Aswath Damodaran raises red flags on alternative investments, says hype doesn’t match reality

Alternative investments, which fall outside traditional assets like stocks, bonds, and cash, have grown in popularity among individual investors over the past two decades. These assets, which were once accessible only to a small subset of investors, have now entered the mainstream, first with choices directed at institutional investors, but more recently, in offerings for individual investors.

They span a wide range—private equity, hedge funds, real estate, cryptocurrencies, commodities, and collectibles—and are often seen as offering better risk-return trade-offs, with the potential for higher returns at a given level of risk.

However, NYU professor and valuation expert Aswath Damodaran, in his latest blog post, urged caution on alternative investments, arguing that they often fail to live up to their marketed promises. 

He said that most traditional investment lessons are geared toward long-only investors in public stocks and bonds, with cash serving as a buffer, and that these lessons largely ignore the broader investing universe—including private businesses, short-selling strategies, and non-traded assets.

“These overlooked areas,” Damodaran says, “make up the alternative investment universe, which has been aggressively sold over the last two decades with the promise of superior risk-adjusted returns.”

The sales pitch typically hinges on two key ideas: first, that alternatives have low correlations with public markets and therefore offer diversification benefits; second, that market inefficiencies are more persistent in the alternative space due to its illiquidity and lack of transparency—allowing private equity (PE), venture capital (VC), and hedge fund managers to potentially generate higher returns.

While this pitch has helped institutional investors buy into the promise, Damodaran notes that the real-world outcomes have often fallen short. “Despite the fanfare, the expected improvements in risk-return trade-offs—like higher Sharpe ratios or lower losses during crises—have largely failed to materialize for most institutions,” he points out.

Why Alternatives Fall Short

According to Damodaran, there are four main reasons for this underperformance:

1. Correlations are overstated. Private investment values are often based on stale appraisals and lagging data, making them appear less connected to market movements. But in times of crisis, they often behave just like public assets.

2. Illiquidity and opacity become liabilities. While fund managers claim to tolerate these characteristics, they become major concerns when markets tumble, or liquidity is needed.

3. The alpha has faded. “Just like mutual funds, the median VC and PE fund now underperform the market,” says Damodaran. While a few top-tier firms still deliver, they are the exception, not the rule.

4. High costs erode returns. Many alternative funds charge steep fees—so high, in fact, that it's difficult for even strong performance to make up for them.

Smart Rules for Risky Bets

Aswath Damodaran advised investors considering alternative investments to focus on those that truly have low correlation with public markets, rather than relying on misleading historical data.

Second, he warns against high-cost or overly exotic options that may not deliver commensurate value. Third, he urges investors to be realistic about their investment time horizons, as many alternative assets require long-term commitments to pay off.

Further, he advises being sceptical of historical correlations and claims of consistent alpha, reminding investors that past performance is no guarantee of future returns.

Disclaimer: The views and recommendations given in this article are those of individual analysts. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.