Managing risks associated with alternative investments can be challenging because these investments are often characterized by asymmetric risk and return profiles, limited transparency, and illiquidity.

Traditional risk and return measures such as mean return, standard deviation of returns, and beta may not provide an adequate picture of characteristics of alternative investments. Moreover, these measures may not be reliable or representative of specific investments.

Operational, financial, counterparty, and liquidity risks may be key considerations for those investing in alternative investments.

It is critical to do due diligence to assess whether (a) a potential investment is in compliance with its prospectus; (b) the appropriate organizational structure and policies for managing investments, operations, risk, and compliance are in place; and (c) the fund terms appear reasonable.

The inclusion of alternative investments in a portfolio, including the amounts to allocate, should be considered in the context of an investor's risk-return objectives, constraints, and preferences.

Practice Question 1

Which of the following investments is the most liquid?

A. Coins and Stamps.
B. Real Estate Investment Trusts.
C. Diamonds.
D. Antiques.

Correct Answer: B

Real Estate Investments Trusts are more liquid because they are a type of mutual fund that is somewhat diversified within the real estate sector and an active public market typically exists for their shares.

Practice Question 2

Investments with low liquidity include:

I. antiques and art.
II. coins and stamps.
III. precious metals.

Correct Answer: I, II and III

A low level of liquidity is virtually guaranteed when there is uniqueness to assets. Financial assets are not unique; for example, one share of IBM is exactly identical to every other share. On the other hand, real assets have variation due to handling and storage conditions. Precious metals are generally more liquid than the others, but they are commonly traded as jewelry, which has uniqueness value. Shipping and insurance also affect the value. For example, a store of gold bars in New York will be worth more to an investor in New York than in San Francisco because of the difference in transportation costs.

Practice Question 3

What is likely the best measure to assess an alternative investment's downside risk?

A. Sharpe ratio.
B. Value at risk.
C. Beta.

Correct Answer: B

Other measures include safety-first risk measure and Sortino ratio. Traditional risk and return measures may not provide an adequate picture of characteristics of alternative investments.

Practice Question 4

Alternative investments returns tend to be leptokurtic, negatively skewed. For this reason investors like to measure the:

A. downside risk.
B. upside return limit.
C. upside risk.

Correct Answer: A

Investors use different measures such as value at risk or safety-first risk measures to assess downside risk.