Alternative vs. Traditional Investments

Once thought exclusive to risk-tolerant investors, the group of assets that have been called “alternative” investments is receiving the attention of more traditional investors. The endowments of select institutions have seen success by altering their investment strategies to include “alternative” investments in their portfolio. As the more traditional investors begin to notice the benefits of altering their investment strategies, it is more important than ever to compare the performance of alternative and traditional investments, and to understand how alternative investments can become part of one’s portfolio.
What is an alternative investment?
Types of Alternatives

• Private Equity
• Hedge Funds
• Managed Futures
• Alternative Mutual Funds
• Real Estate
• Commodities
• Infrastructure

Alternative investments use different strategies than the other investment types; these may include:

• Absolute rather than relative performance objectives
• The use of leverage instead of the use of limited or no leverage
• Usually being less liquid than the other types of investments, which offer daily liquidity
• Requiring often higher fees than the other investment types

Consequently, the performance of these investments is only moderately correlated to market indices. By comparison, the performance of the traditional types of investments is highly correlated to market indices.
Correlation Coefficient for Equities and Alternatives: 0.73
Correlation Coefficient for Fixed-Income and Alternatives: -0.09

How does the performance of alternative investments compare to traditional investments, such as equities and fixed-income investments?
Figure 1 shows the comparison of returns from traditional and non-traditional investments. Although there is generally less risk associated with investing in traditional investments, the graph clearly demonstrates that the non-traditional investments have the potential for greater returns; additionally, alternative investments outperformed traditional investments during crises.

 
Figure 1: Alternative vs. Traditional Investment Returns

How have endowments included alternative investments in their portfolios?
Despite the potential risks of certain alternative investments, there can be clear benefits associated with investing in alternative investments. An investor might choose to include these types of investments to improve the performance of his portfolio. Diversifying by including alternative investments may actually reduce volatility, and improve the risk-return characteristics of a portfolio.

The Endowment Model (aka the Yale Model):

Over the last quarter century, certain large endowments, such as Harvard and Yale, have restructured their portfolios. They have invested more in “alternative” assets, and less in long-only public equity and long-only public fixed income. Consequently, their portfolios have experienced strong returns. They have even outperformed portfolios invested more conservatively in “traditional” assets.