Investing in Alternatives – Benefits and Risks

20.6 Investing in Alternatives – Benefits and Risks

In the ever-evolving landscape of investment, alternative investments have emerged as a compelling option for investors seeking to enhance their portfolios. This section delves into the primary reasons for including alternative investments, such as hedge funds, private equity, real estate, and commodities, in a diversified portfolio. We will explore how these investments can contribute to portfolio stability and growth, while also examining the associated risks.

Introduction to Alternative Investments

Alternative investments are financial assets that do not fall into the conventional categories of stocks, bonds, or cash. They include a wide range of investment vehicles such as hedge funds, private equity, real estate, commodities, and more. These investments are often sought after for their potential to provide diversification, generate alpha, and increase absolute returns.

Diversification

One of the primary reasons investors turn to alternative investments is diversification. Diversification involves spreading investments across various asset classes to reduce risk. Alternative investments typically have a low or negative correlation with traditional investments like stocks and bonds. This means that when traditional markets are volatile or declining, alternatives may perform differently, thereby reducing overall portfolio risk.

Example: Consider a Canadian pension fund that includes real estate and commodities in its portfolio. During a stock market downturn, the real estate market might remain stable or even appreciate, providing a buffer against losses in equities.

Adding Alpha

Alpha represents the excess return on an investment relative to the return of a benchmark index. Skilled managers of alternative investments often employ unique strategies to generate alpha, enhancing risk-adjusted returns. These strategies may include leveraging market inefficiencies, employing sophisticated financial instruments, or capitalizing on niche market opportunities.

Example: A hedge fund manager in Canada might use a long-short equity strategy to exploit pricing inefficiencies in the Canadian stock market, aiming to outperform the TSX Composite Index.

Increasing Absolute Returns

Absolute return strategies aim to achieve positive returns in various market conditions, regardless of market direction. This contrasts with relative return strategies, which focus on outperforming a benchmark. Alternative investments often employ absolute return strategies to provide consistent performance.

Example: A Canadian alternative investment fund might invest in a mix of global commodities and currencies, seeking to generate returns irrespective of the performance of Canadian equities or bonds.

Contribution to Portfolio Stability and Growth

Alternative investments can play a crucial role in stabilizing and growing a portfolio. By providing diversification, they help mitigate risk and reduce volatility. Additionally, the potential for alpha generation and absolute returns can enhance overall portfolio performance, contributing to long-term growth.

Portfolio Stability

The inclusion of alternative investments can lead to a more stable portfolio by reducing exposure to market-specific risks. For instance, during periods of economic uncertainty, real assets like real estate or infrastructure can provide steady income streams and preserve capital.

Portfolio Growth

Alternative investments offer opportunities for growth through access to unique markets and strategies. Private equity, for example, allows investors to participate in the growth of private companies, which may offer higher returns than publicly traded companies.

Glossary

• Alpha: A measure of an investment’s performance on a risk-adjusted basis, indicating the value added by the manager.
• Beta: A measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole.
• Absolute Return: The return that is achieved over a period by an investment, regardless of the performance of other benchmarks.

Risks of Alternative Investments

While alternative investments offer numerous benefits, they also come with risks that investors must consider:

• Liquidity Risk: Many alternative investments are less liquid than traditional assets, meaning they cannot be easily sold or exchanged for cash without a substantial loss in value.
• Complexity and Transparency: Alternative investments often involve complex strategies and structures, which can be difficult for investors to fully understand. Additionally, they may lack the transparency of traditional investments.
• Regulatory Risk: The regulatory environment for alternative investments can be less stringent, leading to potential risks related to oversight and compliance.

Canadian Context and Regulations

In Canada, alternative investments are subject to specific regulatory frameworks and guidelines. The Canadian Investment Regulatory Organization (CIRO) oversees the conduct of investment dealers and their registered representatives. Investors should be aware of the regulatory landscape and ensure compliance when investing in alternatives.

Frameworks and Resources

• Sharpe Ratio and Risk-Adjusted Performance: A useful tool for evaluating the risk-adjusted performance of alternative investments. Learn more.
• Books: “Against the Gods: The Remarkable Story of Risk” by Peter L. Bernstein offers insights into the history and management of risk.
• Online Articles: Explore the Benefits of Alternative Investments for a deeper understanding of their role in a diversified portfolio.

Conclusion

Alternative investments provide a valuable means of enhancing portfolio diversification, generating alpha, and achieving absolute returns. However, they also come with unique risks that require careful consideration and management. By understanding the benefits and risks, investors can make informed decisions and effectively incorporate alternatives into their investment strategies.

Ready to Test Your Knowledge?

Practice 10 Essential CSC Exam Questions to Master Your Certification