Explore the key drivers behind allocating to alternative investments, along with portfolio construction principles, asset allocation approaches, and the governance responsibilities that shape investor decisions.
Investors across the globe have become increasingly fascinated with alternative investments—hedge funds, private equity, real estate, infrastructure, natural resources, and, more recently, digital assets. But why? Why stray from the old-school, tried-and-true approach of stocks and bonds? I remember the first time I heard about someone investing in farmland. I thought, “Wait, farmland? You mean actual dirt and crops?” It turned out to be an incredibly smart inflation hedge for them. That’s just one small example of the wide range of motivations people have when they consider venturing into alternatives.
This article will explore these motivations in detail, from the quest for higher returns to the need for diversification. We’ll also break down fundamental asset allocation strategies—especially the influential “Endowment Model”—and highlight how strategic and tactical approaches differ when considering alternatives. We’ll touch on risk tolerance, liquidity needs, operational considerations, and how managers juggle fiduciary responsibilities when mixing alternatives into client portfolios. By the end, you’ll have a thorough map of how (and why) to incorporate alternative assets.
Probably the number one reason folks bring alternatives into the mix is good old-fashioned diversification. Traditional portfolios loaded with equities and bonds can be susceptible to market fluctuations; large drawdowns in equity markets can lead to sleepless nights for even the most seasoned investors. Hedge funds, private credit instruments, infrastructure, or farmland can behave differently in varying market regimes.
When you throw in an asset that has a relatively low correlation with stocks and bonds, you may reduce overall portfolio volatility and, potentially, boost a portfolio’s risk-adjusted returns. For instance, farmland returns often hinge on weather patterns and crop yields rather than corporate earnings. That uncorrelated return can be a blessing in times of stock market turbulence.
Alternative assets, such as venture capital or private equity, have generated some pretty compelling returns historically—especially if you get lucky with a startup that eventually goes public or is acquired at a high valuation. These returns typically come with a big dose of risk. But for institutions with long horizons, it can be worth taking that plunge.
For instance, consider a private credit fund that invests in mid-sized companies at relatively high-interest rates. Sure, the default risk can’t be ignored, but if the lender does its homework and structures the investments wisely, the yields might far exceed what is available in the public bond market. This higher return potential is precisely why many endowments and pension plans maintain robust alternative allocations.
Inflation can be a stealthy villain—slowly eroding purchasing power over time. Allocations to tangible assets, like real estate, farmland, timberland, or commodity-linked instruments, can help preserve real value when inflation rears its head. By owning assets that tend to move in tandem with inflation, investors can better protect the real (inflation-adjusted) value of their portfolios.
Pension funds have future liabilities to pay out to beneficiaries. If they foresee a certain amount of obligations in real (inflation-adjusted) terms, they may look to real assets like infrastructure. Infrastructure deals, for instance, often feature long-term contracted cash flows that may be linked to inflation adjustments. This matching of income to future liabilities helps reduce the risk that the plan cannot meet obligations a couple of decades down the road.
Over the years, we’ve seen the so-called Endowment Model—pioneered especially by David Swensen at Yale—gain traction among investors seeking diversified and higher-return portfolios. Instead of focusing on standard 60/40 stock/bond mixes, the Endowment Model advocates for a substantial allocation to alternatives such as private equity, real estate, hedge funds, and natural resources.
In Swensen’s approach, the emphasis is on long-term capital appreciation with a keen eye on diversification. While not every organization can replicate Yale’s deep investment staff or resources, the principle remains compelling—allocate heavily to less correlated, alternative assets that can deliver uncorrelated returns over long horizons.
When you set an asset allocation, you typically plan out a “target” mix of investments that reflect your expectations of returns, risks, and future spending needs. But how do alternatives fit in?
Strategic Asset Allocation (SAA) is about setting a long-term policy mix. An investor might decide that, say, 30% of the portfolio will be in alternative assets. This decision is guided by broad capital market assumptions: expected returns and volatilities for each asset class, correlation structures, and the investor’s overall strategy.
For example, a university endowment with a 30-year horizon can afford to hold a larger slice of illiquid alternatives like private equity or venture capital, since it doesn’t need to liquidate assets regularly. The entire portfolio is built around these assumptions, so the endowment invests in line with those policy dictates.
Tactical Asset Allocation (TAA) is a shorter-term tweak to your overall policy. If you suspect that private credit opportunities are temporarily more attractive—maybe because interest rates are rising, and certain pockets of the market are under stress—you might shift an extra 5% of assets into private credit for a few months or a few quarters.
Unlike strategic allocation, TAA is designed to exploit perceived mispricings in various markets. It’s more active. If an investment manager sees an opportunity in distressed real estate, they might pivot from, say, global macro hedge funds to real estate until that window closes. Then they return to (or near to) the strategic “baseline” mix.
It’s easy to get excited about the potential returns of alternatives. But it’s also important to address the fact that many alternatives come with longer lock-up periods or lower liquidity. A private equity fund might lock in your capital for a decade. A real estate partnership might only allow redemptions every few years.
