Alternative investments refer to assets and strategies outside of traditional investments in stocks, bonds and cash. They encompass a wide range of categories including hedge funds, private equity, venture capital, real estate, infrastructure, commodities, and derivatives. The main appeal of alternative investments is diversification and return enhancement. By having low correlation with traditional assets, they can reduce overall portfolio risk and volatility. Many alternative strategies also aim to generate higher absolute returns through leverage, shorting, and illiquidity premiums. However, alternatives come with higher fees, complexity, and liquidity constraints. Thorough due diligence and portfolio construction is key.
Hedge funds utilize dynamic strategies
Hedge funds are actively managed pools of capital that invest across a wide variety of assets and derivatives. They utilize leverage, shorting, and other more complex strategies to target absolute returns regardless of market conditions. Some common hedge fund strategies include equity long/short, event-driven, macro, relative value, managed futures, and more. The flexible mandate allows managers to dynamically shift exposures based on opportunities. However, hedge fund returns tend to have higher volatility and their opaque nature presents risks that need to be evaluated.
Private equity and venture capital target illiquidity premium
Private equity refers to investments in private companies not listed on public exchanges. The illiquidity premium captured and the use of leverage allows private equity to generate higher returns than public markets. Private equity encompasses venture capital investments in early stage startups, growth equity in more mature private firms, and leveraged buyouts of public companies. Venture capital in particular targets technology and other high growth startups and innovators. The high risk is compensated by the potential outsized returns from identifying the next superstar companies early on.
Real assets provide tangible value and inflation hedge
Investments in real assets like real estate, infrastructure, timber, farmland and commodities provide tangible value and ownership. Their intrinsic value has historically kept pace with inflation, providing an inflation hedge for portfolios. Additionally, factors like rising populations, urbanization, and growing resource constraints provide tailwinds for appreciation. The illiquidity premium also boosts returns for long-term investors. However real assets exhibit cyclicality tied to economic conditions and typically require specialized institutional-scale access.
Portfolio construction is key for risk and diversification
While alternatives can enhance portfolio returns, thoughtful construction is critical to balance those benefits with the risks. Illiquidity, leverage, volatility and opacity need to be addressed at both the strategy and portfolio levels. Diversification across strategies, managers, and vintage years is key to reducing risks. Portfolio level constraints should match the liquidity terms and risk tolerances of the investors. The due diligence burden also escalates for more complex strategies, requiring rigorous qualitative and quantitative assessment of track records, personnel, operations and more.
Alternative investments encompass a diverse range of non-traditional assets and strategies external to conventional stock and bond allocations. Used judiciously, they can enhance portfolio returns through diversification, risk reduction, and capturing illiquidity and complexity premiums. However, alternatives come with unique risks that need to be evaluated carefully during due diligence and portfolio construction.