LOS C requires us to:
describe potential benefits of alternative investments in the context of portfolio management
1. The most fundamental principle that guides all the investments in the alternative assets is that these markets are inefficient and offer positive alpha returns (that is the real risk-adjusted returns).
The alternative assets, thus, require active management in order to generate positive alpha returns. And thus, the alternative assets act as return enhancers and portfolio diversifiers.
There are, however, certain challenges towards investing in alternative assets. Some of them are finding reliable measures of risk and return, identifying the appropriate allocation, selecting the right portfolio managers, etc.
2. Most of the alternative assets have a low to zero correlation with traditional investments. This can be evidently seen by calculating the coefficient of correlation between the historical data of both categories of investments. They, therefore, provide diversification benefits to the portfolio.
The main reason behind the low degree of correlation is that the alpha of an asset is generally not correlated to its beta.
3. Most categories of alternative investments offer higher returns, therefore increases the return on the portfolio.
The main reasons for the higher return on the alternative investment are: the tax benefits involved with investing in the alternative assets, higher management capability due to the requirement of active management, higher return premium for illiquidity, and the use of leverage.