Diversification is the word on every portfolio manager or investor manger’s lips which I would say is a step in the right direction.
Diversification has different meanings to different classes of investors. To the retail investors, diversification means buying equities, bonds, treasury bills & mutual funds into their portfolio. For high-net-worth and institutional investors, they look at diversification as an exclusive purpose. I am sure you might be wondering: How do we diversify? This can be done by the way of alternative Investment.
How can we define alternative investment?
Alternative investment is simply an investment in other asset classes aside from the traditional asset classes such as stocks, bonds, and cash.
Alternative investments include investments in five main categories: hedge funds, private capital, natural resources, real estate, and infrastructure.
Characteristics of Alternative Investment
Lower liquidity: Based on the nature and character of this investment type, it takes a longer period for the asset to be converted to cash, especially when compared to the traditional asset class.
Less regulation: This investment class is less regulated. This can be good or bad. In an unregulated market, investors get to suffer, especially where there are no rules or regulations guiding the players in industry. The good side to this is the upside potential of high returns.
Lower transparency: The impact of low regulation in this asset class is low or there is no transparency among players in the market. This is due to transactions being private.
Higher fees: The transaction cost in this asset class is high and it is usually not standardised.
Limited and potentially problematic historical risk and return data: The data to make informed decisions is usually limited.
Why Alternative Investment?
It is a strong tool for diversification: it is important for one not to put all her eggs in one basket. This asset class can help the investor achieve diversification from the traditional asset class.
There is usually an inverse relationship between the traditional asset class and alternative investments. A low correlation with markets which makes them less susceptible to systematic risk or market-oriented risk elements.
High returns on investment: This asset class offers high returns on investments as the calculated risk being taken by the investor is also high.
Tax Benefits: Some of these investments offer tax benefits. This enhances the returns of the investment especially when compared to the traditional asset which deducts tax from the earnings.
- Complex in nature: The investor must be knowledgeable before investing in this asset class. This is because of the complexity of the investment class. On
- Higher transaction fees: Transaction fees are usually on the higher side more so when compared to traditional asset classes.
- More volatile than traditional investments: The beta of this investment class is usually above one.
- Relatively illiquid: It is illiquid when compared to the traditional asset class. Investors might have to go through the Over-the-Counter Platform to sell the stock.
Diversification and higher returns define the essence of alternative investments, and one needs to put in thorough due diligence before parking funds in them.