What is Private Equity? | What is Correlation? | Portfolio Diversification |
What is Alternative Investment?
Alternative Investment is referred to as investment in asset classes other than traditional avenues such as stocks, bonds and cash (includes liquid funds).
Alternative Investments includes Private Equity, Hedge Fund, Commodities, Real Estate, Art objects, etc.
Alternative Investments are something which requires specialized knowledge because they are less liquid, less transparent and use a lot of leverage. Thus with such characteristics it also requires to be compensated with higher returns.
Take for example, Real Estate. Buying a piece of property for investment purposes comes with several constraints. It is less liquid because it cannot be sold off in case of urgent requirement of funds. If sold, the value realized will be less than its actual, sort of distressed sale.
Similarly, it is the case with Private Equity. Private Equity refers to investment in private companies like start-ups where the shares are not listed or traded in the stock market. Thus, these investments are less liquid. Here Private Equity funds directly invest in the private companies which are still not fully grown but have the potential to be market leaders of tomorrow in their segments. Such companies are identified and invested into at lower valuations. And then as the company grows, the equity valuation increases and thus then Private Equity funds offload the stake. But these gains are exponential.
Thus from above two cases, it can be seen that alternative investments require specialized knowledge but have the potential to deliver larger return than the traditional investments due to its inherently having more risk than later.
But why should one invest in these asset classes?
Historically, it has been found that the asset classes under alternative investments that is Private Equity, Hedge Fund, Commodities, Real Estate, Art objects, etc. tend to have less correlation with the traditional asset classes which includes stocks and bonds.
What is Correlation?
Correlation is simply a measure to capture the co-movement of two different asset classes. That is to know if both asset classes move in the same direction in terms of return or not. If they respond differently to a particular economic scenario means they are less correlated.
In simple language, they don’t tend to move in the same direction. Meaning when a traditional asset class performs, the alternative may not perform or perform less and when alternative asset classes perform, the traditional may not perform.
Higher the correlation between two asset classes, higher the possibility of both of them moving in the same direction. Lower the correlation, they tend to move in opposite directions.
This tendency of low correlation makes them a perfect fit for inclusion in a portfolio. Because when we talk about portfolio diversification, what we basically aim to achieve is such a combination of asset classes which tend to strike off each other’s volatility in order to provide stable returns on the overall portfolio.
Conclusion
Thus including alternative investment in the portfolio will result in increase in the expected return of the portfolio as Expected return on a portfolio is simply the weighted average of the expected returns on the asset classes. And as the expected returns on the alternative investments are higher as compared to traditional asset classes, it will lift up the overall portfolio returns.
And as the correlation of alternative investments is less with traditional asset classes, it helps to reduce the volatility of the overall portfolio thus reducing the standard deviation of the portfolio.
Hence it will increase the excess return per unit of risk for the portfolio or to say it will increase the Sharpe Ratio of the portfolio which always remains one of the basic objectives of any investor.
Thus, increase in expected returns and decrease in risk or standard deviation of the portfolio proves the base case for investment in the Alternative Investment as an avenue.
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