You may have heard the term “alternative investments” and wondered if this asset class is a fit for your investment portfolio. Investors today are not bound to the traditional 60% equity and 40% bond portfolio. Alternatives offer additional ways to access differentiated risk and return objectives, but benefits must be evaluated against meaningful tradeoffs.
What are Alternative Investments?
The term “alternative investments” describes investments and strategies outside publicly traded stocks and bonds. The category can include private equity, real estate, private credit, hedge funds, royalties, litigation finance, and other specialized strategies.
Alternative investments often involve a degree of illiquidity and information asymmetry. Investors might expect higher returns, lower volatility, income, diversification, or other portfolio goals in exchange for accepting these risks, though no outcome is guaranteed.
What Purpose Do Alternative Investments Serve in a Portfolio?
Diversification
In an environment of increasingly concentrated public markets, alternative investments can provide access to companies and strategies that may add diversification to portfolios. In private equity, for example, investors may be able to access small businesses and sectors that are underrepresented in large stock indices.
Income Generation
Some alternative investment strategies, such as infrastructure and private credit, may produce income that could exceed what is available in the public markets for investors focused on capital preservation and income generation.
Inflation Protection
Real assets and infrastructure investments may provide some protection against inflation when contracts or asset values rise along with prices.
Access to Private Markets
The investment landscape has changed in recent decades as many U.S. companies have remained private for longer. In the mid-1990s, there were more than 7,000 publicly traded U.S. companies; today, that number is closer to 4,500 (Harvard Law). Alternative investment structures can provide access to businesses that are not available through public stocks alone.
Risks of Alternative Investments
The role and allocation of alternative investments will depend on an investor’s goals, investment horizon, liquidity needs, and risk tolerance. Alternative investment structures and strategies can vary, so each investment should be evaluated individually.
Manager Selection
As with any actively managed investment, manager selection is a critical part of allocating to alternative investments. It is important to understand how a manager is compensated, how that compensation aligns with investors’ interests, and what the manager’s track record and tenure are.
Illiquidity
Most alternative funds limit liquidity, including many evergreen vehicles that offer periodic rather than daily redemptions. In traditional drawdown funds, investors can generally expect their capital to remain committed for 10 years or longer, with the timing of distributions controlled by the fund manager.
Information Asymmetry
Because alternative assets are not publicly traded, investors may receive less frequent, less standardized, or less independently verified information about performance and valuation. Alignment of interests between investors and managers can reduce some conflicts, but it does not eliminate the need to evaluate the manager’s process, reporting, fees, and valuation practices.
Conclusion
Alternative investments can play a useful role in a thoughtfully constructed portfolio by broadening exposure beyond publicly traded stocks and bonds and diversifying potential sources of risk and return. Their suitability depends on the investor, the strategy, and the terms of the investment. A careful assessment of liquidity, fees, valuation, manager alignment, and portfolio fit is essential before committing capital.