Alternative investments could be return-enhancing: CAIA's Keith Black

Does alternative investment help in reducing portfolio volatility?

Alternative investments can reduce portfolio volatility in two ways.  First, most alternative investments have lower volatility than investments in stock market indices.  Adding low volatility investments, such as hedge funds or real estate, to a portfolio will reduce portfolio volatility.  Alternative investments can also reduce portfolio volatility when the returns on alternative investments have a low correlation to the stocks and bonds already held in a portfolio.  For example, commodities have an equity-like volatility, but can reduce portfolio volatility when added to an equity portfolio because of the low correlation between the returns on stocks and commodities.

What are the benefits of investing in hedge funds compared to mutual funds?

Mutual funds are typically long-only, where an equity mutual fund would have close to 100% of assets invested in stocks.  Many hedge fund styles have both long and short positions.  For example, a long-short equity hedge fund may have 100% long positions and 50% short positions. The equity hedge fund, then, will have 50% net long exposure to the underlying stock market.  The hedge fund is expected to outperform in times when stock markets decline and underperform in times of large stock market gains.

Investors often have concerns over safety of hedge funds investment since they are not perceived to be as tightly regulated as mutual funds. What are your views?

Institutional investors perform a strict due diligence process before investing in hedge funds.  While hedge funds are less regulated than mutual funds in many jurisdictions, careful due diligence of investment and operational processes before investing can reduce the risk of investing in funds that experience losses unrelated to normal market movements.

Is liquidity a concern with alternative investment such as hedge funds and private equity?

While less than 20% of hedge funds have lockup periods of one to three years, most hedge funds now offer at least quarterly liquidity.  Private equity and venture capital are long term asset classes, where most funds have a stated life of eight to twelve years, typically without a provision for investor withdrawals until the fund's general partner has been able to sell or exit a portfolio holding.  While a long lockup period may not fit the needs of some investors, other investors seek to maximise their holdings of private equity and venture capital, as long-term returns to these less liquid investments have been more than 3% above the annual returns to investments in public equity markets.