In our opinion, alternative investments are like the vegetables of the core portfolio – most qualified investors are not getting enough. Higher forecast estimates and structural tailwinds argue for a heftier serving.

With alternatives having some of the highest strategic return estimates (SREs)among all the asset classes in our Adaptive Value Strategies (AVS) framework over the next 10 years, our suggested allocation for an appropriate moderate-risk investor is, in the aggregate, 27%:  12% of the portfolio to hedge funds, 10% to private equity and 5% to real estate for those who understand the level of illiquidity that may be added to a portfolio. We should note that, while prospective returns for alternatives are high, these are also the same expectations and weightings we have recommended for the last three years.

If 27% sounds like a lot to you, consider that alternatives allocations among US institutional investors in 2022 ranged from an average of 34% for state and local pension plans¹ to 59% for endowments.² Although certain subsets of our clients such as large family offices³ are adopters of alternative assets in their portfolios, with the average large family office allocation sitting around 46%,⁴ allocations to alternative investments by other qualified individual investors remain by and large lower than they should be, in our opinion, with most in the single digits.

Alternative investments come with their own additional risks, including liquidity constraints and the potential for asymmetric losses from the possible use of leverage. Nevertheless, reconsidering your approach to constructing a core portfolio that includes a higher allocation to alternatives has some opportunities:

• Private equity and real estate have generated more wealth over time than a portfolio made of exclusively public equities (Figure 1). In our Opportunistic section, see “Investing with and in unregulated financial companies” for an explanation of some of the larger, structural issues creating opportunities for private equity firms today.

• When markets become more volatile, hedge funds have historically proven able to preserve capital better than long-only strategies, with certain funds capable of producing positive returns during negative market periods (Figure 2). That said, they are also subject to potentially higher volatility, can see limited redemptions and can change the risk profile of your portfolio.  

• Alternative credit strategies, a subset of private equity or hedge funds, can potentially generate a yield premium over traditional fixed income portfolios. At a time when bond yields themselves are higher, the payouts for non-traditional credit can be higher for those willing to stay invested for the long term. Just understand that, unlike with traditional bonds, there are no regular coupons.

We believe that alternatives are a key part of a core portfolio for qualified clients for whom the potential asymmetric risks and liquidity constraints are appropriate. That also means alternative investments may be evaluated under the same lens as traditional investments, in an integrated manner, starting with an understanding of one’s objectives, risk tolerance and liquidity requirements. Each investor has his/her/their own unique investment objectives that will drive individual asset allocation decisions. There is no one-size-fits-all answer to the question of how to build an allocation with alternatives. However, the alternative investment universe does contain a wide variety of options across the risk/return spectrum to choose from. Let us explore how you might evaluate your own situation to build a more diversified portfolio that includes alternatives.

Broadly speaking, alternative strategies can be placed into two groups, diversifying and directional strategies. Diversifiers provide some degree of downside protection and can profit from volatile markets but may underperform during bull markets. Directional strategies seek to generate alpha and/or yield above traditional credit and equity exposures. A conservative approach may emphasize diversifying and yield strategies while someone with a more moderate or aggressive profile might add more directional strategies to the mix.

The benefits of adding alternatives to a diversified portfolio are potentially significant, but as noted, these benefits come at the cost of illiquidity.  Illiquidity means that some of these strategies have limited or no redemption periods when clients need to access their funds. This requires a holistic evaluation of an entire portfolio within the context of one’s time horizon and liquidity. What are your short- and long-term cash needs? Even the most liquid “liquid alts” funds will only provide for monthly or quarterly cash-out options, not daily. And some strategies will lock up capital for years in seeking to generate returns. Understanding one’s cash needs is among the first risk analyses to be done when setting the portfolio parameters and selecting potential investment opportunities.

Once you have established the objectives and risk tolerances, you may want to consider a portfolio of individual funds and co-investment holdings or utilize a third-party investment manager for fund/deal selection. An advantage of building a portfolio of individual investments is customization and one less layer of fees; one of the downsides is the added due diligence required by you and your financial professional. A third option may be to outsource manager/fund selection to a platform fund or fund of funds that invests across multiple managers (and often across multiple strategies), accessing ideas of professionals dedicated to each asset class and strategy. 

For hedge funds, one can meet an allocation target over a relatively short period of time and then manage exposures dynamically. However, private equity, private credit and real estate take a longer-term plan and implementation period, because they are typically structured as drawdown vehicles that have a finite term. They call the committed capital over a period of three to five years as suitable investments are identified and funded to fill the portfolio. Then invested capital and gains are distributed to investors as the individual portfolio investments are sold over a total fund life of eight to twelve years. Investors may get impatient and try to fully allocate to the asset class in the first year, when the preferred option should be to build a sustainable exposure over time. A rushed approach can then create more angst on the back end as well. We suggest working closely with your investment professional to determine your expected liquidity needs, then developing a slow and steady plan you can stick with over many vintage years.