The post-COVID experience – and specifically the challenging environment of 2022 – has brought the conversation about owning alternative assets back into the spotlight for both retail and institutional investors. Broadly, the industry agrees on the benefits of incorporating alternatives into portfolios. As such, our focus here is on providing a framework to do this by taking sizing, liquidity constraints, fund structures and costs into account.

Why alternatives now?

Our Long-Term Capital Market Assumptions (LTCMAs) put forth an environment of higher inflation volatility and, by extension, less stable stock-bond correlations over the coming business cycle. This means that portfolios will need to hold assets that provide diversification above and beyond traditional, high-quality fixed income. Furthermore, we expect that private equity will outperform U.S. large cap stocks by 3.5 percentage points per year over the 10- to 15-year forecast horizon, direct lending will outperform high yield by 1.5 percentage points and U.S. core real estate will continue to look attractive with a projected annualized return of 8.2%. So, while we still believe in the strength of a traditional 60/40 portfolio, alternatives can help produce better risk-adjusted outcomes for clients who can benefit from the illiquidity premium.

The good news is that alternative investments have become increasingly accessible in recent years, leaving investors with a variety of levers to pull across the liquidity spectrum. The main question is not whether to invest in private alternatives, but how to structure and manage the alternatives allocation so that liquidity is a resource rather than a constraint. Blending public and private assets in a portfolio can help smooth the ride during periods of volatility, allowing investors to stay invested and experience more robust risk-adjusted returns. As investors look to build portfolios to navigate the next 10-15 years, alternatives need to be part of the conversation, and it is crucial to use all the tools available.

The benefits of alternatives

Alternative assets have become an increasingly important component of institutional investment portfolios, offering benefits that traditional stocks and bonds often cannot provide. One of the primary advantages of owning alternatives is the potential for alpha generation – the ability to achieve returns above those of public markets. Private equity, for example, is well known for its capacity to deliver outsized returns through active management, operational improvements and access to unique growth opportunities not available in public markets. For investors seeking to enhance portfolio performance, private equity can be a powerful source of alpha.

Another key benefit of alternative assets is enhanced income. Real assets, such as infrastructure, and certain types of private credit can provide steady, predictable income streams that are less correlated with traditional fixed income. These assets often benefit from long-term contracts, inflation-linked cash flows or tangible collateral, making them attractive for investors who prioritize income stability and protection against inflation.

Diversification is a further advantage, particularly through investments like private real estate. Private real estate typically exhibits low correlation with traditional asset classes, such as stocks and bonds, helping to reduce overall portfolio volatility and improve risk-adjusted returns. Additionally, private real estate investments often generate stable and attractive income through rental payments and long-term leases, providing investors with a reliable cash flow that can complement other sources of yield.

As the following chart illustrates, private alternatives can provide an array of benefits including return enhancement, risk reduction and income generation.

Which private markets make sense for my portfolio?

It is important to recognize that an allocation to alternatives should be outcome oriented, tailored to the specific goals and needs of each investor. Rather than adopting a one-size-fits-all approach, investors should consider which alternative asset classes best align with their desired outcomes. For those seeking higher returns, private equity may be the most suitable. For those prioritizing income and capital preservation, real assets and private credit may be more appropriate. Investors looking to reduce portfolio risk and smooth returns might benefit most from hedge funds. Ultimately, a thoughtful allocation to alternatives – driven by clear objectives and a deep understanding of each asset class – can help investors achieve a more resilient and effective portfolio.

So how do you choose which alternative assets to include in a portfolio? To us, there are a handful of key considerations. To start, what are you trying to achieve by adding alternatives? Is it uncorrelated income? A more robust rate of return? Or perhaps additional sources of diversification? Whatever the reason, a framework focused on outcomes – alpha, income and diversification – is the best place to start. Put differently, step one in this process is determining the problem to solve. Step two is identifying the private market asset that can provide the intended solution.

