Why Invest In Alternative Investments?
Investors often include alternative investments in their portfolios for three main reasons: to diversify the portfolio, to add alpha, and to increase the portfolio’s absolute return nature. This section will delve into each of these reasons in detail.
Diversification
Efficient diversification is a hallmark of well-constructed portfolios. Most investors have some degree of diversification within their balanced portfolios. However, even a traditionally balanced portfolio can come under stress and must be reevaluated in periods of stock and bond market volatility.
A vast myriad of investments with various risk exposures are available in the alternative investment marketplace. These investments can exhibit low or even negative betas with traditional stocks or bonds and thus can add a level of diversification to an investor’s overall portfolio.
Benefits of Diversification with Alternative Investments:
- Reduced Volatility: A more stable net asset value (NAV) for the overall portfolio.
- Downside Protection: Reduced drawdowns during periods of market stress.
- Greater Allowance for Leverage: This can offer higher expected returns.
Did You Know? A well-diversified portfolio carries less risk, enabling it to safely take on more leverage relative to poorly diversified portfolios.
Adding Alpha
As indicated in Chapter 15, alpha is a measure of the manager’s performance. A positive alpha indicates that the manager has produced more return than predicted by their beta calculation, adding value to the portfolio. Conversely, a negative alpha indicates underperformance for the risk taken.
Key Features of Alternative Investment Funds Contributing to Alpha:
- Highly Skilled Managers: Attracted by pay-for-performance compensation structures.
- Flexible Strategies: Including short selling, leverage, and derivatives, limited or unavailable to conventional mutual fund managers.
- Diverse Asset Classes: Greater flexibility to invest in less liquid securities like private equity, real estate, and distressed securities.
Given their expertise and the strategies and investments available to them, alternative managers generally produce higher risk-adjusted returns relative to conventional managers. The ability to use sophisticated strategies, coupled with a diverse range of investment opportunities, helps investors move to a higher efficient frontier, enhancing portfolio diversification, risk control, and potential returns.
Increasing Absolute Return
Many alternative investments target absolute returns, aiming to produce positive returns regardless of market direction. This resilience makes the portfolio more resistant to capital erosion in the market.
Note: The term ‘risk’ in this context refers to both volatility risk (measured by standard deviation) and drawdown amount. Both concepts are discussed in the next chapter.
Key Takeaways
- Diversification: Alternative investments help reduce portfolio volatility, offer downside protection, and allow for greater leverage.
- Adding Alpha: Skilled managers and flexible strategies contribute to higher risk-adjusted returns, adding value to the portfolio.
- Absolute Return: Target absolute returns make portfolios more resilient to market downturns and enhance overall performance.
Frequently Asked Questions (FAQ)
1. What are alternative investments?
Alternative investments refer to assets that do not fit into traditional investment categories such as stocks, bonds, or cash. Examples include hedge funds, private equity, real estate, commodities, and more.
2. How do alternative investments contribute to diversification?
Alternative investments often exhibit low or negative correlation with traditional investments, thus reducing overall portfolio risk and volatility, especially during market downturns.
3. What is alpha, and why is it important?
Alpha is a measure of a manager’s performance relative to a benchmark. Positive alpha indicates added value, while negative alpha indicates underperformance. It’s important because it helps assess the manager’s ability to generate excess returns.
4. Why should I consider adding leverage to my diversified portfolio?
Leverage can amplify returns (and losses), but in a well-diversified portfolio with reduced risk, taking on leverage can potentially enhance expected returns.
Glossary
- Alpha: A measure of an investment’s performance on a risk-adjusted basis.
- Beta: A measure of the volatility of an investment relative to the market.
- Net Asset Value (NAV): The value of an entity’s assets minus the value of its liabilities.
- Leverage: The use of borrowed capital to increase the potential return of an investment.
- Drawdown: The peak-to-trough decline during a specific period for an investment.