So, if you’re the kind of investor who frets about needing immediate access to your funds, you need to figure out the right balance of liquid versus illiquid holdings. Institutions with long time horizons—like pensions, endowments, or multi-generational family offices—are generally better positioned to handle the illiquidity of alternatives.
Then there’s risk tolerance, shaped by both internal governance (risk committees) and external constraints (like regulation). If an investor can stomach large risks, they might embrace highly volatile hedge fund strategies. Others might prefer safer corners such as senior secured private debt.
Including alternatives in a portfolio comes with a range of operational tasks. Due diligence is paramount—managers must scrutinize each potential investment, ensuring the team, track record, and strategy are sound. In private funds, the governance structures (LP agreements, side letters, etc.) must be carefully reviewed.
From a fiduciary standpoint, managers have a duty to act solely in the interest of their clients or beneficiaries. This responsibility often includes verifying that hazards like valuation risk or operational risk in hedge funds are well understood. In addition, compliance with whichever regulatory regime applies—like the U.S. Investment Advisers Act or relevant EU regulations—becomes more complex when dealing with private placements and offshore structures.
Many large investors love to compare notes. Pension plans and endowments often “benchmark” their alternative allocations against a peer group to see how they stack up. If your pension plan invests 25% in alternatives while another invests 40%, are you missing out? Or maybe you’re being more prudent? These peer comparisons can influence strategic decisions:
However, overreliance on peer comparisons can be detrimental. Each institutional investor has different objectives and constraints, so blindly copying the fund next door might do more harm than good.
Investors often face real-world constraints when contemplating alternatives:
These constraints can shrink the opportunity set and push investors to specialized pooled vehicles or simpler strategies (e.g., mutual funds or ETFs that replicate certain alternative exposures).
Over time, portfolio weights drift. If your hedge fund allocation outperforms, it might become a larger slice of the pie than you intended. Or if your real estate portfolio struggles, it might represent too little. Rebalancing ensures you bring these exposures back to your target mix.
Say your strategic policy is 20% alternative investments. If a private equity slug grows to, say, 25%, you might trim some of that exposure (perhaps selling a stake on the secondary market or reducing new commitments) and reallocate to underweight segments. This discipline prevents any single asset from dominating the portfolio and keeps your risk exposures relatively steady.
Below is a simple Mermaid diagram illustrating key factors that drive an investor’s decision to incorporate alternatives and the feedback loop involved when rebalancing or reassessing strategy.
flowchart LR
A["Identify <br/>Investor Goals"] --> B["Evaluate <br/>Risk Tolerance, <br/>Time Horizon, <br/>Liquidity"]
B --> C["Allocate to <br/>Alternatives <br/>(Strategic)"]
C --> D["Tactical Shifts <br/>Based on <br/>Market Conditions"]
D --> E["Monitor <br/>Performance and <br/>Peer Benchmarks"]
E --> F["Periodic <br/>Rebalancing"]
F --> B
In this diagram:
• The investor starts by clearly identifying their goals.
• Then, they assess their ability to accept risk, illiquidity, and a lengthy horizon.
• They decide on a strategic allocation to alternatives, which might be tweaked periodically (tactical shifts).
• Performance is monitored regularly, in part by comparing to peers or benchmarks.
• Rebalancing decisions feed back into the risk tolerance equation.
• Overcommitment to Illiquid Assets: Overly ambitious alternative targets can backfire if the investor suddenly needs cash.
• Neglecting Due Diligence: Rushing into a fund might lead to surprises down the road—from hidden fees to questionable governance.
• Chasing Past Performance: Hedge fund managers that delivered stellar returns last year might not replicate that success. Carefully examine the sustainability of their strategy.
• Poor Rebalancing Discipline: Letting winners ride can be tempting, but it might lead to an unintended concentration that increases overall risk.
In summary, alternatives can offer tremendous benefits—diversification, inflation hedging, potential for enhanced returns, and a better match for long-term liabilities. But none of these perks come free of complications. A careful, methodical approach to allocating to alternatives requires a blend of strategic forethought, tactical flexibility, awareness of liquidity constraints, operational diligence, and a healthy respect for fiduciary obligations.
Done well, an alternative allocation can enhance a portfolio’s risk-return profile, align more effectively with an investor’s liabilities, and provide unique exposures that aren’t readily found in traditional markets. Just keep your rebalancing plan in place, stay aware of potential pitfalls, and remember that what works for one large endowment might not be the perfect fit for every investor.
• Emphasize the relationship between asset-class characteristics and investor-specific constraints, especially in scenario-based questions.
• Demonstrate a clear understanding of how strategic and tactical decisions differ, and how both might appear in a case study.
• Watch for questions requiring you to address rebalancing, especially in multi-asset portfolios with both public and private holdings.
• Be prepared to illustrate how fiduciary responsibilities and governance structures align (or conflict) with the push for alternatives.
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