Alternative Investments

How to Allocate Alternatives in Portfolio Management

Alternative investments — in theory at least — should “complement” an investor’s traditional equities and fixed-income holdings, rather than comprise the entirety of a portfolio.

Since the 2008 recession, more institutional investors have diversified their portfolios into alternatives such as hedge funds, private equity funds, real assets, and commodities.

While most of these institutions — e.g. university endowment funds, and pension funds — have opened up to alternatives, the proportion of their capital placed in such vehicles as a percentage of their total assets under management (AUM) remains relatively small.

The recommended asset allocation into alternatives versus traditional investments depends on a specific investor’s risk appetite and investment horizon.

In general, the benefits of alternative investments are as follows:

• Diversification: Complement traditional portfolio holdings and mitigate market risk (i.e. not entirely concentrated on just one strategy).
• Return Potential: Alternatives should be viewed as another source of returns from the exposure to more securities and strategies.
• Lower Volatility: Despite many of these funds being riskier, their inclusion in the portfolio can reduce the total portfolio volatility if strategically weighted (e.g. they can help offset losses against traditional investments in a recession).

Performance of Alternative Investments

^{Historical Performance of Alternative Investments (Source: Merrill Lynch)}

What are the Risks to Alternative Investments?

One major drawback to alternative investments is liquidity risk since once invested, there is a contractual period during which the capital contributed cannot be returned.

For instance, an investor’s capital could be tied up and be unable to be withdrawn for a long duration of time as part of an alternative investment.

Since most alternative investments are actively managed vehicles, there also tend to be higher management fees plus performance incentives (e.g. the “2 and 20” fee arrangement).

Given the higher risk of losing capital, certain strategies like hedge funds are only available to investors that meet certain criteria (e.g. income requirements).

The final risk to consider is that certain alternative investments have fewer regulations and oversight from the U.S. Securities and Exchange Commission (SEC), and the reduced transparency can create more room for fraudulent activities such as insider trading.