Conclusion
Incorporating alternative investments into a portfolio can significantly enhance diversification, provide higher risk-adjusted returns (alpha), and target absolute returns for greater resilience against market downturns. Understanding these benefits helps in constructing a robust portfolio tailored to navigate different market environments effectively.
📚✨ Quiz Time! ✨📚
## Why might an investor include alternative investments in their portfolio?
- [ ] To avoid any form of risk
- [ ] To exclusively invest in traditional stocks and bonds
- [x] To diversify the portfolio
- [ ] To entirely replace conventional investment strategies
> **Explanation:** Investors add alternative investments to diversify their portfolios, which incrementally decreases risk faster than returns decrease.
## What does adding alpha to a portfolio mean?
- [ ] Increasing the number of holdings without regard to return
- [x] Incrementally increasing risk-adjusted returns
- [ ] Only investing in long-term government bonds
- [ ] Avoiding all risks
> **Explanation:** Adding alpha refers to incrementally increasing risk-adjusted returns, indicating better performance by the portfolio manager.
## How do alternative investments help diversify a portfolio?
- [x] By exhibiting low or negative betas with traditional stocks or bonds
- [ ] By exclusively investing in high-risk stocks
- [ ] By avoiding diversification entirely
- [ ] By primarily focusing on a single asset class
> **Explanation:** Alternative investments can exhibit low or negative betas with traditional stocks and bonds, providing additional diversification benefits.
## What is a primary benefit of diversification with alternative investments?
- [x] Reduced volatility through a more stable net asset value (NAV)
- [ ] Increased volatility through unstable NAV
- [ ] Completely eliminating market risks
- [ ] Guaranteeing unlimited returns
> **Explanation:** Diversification with alternative investments helps reduce volatility and stabilize the net asset value of the overall portfolio.
## What is the role of skilled managers in alternative investment funds?
- [ ] Only to follow basic mutual fund strategies
- [x] To utilize strategies like short selling, leverage, and derivatives
- [ ] To avoid all forms of trading and risk
- [ ] To manage only traditional investments
> **Explanation:** Skilled managers in alternative investment funds use strategies like short selling, leverage, and derivatives that are often unavailable to conventional mutual fund managers.
## How can alternative investments provide downside protection during market stress?
- [ ] By eliminating all risks completely
- [x] By reducing drawdowns through efficient diversification
- [ ] By focusing solely on bonds
- [ ] By increasing exposure to high-risk investments
> **Explanation:** Alternative investments can provide downside protection by reducing drawdowns through efficient diversification during periods of market stress.
## What type of returns do many alternative investments target?
- [ ] Only short-term losses
- [ ] Guaranteed returns irrespective of strategy
- [x] Absolute returns, aiming for positive results regardless of market direction
- [ ] Only losses under all market conditions
> **Explanation:** Many alternative investments target absolute returns, meaning they aim to produce positive returns regardless of market direction.
## What is one of the benefits of alternative investments in terms of leverage?
- [ ] Reduced returns and higher risks
- [x] Greater allowance for leverage, potentially offering higher expected returns
- [ ] Increased dependency on traditional stocks
- [ ] Lower possible returns due to limited investment opportunities
> **Explanation:** Alternative investments can provide a greater allowance for leverage, which can lead to higher expected returns.
## What indicates the manager’s added value to the portfolio via alternative investments?
- [ ] A negative alpha
- [x] A positive alpha
- [ ] An alpha value of zero
- [ ] Only the beta value
> **Explanation:** A positive alpha indicates that the manager has produced more return than was predicted by the beta calculation, adding value to the portfolio.
## Why might alternative managers generally produce higher risk-adjusted returns relative to conventional managers?
- [ ] Due to their lack of flexibility in investments
- [ ] By strictly adhering to low-risk bonds
- [x] Due to their expertise, flexible investment strategies, and the ability to use derivatives and leverage
- [ ] By avoiding any high-risk strategies
> **Explanation:** Alternative managers generally produce higher risk-adjusted returns because of their expertise, flexible investment strategies, and the ability to use derivatives and leverage.