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Why Invest in Alternatives?

Preqin

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In lesson 1, you were introduced to the asset classes within alternative investments. In this lesson, we'll be exploring the reasons why an investor chooses to allocate funds to these asset classes and how it affects their portfolio.

When an investor develops their portfolio they choose investments based on efficiency, aiming to earn maximum return for minimum risk. Alternative assets are often attractive because of the high returns they can generate, and the opportunity they provide to diversify an investment portfolio away from traditional investments, which consequently reduces overall portfolio risk. Let’s explore some of these concepts in more detail:

Portfolio Diversification

Alternative investments typically have a low correlation to more traditional asset classes, as discussed. Alternative assets therefore provide an opportunity for portfolio diversification, reducing overall risk exposure across investments. Many alternative assets also provide a hedge against inflation.

Enhancing Returns

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.

What Is Correlation?

In the investment industry, correlation is the relationship between the returns of two investments. Correlation values can fall between -1 (perfectly inversely correlated) and +1 (perfect linear correlation). Investments that exhibit a correlation of -1 will post returns that move in opposite directions of each other, while investments with a correlation of +1 will move in tandem. Correlations can be calculated at an asset class level (such as hedge funds vs. equity markets), or at an individual investment level (for example, comparing two stocks).


How Does Correlation Work?

The correlation value is largely dependent on the sources of returns for the two investments in question. The factors that drive equity market prices differ from what drives fixed income prices, buyout fund performance differs from venture capital performance, and so on. Each asset class or investment strategy is exposed to unique risks, so correlations can vary. Alternatives offer lower correlation to the market than traditional asset classes, hence their appeal. For example, real estate investment returns are mostly independent of how the public equity market is performing. The same goes for all private markets and almost all hedge fund strategies. And though hedge funds are exposed to equity market risks, they can lower their correlation using leverage, shorting, and trading additional asset classes.

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 Risk 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. Depending on the length of commitment, investors can achieve rewards far surpassing capital they have allocated within the industry. Fund managers ensure that risks are calculated accurately and managed carefully.

Reasons for investing in alternatives vary across asset classes. Preqin regularly conducts surveys with investors in the industry to monitor their views on topics of interest. The chart below shows why investors allocate to each alternative asset class.



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. For example, real estate and infrastructure are often selected for their ability to deliver long-term reliable income streams, while private equity is selected for its potential high absolute returns.
In this lesson, we uncovered the reasons why investors allocate to alternative assets. From low correlation to the public market to the potential for higher returns on their investments, there are many reasons why alternatives can benefit an investor’s portfolio. We also looked into the risk/return profile of alternatives, an important factor for investors, who typically look for low-risk and high-return investments from their portfolios.
Go back: What Are Alternative Assets?
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