20.2.1 Benefits of Alternative Investments

Introduction

Alternative investments are financial assets that do not fall into the conventional investment categories such as stocks, bonds, and cash. These can include assets such as real estate, hedge funds, commodities, private equity, and collectibles. This section explores the benefits of incorporating alternative investments into an investment portfolio, particularly focusing on diversification, potential for higher returns, and acting as an inflation hedge.

Diversification

One of the primary benefits of alternative investments is diversification. Diversification is the practice of allocating investments in a manner that reduces exposure to risks associated with any single asset or group of assets. Here’s how alternative investments contribute to diversification:

• Low Correlation: Alternative investments often have low to negative correlations with traditional asset classes. This means their performance does not directly follow the typical market patterns of stocks and bonds. As a result, adding alternative investments to a portfolio can help in smoothing out returns and reducing overall portfolio volatility.

    graph LR
	  A[Traditional Assets] -->|+ve Correlation| B(Stocks)
	  A -->|+ve Correlation| C(Bonds)
	  A -->|Low Correlation| D(Alternative Investments)
	  subgraph "Portfolio Composition"
	    B
	    C
	    D
	  end

“+ve Correlation” is shorthand for “positive correlation.” Positive correlation means that two variables move in the same direction – when one variable increases, the other tends to increase as well, and when one decreases, the other tends to decrease. In the context of this diagram, it indicates that traditional asset classes, such as stocks and bonds, often move in tandem with each other to some degree.

• Broadened Asset Base: Including a mix of assets such as commodities, real estate, or private equity structures further broadens the asset base. During market downturns, where traditional assets might falter, alternatives could generate stable or positive returns, reducing overall investment risk.

Higher Returns

Alternative investments also present the opportunity for higher returns compared with traditional investments due to several reasons:

• Complex Strategies: Many alternative investment vehicles, such as hedge funds and private equity, leverage complex strategies that aim to exploit market inefficiencies. With active management and sophisticated approaches, they can capture returns that are often inaccessible in general equity or fixed income markets.

• Unique Assets: Alternative investments provide access to exclusive types of investments such as fine art, commodities, or arbitrage opportunities. These unique assets are often valued based on distinct principles from stock or bond valuation, allowing investors to realize potential value gains outside traditional markets.

Inflation Hedge

Inflation erodes purchasing power by increasing the price of goods and services. Alternative investments can serve as a hedge against inflation, aiding in the preservation of capital:

• Real Assets Wood: These include commodities such as gold or real estate, which historically show appreciation during inflationary periods. Their intrinsic value often increases with rising prices, thus providing protection against inflationary pressures.

• Floating Rate Income: Some alternative investments, such as infrastructure debt or funds with exposure to floating interest rate structures, automatically adjust income yields with inflation, maintaining real income levels over time.

Conclusion

Integrating alternative investments into a diversified portfolio offers numerous strategic advantages through diversification, enhanced potential returns, and protection against inflation. While these benefits are significant, investors need to carefully weigh these against the potential risks — such as illiquidity and higher fees— when deciding the inclusion and proportion of alternative investments suitable for their individual investment strategy. Mindful implementation aligns this promising asset class with long-term investment objectives, risk tolerance, and liquidity needs.

Glossary

• Diversification: The process of spreading investments across various assets to reduce risk.
• Correlation: A statistical measure that indicates the extent to which the returns of two investments move in relation to each other.
• Inflation Hedge: An investment that tends to protect the investor against a decrease in the purchasing power of money.

Additional Resources

• The CFA Institute Research Foundation — Introduction to Alternative Investments
• Managed Futures and Their Role in Investment Portfolios: A Guide by Institutional Investor Books
• The Handbook of Alternative Investments by Darrell R. Jobman

By understanding and carefully applying the benefits outlined here, investors can harness the distinct characteristics of alternative investments to enhance their portfolios in meaningful ways.