Friday, May 25, 2007

Why Alternative Investments for Indians?

Just as the lower end of Indian investors (more like savers actually) used predominantly debt asset class, the higher end stuck to a combination of debt and equity. Over time, real estate also found way as a stable and "real" investment avenue.
All along, however, the investments were exposed to the same set of drivers in terms of value - interest rates, economic growth, monetary policy, exchange rate.
The Indian investor is now waking up to the potential of alternate assets in providing truly diversified returns over a long term. The word truly is based on the observation that within equity markets, you can only do so much of diversification. After all, most of the stocks tend to move together, if you actually draw up the correlations across blue-chip stocks, you are unlikely to find many low correlation options. In the domain of diversified funds, the correlations are even higher.

For an investor willing to take on risks, there was not much of a choice beyond equity till recently. However, increasingly the asset classes such as private equity, venture capital, gold (and other commodities), real estate (more through professionally managed funds) and even hedge funds are catching the attention of investors and investment consultant alike. The reason is straightforward, these asset classes have very low correlation with the traditional asset classes like debt and equity.

One reason for this low correlation is fundamental factors driving the asset prices (in case of commodities and real estate) and in some cases the reliance on the fund manager's skills to generate returns. The different between the mutual fund manager and hedge fund manager is that a large part of the former's returns are explained by the market movement whereas the latter strives to generate market neutral and absolute returns. Likewise, private equity fund manager tries not to diversify away the single stock risk but actively seek it to maximize his returns - his fortunes though somewhat linked to market, are not dominated by general stock market movements (unless they are extreme). The movement is clearly towards skills based return generation.

The trend is similar to one seen in the developed markets. As of now, the developed markets have debt returns not more than 5% at best and the equity returns of 10% are considered quite acceptable. The promise of active fund managers to deliver returns above this has drawn investors to park part of their risk capital with these growth opportunities.

As the Indian stock markets growth numbers come more within the usual ranges of nominal GDP growth + 5-10%, the Indian investors will also start seeing greater value in
seeking returns beyond the market - not above or below but simply beyond. So that they have a return generation avenue independent of the markets.

Alternate investments reduce risk of a given portfolio for a given target return rate. Seen from other side, they increase returns for a given level of risk. The basic argument is built along the lines of efficient portfolio frontier. The more diversified the portfolio, the lesser the risk. The diversification can happen at multiple levels - asset class, geography, within asset class and so on.

The quest for efficient investment management will lead people to seek newer avenues of making the best of their money. Alternate investments of today will become the mainstream of tomorrow and there will be a new set of "alternate" investments! So is the story of economic growth!

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