One of the main reasons for owning alternative investments is to achieve greater diversification and less exposure to traditional market risks. But investors should note that increased diversification does not always result in increased portfolio efficiency.

Portfolio risks constitute more than just volatility, and investors will always need to consider and assess the multiple dimensions of risk to avoid surprises with their portfolio outcomes.

The Role of Alternatives in a Portfolio

Before determining whether a particular investment can help a portfolio meet a specific investment objective, one must have clarity about what that objective is. Diversification and volatility management are often assumed to be synonymous, but they are actually very distinct concepts. Any discussion of their distinctions must also take into consideration a third, related concept―portfolio efficiency.

Diversification is about allocating capital to reduce exposure to any one particular asset or to risk by investing across additional asset classes or other securities.

Managing Volatility is about allocating capital in a manner that is consistent with the goal of reducing overall portfolio volatility to be within an acceptable range.

Portfolio Efficiency is a further refinement of volatility management and is about allocating capital to maximize the return realized for each unit of volatility assumed.

The importance of making these distinctions arises from the fact that increasing diversification does not always bring lower volatility or increased portfolio efficiency.

The Potential Benefits of Alternative Strategies

One of the main reasons investors turn to alternatives is to manage some type of risk. Volatility has traditionally been the primary attribute that investors associate with risk, but risk is multi-dimensional and extends far beyond volatility. One dimension of risk worth close examination is sensitivity to particular markets, such as equities or fixed income.

[Watch videos: Benefits of a Multi-Strategy Alternative Portfolio]

In looking at equity beta for example, alternative assets such as real estate investment trusts (REITs), master-limited partnerships (MLPs) and commodities, have historically higher sensitivity to equities. On the other hand, alternative strategies such as long/short equity, market neutral, or a multi-strategy approach, typically exhibit lower sensitivity to equities.

Also, with strategies that invest in a single asset class, it can be a much more straightforward exercise to understand the risks and sensitivities that are present. However, with a multi-asset strategy that may invest both long and short, determining the sources of risk is a much more nuanced and detailed process. So to know whether an alternative strategy can work effectively in helping an overall portfolio achieve its objectives, one must understand and analyze all sources of risk for that strategy.

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