Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which of the following return characteristics differentiates alternative investments from traditional investments?

1. Liquidity

2. Normality

3. Diversification

4. Efficiency

The correct answer is: Diversification

The characteristic that differentiates alternative investments from traditional investments is diversification. Alternative investments, such as hedge funds, private equity, real estate, and commodities, tend to have return profiles that are less correlated with traditional investments like stocks and bonds. This low correlation allows investors to enhance their portfolios through diversification, which can potentially reduce risk and improve returns. Moreover, alternative investments can access different markets and asset classes that traditional investments may not cover, further enhancing diversification benefits. For example, they might provide exposure to unique strategies that are not available within traditional equity or fixed-income markets, allowing for a broader range of investment opportunities. In this context, while liquidity, normality, and efficiency are important concepts in finance, they do not capture the unique aspect of how alternative investments can complement traditional portfolios through diversification. Traditional assets often exhibit higher liquidity and are generally subject to normal distribution assumptions, whereas many alternatives may not follow these patterns, offering unique risk-return profiles that contribute to a well-diversified investment strategy.