The New Science of Asset Allocation: Risk Management in a Multi-Asset World

CHAPTER 7

Sources of Risk and Return in Alternative Investments

Any investment outside of traditional fixed income, equities, or cash is often considered an alternative investment. As such this category occupies a vast space in finance. Most books on asset allocation, however, continue to emphasize the return and risk characteristics of traditional stock and bond investments. Chapter 7 travels a new road and focuses on major forms of alternative investments, their source of returns, and their recent performance. Alternative investments include hedge funds, managed futures, private equity, real estate, and commodities.¹ In this chapter a working definition for each is provided. For a range of alternative investments, the historical performance and correlation with certain performance benchmarks such as the S&P 500 are presented. The overall goal is to demonstrate how these asset classes should perform within a multi-asset portfolio. Throughout the analysis the period 2001 through and including 2008 is used as a reference period. This period was chosen because 2001 corresponds to the end of the dot-com bubble and is perhaps a bit more reflective of future equity and fixed income markets. There are significant caveats, however, with this approach. First, reference periods can always be used to game pro forma return results as well as risk projections. Where a period starts and where it ends can have significant consequences as to whether the performance looks great or whether the ...