Despite unique risks and considerations, alternative investments can be useful tools to improve the risk-return characteristics of an investment portfolio. They can increase diversification and reduce volatility, given low correlations to more traditional investments; they can offer the potential for enhanced returns due to the wider investment opportunity set; and they can hedge certain portfolio exposures, thereby reducing concentration risk. This graph illustrates a sample Markowitz efficient frontier, representing all portfolios with the lowest risk (as measured by volatility) for a given level of return, or conversely all portfolios with the highest return for a given level of risk. The inclusion of alternative investments can move the efficient frontier up and to the left, so for a given level of return, risk is lower, or for a given level of risk, return is higher.
While alternative investments on their own may have higher volatility than more traditional investments, particularly fixed income, they typically have low correlations to more traditional asset classes. As such, their inclusion in an investment portfolio tends to result in lower overall volatility.
Because they have a wider universe in which to invest and do not have some of the same investment constraints (can short and hedge), alternative investments have the potential for higher performance than traditional investments.