Executive Summary
- With challenging opportunities for alpha and diversification in traditional assets, alternative investments – including private equity, real estate, infrastructure, private credit, and more – have evolved from being optional to essential components of investor portfolios.
- Historically, constructing alternatives portfolios was more art than science, likened by some to "finger painting", due to limited access to fundamental data, modelling challenges, and a narrower investment universe.
- As alternatives have matured in scope, scale, and accessibility, a "finger-painting" approach will no longer suffice.
- To present a more systematic approach to portfolio construction, this paper proposes a comprehensive investment framework for multi-alternatives (multi-alts) portfolios, which integrates the strategic sizing of positions with active marginal capital allocation. The framework is designed with objectives to improve portfolio returns and reduce downside risk, moving beyond sole reliance on historical trends and qualitative assessments.
- Despite the growth of alternatives, the industry still faces significant hurdles in accessing institutional-quality alternatives data, resulting in persistent market inefficiencies. These inefficiencies, together with significant dispersion in returns across asset classes and among managers, present opportunities for skilled allocators to generate alpha by taking advantage of information asymmetries.
- A key contribution of this research is the explicit quantification of two distinct sources of alpha in alternatives investing:
- Dynamic asset allocation alpha (“Alpha 1”): captured through dynamic allocation decisions that exploit return dispersion across alternatives asset classes.
- Manager selection alpha (“Alpha 2”): captured by identifying the performance differential among managers within a single category and investing with outperforming managers, particularly in non-core or capital appreciation-oriented alternatives.
- To demonstrate a practical application, the paper presents an established multi-alts investment framework that adapts to evolving macroeconomic conditions and investment views. It outlines a six-step process for constructing and managing multi-alts portfolios:
- Establish investment objectives
- Identify the target universe of alternatives
- Size long-term positions and set strategic allocations
- Actively allocate capital to capture near-term opportunities
- Integrate risk management
- Maintain ongoing evolution and oversight
- The framework enables allocators to systematically address data challenges, capitalise on market inefficiencies, and build resilient portfolios, demonstrating the benefits of a thoughtfully sized and actively managed multi-alts portfolio.
Introduction
Portfolio construction in alternatives1 has traditionally been more of an art than science, primarily due to the opacity of investment data and unique challenges posed by alternatives compared to traditional assets, such as data availability, illiquidity, and execution complexities. A senior executive of a pension plan once described their approach to investing in alternatives as “akin to finger painting”.
While this approach may have worked in the past, there have been significant developments in the alternatives industry over the past decade. Today, with the maturation and growth of alternatives across scope, scale, and access, as well as the critical place they have taken in portfolios, such “finger painting” will no longer suffice.
Investing in alternatives today presents a wide range of opportunities. Success, however, is dependent on developing and implementing a comprehensive investment framework that takes into consideration the breadth of variables which can influence portfolio outcomes. In this paper, we discuss:
- The importance of adopting a systematic, data-driven approach to building multi-alternative (multi-alts) portfolios for institutional investors;
- The key factors that contribute to an effective framework for a multi-alts portfolio—sizing and active capital allocation. In the latter, we quantify two important alpha sources in multi-alts investing—allocation alpha and manager selection alpha—which go beyond just harvesting structural risk premia and the diversification benefit from alternatives;
- An original step-by-step guide on building a multi-alts portfolio, including practical insights on active management to reap allocation and manager alpha, alongside risk management and liquidity considerations.