We see allocations to alternatives expanding over the next decade as many private wealth investors increasingly turn to alternatives to meet their investment objectives of alpha, income and diversification.
In brief:
- We have developed a framework that starts with investor objectives and builds solutions based on the roles that different alternatives may fulfill within an overall portfolio.
- Our analysis looks at the potential for an allocation to private market alternatives to improve returns or lower volatility—or do both—across different types of portfolios.
- Investing in alternatives has distinct challenges, including illiquidity, dispersion of returns, limited transparency, tail risk and complex fee structures.
Defining private market alternatives
“Alternatives” is often used as a catchall phrase for all nontraditional assets, including private equity, private credit and real assets, such as real estate and infrastructure. Alternatives also share characteristics that distinguish them from traditional stocks and bonds. To different degrees, most alternatives are less liquid and less transparent, have longer investment horizons and operate in private markets, which are less regulated. For all of these reasons, alternative investments generally:
- Exhibit low correlations with stocks and bonds, which means they may be able to help diversify a traditional portfolio
- Have potential to enhance portfolio returns through either income or alpha generation
- Come with higher fees than traditional stock and bond investments
Considering investor objectives
The vast array of alternatives options can distract investors from thinking more holistically about what they are trying to achieve with their alternatives allocations.
Rather than focusing on specific categories, such as private equity, private credit or core real assets, it’s helpful for investors to first consider their objectives for investing in alternatives and then the portfolio outcomes they are seeking to achieve.
Alternatives can complement traditional asset classes, and aid investors seeking three key objectives: alpha, income and diversification.
- Alpha: For investors seeking a higher level of returns, generating alpha—the excess return above a given benchmark—via an actively managed strategy is typically necessary. Private equity can be an attractive source of alpha.
- Income: Income can play several roles in a portfolio: some investors need to make regular distributions while other use it for liquidity or stability. Core private credit and real assets, including core real estate and infrastructure, may also provide a stable income stream in downturns.
- Diversification: Diversification can help manage risk and provide less correlated sources of returns to a portfolio that may help reduce volatility. Core real assets and core private credit can also diversify public equity risk, as their return streams are driven by higher quality income and/or local economic factors.
Focusing on characteristics and roles in the portfolio
Rather than focus on labels, such as private credit, real assets and private equity, a useful framework for thinking about how to add alternatives to a portfolio looks at the characteristics of different alternative assets and the roles they can play in a portfolio.
For example, certain types of assets share characteristics with fixed income, such as core private credit, while other are more equity-like, such as private equity. In the middle are hybrid assets, including core real estate and infrastructure, which have more all-weather characteristics.
The resulting framework helps investors think about alternatives in three broad categories:
- Fixed income-like alternatives, such as core private credit, tend to offer stable cash flows that are the primary drivers of returns and can also be useful for diversification.
- Hybrid alternatives, like core real assets can provide potentially enhanced returns benefiting from secular themes and some diversification but come with increased risk.
- Equity-like alternatives, most notably private equity, have potential to produce the strongest returns across a market cycle but also involve the highest risk.
Finding the appropriate allocation
After investors decide what kinds of alternatives might be appropriate, the next step is determining how much to allocate to different alternative asset classes. We look at three scenarios that show how investors with different risk/return objectives can improve on their traditional stock/bond portfolio outcomes.
In the example, we reallocate 10% and 20% of capital from a conservative, a balanced and an aggressive stock/bond portfolio to a diversified set of alternatives in a way that matches each risk profile (Exhibit 1). For example, the conservative portfolio has an alternatives allocation with a fixed income-like tilt, the balanced portfolio has a hybrid alternatives allocation and the aggressive alternatives allocation has an equity-like tilt.
Incorporating an alternatives allocation may improve the overall expected portfolio risk and/or return, depending on the portfolio. In the conservative portfolio, adding alternatives may reduce volatility without compromising on returns; in the balanced portfolio, alternatives can increase the return and lower the volatility; in the aggressive portfolio, an alternatives allocation may increase the return potential without adding volatility (Exhibit 2).
Putting the risks and rewards in perspective
Private market alternatives are an attractive way for investors to potentially enhance returns and/or diversify risk in their portfolios. As with most investments, increased rewards tend to come with increased risks or challenges—and alternatives are no exception.
Key risks when investing in alternatives are illiquidity and the wide range of potential returns, known as dispersion, which applies to both manager and asset class returns. These risks are related but vary by strategy.
Let’s first look at core real asset alternatives. Many of these strategies tend to be hybrids: they are more liquid and have returns that are driven by income, leading to a lower and more stable return profile than private equity. As a result, manager performance is less differentiated.
However, while core real assets have relatively low manager dispersion, the category has consistently exhibited high asset class dispersion—exceeding 20%, on average, over the past 15 years. One explanation for this high asset class dispersion is that the underlying drivers of return vary across core real assets and are impacted by different economic factors at different stages of the economic cycle.
For example, core infrastructure, with its relatively stable cash flow profile, outperformed during the uncertainty of the COVID-19 pandemic. Conversely, core private real estate has tended to benefit from periods of broad macroeconomic strength.
Interestingly, dispersion within real estate assets can also occur in certain conditions. For example, core liquid real estate assets, such as real estate investment trusts (REITs), may sometimes have higher correlations with public equities, leading to price dislocations and compelling relative value opportunities in private core real estate. This dispersion in core real asset returns can be an additional source of diversification
At the other end of the spectrum, private equity, which requires a long-term capital commitment to allow time for an investment to mature, is a relatively illiquid investment. However, this equity-like alternative has the greatest potential for significant capital gains to drive returns. As a result, manager dispersion is high, reflecting the difference in manager skill and ability to access to the most compelling deals (Exhibit 3).
Importantly, dispersion risk may be somewhat higher for individual investors vs. large institutional investors due to more concentrated allocations, limited access to the top managers and potentially higher fees. Investors should also be mindful of “tail risk”—the low probability of an extreme (negative) outcome. Limited transparency that can hinder obtaining a full picture of a strategy’s risks and more complex fee structures are additional risks.
Summing up key considerations
Alternatives can aid a portfolio by contributing alpha, income and diversification. Investors can use a framework based on the characteristics of different alternatives asset classes to build a portfolio that includes private market alternatives that meet their objectives and needs. The strategies within these categories will offer different risk/reward profiles that investors will need to match with their unique situations.
Investors should also consider some practical aspects of investing in private market alternatives, including liquidity, commitment size and fees.
As alternatives are increasingly considered essential, not just optional, and the variety of strategies and vehicles expands, investors will have a steady influx of choices to consider. Remembering to step back and focus on investment objectives and then the characteristics and roles that different alternatives can play in a portfolio can be a helpful way to cut through a myriad of options. While investors will need to carefully consider the risks of each type of investment against their own risk tolerance and constraints, alternatives have great potential to add returns and diversification to portfolios.