A simple method of distinguishing between what is a traditional investment and an alternative investment is to carefully review their return characteristics. For example, stock returns refer to the returns of publicly traded equities. In similar fashion, the returns of bonds refer to the returns of publicly traded fixed-income securities. That said, investment options that offer returns that are significantly different from the returns offered by traditional stocks and bonds, are very likely to be regarded as alternative investments.
Investors seeking to diversify their portfolio often seek-out alternatives to balance the risks associated with their traditional holdings. Given that returns from alternative investments are uncorrelated with (or only slightly correlated with) traditional investments, non-traditional assets are seen by many as an appealing investment opportunity.
Investment products viewed as having little or no return correlation with traditional assets are also called absolute return products. This reflects the thought that their returns should (generally speaking) be analyzed on an absolute basis, rather than be relative to the returns of traditional investments.
- Using an absolute return standard means that returns are to be evaluated relative to zero or relative to the risk-less rate and therefore independent of the performance of equity markets, debt markets, or any other financial markets. Thus an investment program with an absolute return strategy seeks positive returns unaffected by market directions.
- Using a relative return standard means that returns are evaluated relative to a benchmark. An investment program with a relative return standard is expected to move in tandem with a particular market but maintain the goal of consistently outperforming that benchmark market.
These things considered, it is important to be aware that many of the investing options currently classified as alternative investments – such as private equity, real estate investments, and some hedge funds, provide returns that are somewhat correlated with public equities over the medium to long term; but, are still regarded as alternative investments.