The following table helps to identify the tradeoffs around how different alternative allocations – funded from different parts of the portfolio – can impact return, volatility and income. The framework starts with our own LTCMAs, providing insight into the expected impact alternatives may have on a portfolio in the coming years.

• Start with a 60/40 portfolio and determine your main objective(s) between return enhancement, risk reduction and income.
• The shading of each metric provides its level of potential impact, with green being the most efficient to red being counterproductive.
• Once an optimal mix has been determined, the framework then provides a path toward determining a funding source and which alternative(s) to implement.

The bottom line is that the funding source can have a meaningful impact on portfolio characteristics. For example, if public equities are used to fund an allocation to private equity, it can result in higher return with lower volatility; on the other hand, funding a private equity allocation from fixed income can result in a portfolio with higher volatility and meaningfully lower income.

How much is enough?

While a 10% allocation is used in the above for illustrative purposes, the reality of the decision is more nuanced. How much of the portfolio needs to be allocated to the solution identified to notably improve the risk-adjusted return? Can the client handle the illiquidity? What about the fund structure? Is there reinvestment risk, e.g., is it a closed-end fund? Are there issues with cash drag while waiting for capital to be called?

The easy part is identifying the problem that needs to be solved; the difficult bit is structuring the solution in a way that is not onerous for the client. To determine the minimum allocation to private alternatives within a portfolio, we adopted a multi-sleeve approach, dividing the alternative sleeve equally among three asset classes: private equity, private credit and core real estate. In the spirit of simplicity and for the purpose of this exercise, each receives one-third of the allocation. The overall portfolio is structured on a 60/40 baseline, funded proportionally from both equity and fixed income sources. The analysis spans a 10-year investment horizon.

The primary objective is to illustrate how adding private alternatives can enhance portfolio performance, while also accounting for the costs and complexities associated with committing capital to these asset classes. Two key types of friction costs are considered and will likely evolve as we continue to see proliferation and further democratization of private alternatives:

• Fixed friction costs: These include overhead, time spent and enhanced due diligence requirements. Importantly, these costs do not increase incrementally as the allocation to private alternatives grows; they are relatively static regardless of allocation size.
• Variable friction costs: These costs rise as the allocation to private alternatives increases. They encompass factors such as illiquidity, management fees and cash drag. As we continue refining our framework, we would look to verify and stress test these costs and their impact on the analysis.

The analysis illustrates both the incremental return uplift from adding private alternatives (before accounting for friction costs) and the associated friction costs. By plotting these two factors, we identify the inflection point where the additional utility from private alternatives is matched by the friction costs incurred. This point is found to be around a 5% allocation to private alternatives. Allocations below this threshold are considered suboptimal, as the costs outweigh the benefits. Of note, this is simply an inflection point where the benefits begin to outweigh the costs and does not indicate an optimal allocation to alternatives. Looking at the chart, while it may appear that more alternatives are simply better, the reality is that client needs should be considered to ensure an optimal balance.

Imagine managing your portfolio like piloting an airplane. If you fly too low (allocate too little to alternatives), you risk significant turbulence due to air friction – these are the inefficiencies below the threshold that drag down your performance. On the other hand, if you fly too high (allocate too much to alternatives), the air thins out – liquidity becomes scarce, and you may struggle to maneuver safely when you need access to cash. The optimal allocation is like cruising at the perfect altitude: high enough to avoid significant turbulence, but low enough to ensure you have enough oxygen (liquidity) to keep the journey smooth and safe.

Finally, the required account size is calculated by applying average minimum investment thresholds for each asset class to the size of the alternative sleeve within the overall portfolio. This ensures that the portfolio meets the minimum requirements for investing in private alternatives.

In conclusion

The evolving investment landscape, shaped by the post-COVID environment and the volatility of recent years, has underscored the importance of alternative assets in portfolio construction. While the benefits of alternatives – such as alpha generation, enhanced income and diversification – are widely recognized, the challenge lies in determining the appropriate allocation, especially considering liquidity constraints, fund structures and the specific objectives alternatives are meant to address.

