Diminishing opportunities for alpha, income and diversification in the public markets have helped convince investors of why alternatives are rapidly becoming essential portfolio components. In “Alternative investments: The essential buyer’s guide” we focus on what many investors are still grappling with — the how of alternative investing.

Choosing alternative asset classes for a purpose-driven portfolio

The how begins with defining your investment objectives, whether you are an experienced institutional investor looking to improve or add to current allocations – or a noninstitutional investor just starting to invest as alternatives become more accessible.  

Once objectives are identified, the challenge is to select the alternative assets that can deliver on your goals. Our guide provides tools for comparing different types of alternatives according to three primary portfolio functions: public equity diversification, income and capital appreciation. Core real assets, for example, can be a welcome source of income-driven returns; hedge funds are recognized as diversifiers and private equity is valued for its potential to deliver appreciation-driven returns.

Matching investment vehicles to desired outcomes

The next step is to choose the best fund structure for execution. An evergreen (open-ended) structure may be most appropriate when allocating to high quality, stabilized core assets such as core real estate, infrastructure and transportation. When investing in private equity or distressed credit, where capital appreciation is the goal, closed-end funds can provide general partners with the time to make the operational improvements essential for generating appreciation-driven returns. Our guide cautions investors about potential pitfalls. For example: When investing in a fund-of-funds, be aware that a mismatch between the liquidity terms of the master fund and its component funds may result in a liquidity squeeze under certain conditions.

How to think about manager dispersion and asset class dispersion

The guide also discusses allocating within core and non-core alternatives, given differences between the two in terms of manager dispersion and asset class dispersion. When allocating to non-core alternatives, investors should focus on manager selection, given the relatively high dispersion of returns across managers. Core alternatives show less manager dispersion, but exhibit a high level of dispersion across asset class returns; different categories outperform/underperform under different economic environments. That suggests using the full spectrum of core alternatives, not only to diversify but to potentially enhance returns through active management across economic cycles.  

How to measure return and risk

Given the variety of alternative investments and performance statistics, we offer guidance on measuring return and volatility. For example, we advocate the use of multiples on invested capital for apples-to-apples comparisons of long-term return performance across different investment vehicles and recommend adjusting for nonnormality and embedded optionality when measuring volatility.

Designing alternatives allocations from a total portfolio perspective

Finally, we review ten common methodologies for constructing alternatives portfolios, addressing their objectives, strengths and limitations. Determining which approach to take depends on investor-specific factors and desired outcomes. Our case study illustrates how distinct the resulting portfolio solutions can be, depending on the models chosen.

Explore how our guide may help you build effective alternative allocations for your portfolio.

DOWNLOAD ARTICLE

Investing in alternative assets might carry a greater investment risk than other investment products. The value of investments may go down as well as up and investors may not get back the full amount invested.