Reading 25: Asset Allocation－LOS i

Each category of alternative investments, such as private equity, hedge funds, and real estate, on its own is fairly risky, but can have significant diversification effects for an investment portfolio. In a portfolio context, alternative investments can significantly increase returns and lower the risk of the portfolio due to their low correlation with traditional asset classes.

Sediques statement is incorrect. Although emerging markets have been shown to have a low correlation with other asset classes, and thus, diversification benefits, in a global crisis, the correlation between emerging markets and developed markets tends to be high. In other words, the diversification benefit of emerging markets is weak at exactly the time when the investor needs it the most. Alvarezs statement is correct. U.S. TIPS are highly liquid and virtually risk free because they are issued by the U.S. government. In addition, as inflation rises, the principal on which the TIPS coupon is based also rises, resulting in higher portfolio cash flows in an environment of rising inflation.

The Taylor investment committee should agree with both of Melbys statements as she has correctly identified some of the practical concerns when investing in global securities and alternative investments such as hedge funds. The practical considerations of including global securities in a portfolio relate to risks that an investor does not face with a domestic-only portfolio such as currency, political, and legal risks. Even if there are diversification benefits from including global securities, a portfolio manager needs to consider that the investor would be exposed to risks that they would not otherwise be exposed to. Melbys second statement is also correct as a lack of information, large amount of required capital, and the need to carefully select out-performers are all drawbacks to alternative investments that potentially could prevent the investment manager from using them in client portfolios.