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Understanding Misconceptions about Alternative Investments

Monday, January 08, 2018
By Joanne Murphy

Joanne Murphy, MD-Asia Pacific, Chartered Alternative Investment Analyst Association (CAIA Association)

Over the last quarter of a century, alternative investments have enjoyed an enviable track record, providing less volatility than equities and better returns than stocks and bonds. Yet many remain wary. This can be contributed to the fact that the concept of alternative investments is surrounded by a great deal of mystery. More than often, they are considered to be exotic, high-risk, volatile or for the ultra-wealthy and sophisticated institutes.

In reality, alternatives have a place in nearly every portfolio, and cover a broad range of vehicle, with a goal to enhance return, add diversification and provide the overall portfolio with some downside protection.

Breaking down Alternative Investment
An alternative investment is an asset that does not come under conventional investment types, such as bonds, stock and cash. Alternative investments include hedge funds, managed futures, private equity, real estate, commodities, exchange funds and derivatives contracts.

While there is positive growth in terms of such investments subsequent to the demonetisation drive, however, this newfound awareness does trigger a wave of misconceptions. The following points will shed more light on the advantages of this new investment vehicle and dispel some pervasive, common myths held by investors:

Alternatives Are Nothing New
Contrary to common notions that these are new, exotic investment option with no long-term track records, alternative investments have actually existed for decades. For instance, hedge funds have been around since the 1940s, and rose to prominence in the 1980s.

Alternative Investments Are Excessively Risky
Another lingering misconception is that alternatives are too risky. Every investment in isolation can be viewed as risky. While it is true that they are unique, with considerable risks, however, alternatives are basically designed to manage volatility and mitigate risk when used as a component of a diversified portfolio. Here, it is important here to make the distinction between risk and portfolio flexibility. While these unconventional investment options may be complex and involve higher risk, they are designed to provide better performance than traditional products. To understand this comprehensively, one should involve a holistic view of an investment’s impact on a portfolio.

Increased Volatility
Another misconception is that alternative investment increases the overall volatility of a portfolio. The truth is alternatives possess low to moderate correlation of returns compared to conventional investments. To help reduce overall volatility, investors should opt to diversify a traditional investment portfolio with appropriate alternatives. During times of increased volatility for stocks and bonds, the low correlation between those two asset classes and alternative investments comes even sharper into focus, making the heterogeneous diversification more attractive. Here an investor can think opt for an array of alternative investments such as equity return assets, equity hedge assets, and opportunistic assets, such as private equity, and direct lending.

The Illiquidity Issue
Investors may hold the belief that all alternative investments are illiquid. In reality, alternatives have varying levels of liquidity, while some strategies tend to have longer investment horizons, other equity strategies have much shorter lock ups. This is usually balanced by improved returns and is termed as an “illiquidity premium.”

Alternatives are designed to outperform stocks
The universe of alternative investments is quite broad, and strategies have unique return objectives. Investors should understand that return and risk objectives vary from strategy to strategy and manager to manager. For this reason, it is imperative that the investor understand the risk and return objective. Understanding this, investors will find that some alternatives, such as private equity, seek to outperform stocks. They will also find that some alternatives seek equity-like returns and lower volatility and downside risks than stocks. There are also some alternatives that are more bond-like in nature, both in terms or return and risk.

As unfamiliar and exotic alternative investments may seem, it is crucial to understand the unique nature and various benefits of these asset. In a nutshell, having an allocation to alternatives both enhances returns and reduces volatility for investors. Due to a number of innovations, these non-traditional investment options can play an integral role in nearly every investor’s portfolio.

As investors seek additional ways to diversify their portfolios to reduce market volatility, alternative investments continue to be one of the fastest growing investment vehicles today.

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