Alternative investments, which have been used by large institutions and endowments for quite some time, have become more mainstream in recent years. Not only are they more popular among individual investors, but there are also more alternative vehicles available, making investing in alternatives possible for a much broader universe of investors.
Given their non-traditional approach and their ability to invest in areas and ways traditional investments cannot, they have the potential to improve the overall risk-return characteristics of a portfolio. As such, a modest allocation to alternatives may be prudent for more investors than previously was the case. However, the non-traditional approach and structure of these investments bring with them unique risks of which investors must be aware.
Alternative investments utilize a different approach to investing than do traditional equity or fixed income investments. This approach may involve holding both long and short positions, using hedging strategies, and investing in illiquid investment vehicles. Investors using alternatives may also have a goal of achieving a particular level of absolute return as opposed to relative performance versus an index.
Given alternative investments' low correlation to traditional investments, they can potentially enhance diversification and reduce risk; with their ability to be more flexible and invest in a wider opportunity set, they can potentially enhance return; and they can be used to hedge certain portfolio exposures, thereby reducing concentration risk. As a result of this different investment approach, alternative investments have different risks and characteristics than do traditional investments. They are often less liquid, particularly in periods of stress; they are generally more complex and less transparent, making them difficult for untrained investors to understand.
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