideal asset allocation states that one should have 10 to 20% of his portfolio exposure in Alternative Investments. But as a rational investor one should consult his financial planner before he could finalise buying these types of product.