Our analysis, grounded in our 2026 LTCMAs, suggests that the traditional 60/40 portfolio, while improved, may not be sufficient to navigate an era of heightened inflation volatility and unstable stock-bond correlations. Alternatives – like private equity, direct lending and core real estate – are poised to deliver superior risk-adjusted returns, but their inclusion must be purposeful and outcome driven. Investors should begin by clearly defining their goals – whether seeking higher returns, uncorrelated income or greater diversification – and then selecting the alternative asset classes best suited to those outcomes.

Determining the optimal allocation requires a nuanced approach that balances the incremental benefits of alternatives against the associated friction costs, both fixed and variable. Our findings indicate that a minimum allocation of around 5% to private alternatives is necessary to justify the additional complexity and cost; allocations below this threshold may not deliver meaningful utility. Furthermore, investors must ensure that their account size meets the minimum requirements for access to these asset classes.

Ultimately, building resilient portfolios for the next decade will require a thoughtful blend of public and private assets, tailored to each investor’s unique objectives and constraints. By leveraging the full spectrum of investment tools – including alternatives – investors can better manage risk, enhance returns and remain invested through periods of market turbulence. As the investment environment continues to evolve, alternatives should remain a central part of the portfolio conversation.

¹ All categories are global, except for timberland and direct lending, which are U.S. Correlations are based on quarterly returns over the time period indicated. A 60/40 portfolio is comprised of 60% stocks and 40% bonds. Stocks are represented by the S&P 500 Total Return Index. Bonds are represented by the Bloomberg U.S. Aggregate Total Return Index. 10-year annualized returns are calculated based on the time period indicated. Absolute Return Hedge Funds: asset-weighted returns from the PivotalPath Global Macro and Relative Value indices. Direct Lending: yields from the Cliffwater Direct Lending Index. Directional Hedge Funds: asset-weighted returns from the PivotalPath Credit, Equity Diversified and Event Driven indices. Infrastructure: MSCI Global Private Infrastructure Asset Index. Private Equity: MSCI Global Buyout Closed-End Fund Index. Real estate: U.S. Core RE: NCREIF Property Index – Open End Diversified Core Equity component. Europe Core Real Estate: MSCI Global Property Fund Index – Continental Europe. Asia Pacific (APAC) Core Real Estate: MSCI Global Property Fund Index – Asia-Pacific. Timberland: NCREIF Timberland Index (U.S.) – EBITDA Return. Transport: a J.P. Morgan Asset Management index and are shown on an unlevered basis, which can be enhanced by adding leverage. Venture Capital: MSCI Global Venture Capital Closed-End Fund Index. Past performance is not a reliable indicator of current and future results.

² Alternative asset classes (including hedge funds, private equity, real estate, direct lending, transportation, infrastructure and timberland) are unlike other asset categories shown in that there is no underlying investible index. The return estimates for these alternative asset classes and strategies are estimates of the industry average – median manager, net of manager fees. The dispersion of return among managers of these asset classes and strategies is typically significantly wider than that of traditional asset classes. For equity and fixed income assumptions, we assume current index regional weight in composite indices with multiple countries/regions. All returns are nominal. The return forecasts of composite and hedged assets are computed using unrounded return and rounded to the nearest 10 basis points at the final stage. In some cases, this may lead to apparent differences in hedging impact across assets, but this is purely due to rounding.

Note on U.S. dollar assumptions: All estimates on this page are in U.S. dollar terms. Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations to all these asset classes and strategies. Exclusive reliance on this information is not advised. This information is not intended as a recommendation to invest in a particular asset class or strategy or as a promise of future performance. These asset class and strategy assumptions are passive only for liquid assets and industry averages (median managers) for alternatives. The assumptions do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns portfolios may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided herein is reliable, but do not warrant its accuracy or completeness. This material is not intended to provide and should not be relied upon for accounting, legal or tax advice.