Four Benefits of Alternative Investments
Alternative investments represent an aggregate of hedge funds, private equity, real estate, commodities, managed futures, and a growing number of other types of (often exotic and mysterious) investments.
They have become increasingly popular and kind of mainstream in the last two decades – not only thanks to stories about billionaire fund managers and star traders, but also because of unique characteristics and benefits alternative investments can bring to a portfolio:
- Diversification potential.
- Inflation hedge.
- New exposures and opportunities.
- Higher returns.
Benefit 1: Diversification Potential
The popular belief that hedge funds and private equity funds are extremely risky investments on a standalone basis is justified to great extent. However, when you think about these investments in the context of total portfolio, you will find that many types of alternative assets have great diversification potential. Their returns show low correlations to traditional asset classes like stocks and bonds and therefore adding alternative investments to a portfolio can reduce volatility without sacrificing part of return. Diversification is among the strongest reasons why some types of institutional investors (including pension plans, endowments, or foundations) invest in alternative assets.
Benefit 2: Inflation Hedge
Some alternative asset classes are a good inflation hedge (their returns are highly correlated to inflation). Infrastructure investments provide a low, yet stable long-term real return. Commodities are also believed to be a good inflation hedge, though you must be ready to accept much higher volatility with commodities.
Benefit 3: New Exposures and Opportunities
Because alternative investments are so diverse, you have plenty of opportunities to find new exposures, which are not accessible with traditional investments. Besides stocks and bonds, you can invest in commodities, infrastructure, real estate projects, or start-up business ideas.
Benefit 4: Higher Returns
Some kinds of alternative investments are very risky on a standalone basis, but investors are rewarded for this risk by higher returns. Like all the other above listed benefits, this only applies to some types alternative investments (e.g. some hedge fund strategies or venture capital investments). Like those of traditional investments, returns of alternative investments vary over time depending on market conditions and economic cycle.
There are Problems with Alternative Investments, Too
The benefits of adding alternative investments to a portfolio are so significant that many investors invest in alternative assets in spite of the difficulties that investing in alternative assets represents. These issues include low liquidity, difficult pricing and benchmarking, legal constraints, and costly due diligence process. Here you can read more about some issues with alternative investments in detail.