We all know to what extent the Indian market is volatile. On top of that, the modern world is in constant conflict and war with each other. India and Pakistan are such two widely known examples.
Today, we cannot even assure that the money we have put in the bank is safe. The recent disaster of PMC bank had kept all the depositors on the line. Goodwin Jewellers scam is another such example.
So, today we all need ways to do alternate investment.
Definition of Alternative Investments
An alternative investment is an investment in an asset class other than traditional investments like stocks and bonds. The term is not very well defined and can consist of tangible assets to non-tangible assets. These include wine, gold, art, coins and as well as financial instruments like hedge funds, private equity, venture capital, distresses debt and also the newly evolved cryptocurrencies.
What are the most popular types of alternative investments?
I have highlighted a few alternatives below however; new products are being developed constantly and this list aims at being more illustrative than exhaustive.
- Private equity
- Hedge fund
- Complex structured products
- Managed futures
- Real estate
- Precious metals
Now that we have understood the meaning and types of alternative investments, let’s jump on to the most important question –
Why investing in alternative investment is important in this highly volatile market?
I will answer this question by providing you with an insight into how these investments can add value to an investor’s portfolio and authenticate them using some real-world examples. So let’s begin –
- Reduce volatility by Diversification
One of the primary goals of investment in alternative classes is to reduce risk through portfolio diversification. The correlation of alternative investments with the major asset classes like equity and bonds is very low and this is its distinctive feature. Alternative investments are also used as an inflation hedge. A portfolio that has allocated a certain percentage of its funds to alternative investments will have reduced risk without majorly affecting the returns.
To understand the diversification benefit better let us look at a real-world example. The below graph has the returns that the S&P 500 and gold offered over a period of the last nine years. The change in returns is shown quarterly.
By looking at the graph it is quite evident that the two asset classes behave in an inverse manner and have a negative correlation. The clearest evidence of this is in the period of 5/11, 5/13 and 9/18 as highlighted in the graph above. So assume an investor who had invested in an alternative asset class – gold during the last nine years in his/her portfolio along with the traditional asset class like stocks would have gained because of the low correlation and diversification benefit in comparison to only having stocks in its portfolio.
Let us now look at the historical correlation between different asset classes (traditional and alternative) from the period of 1994 to 2007.
It can be clearly seen that alternative investments apart from the 2x Geared large-cap stocks have had a lower correlation with the S&P 500 in fact, 1x Geared large-cap stocks have a perfect negative correlation with the S&P 500 providing the maximum diversification benefit.
- Alternative Investment reduces volatility and increases return
One of the major goals of alternative investments is to increase the return by adding other assets that have different risk and return characteristics than that of the traditional portfolio. The scope of alternative investments is huge and it has a wider universe to invest in. . Another important point is that there is no constraint in the case of alternative investments like the traditional assets and they are also allowed to short.
Alternative investments add return because of the five factors mentioned below. Please note that there are a lot of products with different characteristics that fall under the umbrella of alternative investments and all these factors may not apply to all the products equally. Investment in Alternative investments should be done as per the applicability of an investor’s portfolio.
For example Hedge funds, Private equity buyouts may benefit my taking leverage while venture capital may not. Consider a net worth individual who has no exposure to debt securities, for him/her investment in Hedge funds or Private equity buyouts may be appropriate in comparison to investment in venture capital.
Let us look at some historic return and risk profiles of various asset classes from 1990 to 2013. This will help you understand how the asset classes have been performing in comparison to the risk they possess.
It can be observed from the above graph that the group of alternative investments has not only outperformed the S&P 500, but they have also done this by taking a lower risk (as measured by standard deviation).
However just investing in alternative investments can also be risky, a proper mix should be attained to reduce risk and increase return.
After reading through the points you would be wondering if alternative investments are suitable for you? and how and where can you get access to these.? Well, alternative investments in its earlier days were only available to the high net worth individuals and institutions. But with its increasing popularity, they are now widely available and liquid.
In order to meet your goal of reducing volatility in your portfolio please consider the below points –
- Are you diversified enough?
- And do you have sufficient investments that will go up when your traditional portfolio is down?
If answers to the above questions are unclear to you please, take the help of your financial advisor before investing in alternative investments.Read more: 7 Free Resources For Learning Ms Excel