Alternative investments—those that fall outside traditional assets such as stocks, bonds, and cash—have grown steadily in popularity among individual investors over the past two decades. Once the preserve of institutional players and ultra-wealthy individuals, these assets have increasingly found their way into retail portfolios, initially through products designed for institutions, and more recently via offerings tailored to individuals.
The category spans a wide spectrum: private equity, hedge funds, real estate, cryptocurrencies, commodities, and collectibles. These investments are often pitched as offering superior risk-return trade-offs, with the potential for higher returns at a given level of risk.
However, valuation expert and New York University professor Aswath Damodaran has urged caution. In his latest blog post, he argues that alternative investments often fail to deliver on their promises.
He notes that most foundational investment principles are built for long-only investors in public stocks and bonds, with cash as a buffer. These lessons, he says, largely ignore the wider investment universe—including private businesses, short-selling strategies, and non-traded assets.
“These overlooked areas,” Damodaran writes, “make up the alternative investment universe, which has been aggressively sold over the last two decades with the promise of superior risk-adjusted returns.”
The sales pitch typically rests on two key ideas: first, that alternative investments are less correlated with public markets and hence offer valuable diversification; second, that market inefficiencies persist in the alternative space due to its opacity and illiquidity—giving PE, VC, and hedge fund managers the opportunity to outperform.
While this narrative has drawn institutional interest, Damodaran notes that actual outcomes have often fallen short. “Despite the fanfare, the expected improvements in risk-return trade-offs—such as higher Sharpe ratios or reduced losses during crises—have largely failed to materialise,” he says.
Damodaran outlines four main reasons for the underperformance of alternative assets:
Correlation is overstated: Private investment valuations are often based on stale or lagged data, making them appear less volatile than they truly are. In times of crisis, however, they tend to behave just like public assets.
Illiquidity and opacity: These features are tolerable in stable markets but pose serious risks when liquidity is needed or markets deteriorate.
Under-performance: “Just like mutual funds, the median VC and PE fund now under-perform the market,” Damodaran observes. While a few top-tier managers still outperform, they are rare exceptions.
High fees: Many alternative funds charge hefty fees—so high that even strong performance may not fully offset them.
For investors still considering alternatives, Damodaran offers practical advice:
--Focus on investments that genuinely exhibit low correlation with public markets, rather than relying on historical data that may be misleading.
--Avoid high-cost or exotic funds that are unlikely to deliver commensurate value.
--Be realistic about time horizons—many alternatives require long-term commitments to be effective.
--Remain sceptical of claims about consistent alpha, and remember: past performance is no guarantee of future results.
(By arrangement with livemint.com)
