Alternative Investments: Investing in Alternatives

The Sharpe ratio is calculated by dividing the excess return on the fund, over and above the risk-free rate of return (on cash, for example), by the amount of risk that manager has taken to generate the excess return, which is measured by the annualised standard deviation of returns.

In simple terms, it represents the return generated by the manager's skill, compared with the amount of risk taken in the process. Or put yet another way, it indicates the unit of return per unit of risk.

The Sharpe ratio is a useful tool, but it does have its limitations. In particular, investors often find it clumsy if they are used to measuring a traditional portfolio in percentage terms against a benchmark or stock market index.

However, because alternative asset classes aim for non-correlation to the traditional stock and bond markets, it is pointless trying to compare the return on an alternative investment with market indices, such as the S&P500.

Alternative investments are sometimes described as absolute return assets, precisely because the returns cannot be judged relative to a benchmark, a market index, or even to each other, theoretically. Although, recently, a number of new indices have emerged that group together alternative investment strategies of a similar profile in order to create a benchmark for investors.

Purists argue that these new benchmarks will straitjacket managers into mimicking the risk/return profiles of the index, rather than developing their own strategies and techniques. In fact, it is true that the only real benchmark for alternative investments is cash, which has been used traditionally to represent a risk-free investment. Beating cash in any market climate is the true occupation of alternative investment managers.