Portfolio diversification policies: Alternative asset classes

Abstract

Alternative investments have been subject for debate for a long time, both in scientific literature and in practice, from two points of view: on the one hand, from the defining perspective, which is aimed to determine what is understood as an alternative investment; on the other hand, from the management perspective, based on defining rationally which weight should be attributed to these asset classes within the context of investment policies. The inclusion of alternative investments in the asset allocation of an institutional investor satisfies the primary need to achieve the optimal risk-return trade-off of a portfolio. Historically, alternative asset classes have shown capability to reward risk, when measured exclusively by variance, more successfully than traditional instruments. In addition, alternative investments have proved to be uncorrelated to equity and fixed income asset classes. The benefits deriving from the inclusion of alternative assets in a financial portfolio cannot be fully evaluated without considering distribution moments higher than the second. This chapter, therefore, analyses the construction of optimal portfolios following the multiple objective model developed by Davies, Kat and Lu (DKL), where investors can decide the level of exposure to each of the four moments of return distribution.