Alternative assets bring qualities to portfolio construction
Despite a unique set of risks, alternative assets allow investors to take a different approach toward portfolio construction. Alternative assets provide tools to sophisticated investors to improve the risk-return tradeoff in their portfolios. Because they have such a low correlation to traditional investments, these assets reduce volatility while increasing diversification in a portfolio.
Alternative assets reduce risk, increase returns
Let’s look at a study.
Standard deviation is the difference between an individual value in a set and the average of the set. The chart above plots risk as measured by standard deviation on the horizontal x-axis. Total annual returns are plotted on the vertical y-axis. Portfolio mixes of 30% equity–70% bonds, 40% equity–60% bonds, 50% equity–50% bonds, 60% equity–40% bonds, and 70% equity–30% bonds have their risks and returns plotted on the lower half of the chart.
Then, the different portfolio mixes were altered to include alternative assets. This was done by reducing allocation to equity by 10% and bonds by 5% in each of the portfolio mixes. In each case, the risk of the individual portfolio decreased. With the decrease in risk, the portfolio’s returns also increase. This is a portfolio manager’s desired outcome.
Because of this risk-reducing characteristic, more investment firms are moving in the direction of alternates. Alternative asset managers such as BlackRock (BLK), the Blackstone Group (BX), Invesco (IVZ), and Legg Mason (LM) are all part of the Financial Select Sector SPDR Fund (XLF), and have benefitted from this trend.