Alternative Assets: Beyond Diversification Myths

Alternative assets have evolved from niche portfolio additions to mainstream allocations across institutional and high-net-worth investors. Endowments pioneered this shift, demonstrating that significant allocations to private equity, hedge funds, and real assets could enhance returns while reducing volatility. Their success spawned an industry built on the diversification narrative.

But the conventional wisdom around alternatives deserves scrutiny. Many claimed benefits rest on questionable assumptions. Correlation estimates derived from smoothed returns overstate diversification. Fee structures erode much of the alpha that justifies high costs. Liquidity constraints amplify during precisely the periods when diversification matters most.

The Diversification Illusion

Alternative assets appear to offer attractive diversification in historical analysis. Private equity returns show low correlation with public equities. Real estate exhibits distinct cyclical patterns from stocks and bonds. Hedge fund returns seem uncorrelated with traditional assets.

These apparent benefits often reflect measurement issues rather than genuine diversification. Private assets report valuations quarterly or less frequently, while public assets mark-to-market daily. This stale pricing smooths reported returns and artificially lowers measured volatility and correlation.

When adjusting for this smoothing, private asset correlations with public markets rise substantially. Private equity fundamentally invests in companies similar to those trading publicly, with returns ultimately driven by similar factors. Real estate values connect closely to interest rates and economic growth, just like stocks and bonds.

Crisis Period Behavior

Diversification matters most during crisis periods when traditional assets decline together. Alternative assets promised to provide ballast during these episodes by moving independently of stocks and bonds. Reality proved more complicated.

During 2008-2009, private equity and real estate suffered comparable losses to public counterparts, with correlations approaching one. Hedge funds collectively declined, with many strategies experiencing losses rivaling equity markets. The liquidity advantages of public assets proved invaluable as alternatives gates went up and redemptions were suspended.

The COVID crisis repeated this pattern. Real estate valuations lagged public markets on the way down but ultimately reflected similar deterioration. Private credit experienced defaults and markdowns. Even supposedly market-neutral hedge funds struggled as liquidity evaporated and factor relationships broke down.

The Fee Burden Reality

Alternative asset fees dramatically exceed public market costs. The traditional "two and twenty" structure charges 2% annually on committed capital plus 20% of profits. Even with recent compression, fees remain substantial. Over long holding periods, these charges compound to consume large portions of returns.

Fee impact is particularly severe for mediocre managers. A private equity fund returning 12% gross before fees delivers 8.4% net after a 2% management fee and 20% carry assuming an 8% hurdle rate. Public equity indexes returning 10% with 0.1% costs net 9.9%. The private fund must generate 200 basis points of annual alpha just to match index returns after fees.

Performance Dispersion

Alternative assets exhibit enormous performance dispersion across managers. Top-quartile private equity funds generate returns far exceeding bottom-quartile funds, unlike public equities where manager performance clusters near market returns.

This dispersion presents both opportunity and challenge. Accessing top managers can justify high fees through superior returns. But most investors struggle to identify top managers prospectively. Past performance provides limited predictive value. Access constraints mean top managers often close to new capital, leaving investors with mediocre options.

The result: most alternative allocations deliver underwhelming outcomes. Studies consistently show median alternative funds underperform public equivalents after fees. Only top-quartile performance justifies the fee burden, access challenges, and liquidity sacrifice.

Liquidity Cost Accounting

Alternative assets embed substantial liquidity risk that investors often underappreciate. Lock-up periods prevent redemptions for years. Even after lock-ups expire, limited liquidity and gates restrict exit timing. Secondary market sales require accepting significant discounts.

This liquidity sacrifice carries real costs that should factor into return expectations. Investors should demand premium returns to compensate for illiquidity. But the standard comparison ignores this, benchmarking alternatives against liquid public markets without liquidity adjustment.

The Option Value Framework

Illiquid assets forfeit the valuable option to redeploy capital in response to changing conditions. If attractive opportunities emerge or portfolio risk needs adjustment, liquid positions enable immediate repositioning. Illiquid holdings cannot adapt, forcing suboptimal static positioning.

This option value is difficult to quantify but clearly positive. During market dislocations, investors with liquid portfolios can opportunistically add to depressed assets. Those locked in illiquid alternatives miss these opportunities. The cost compounds over multiple market cycles.

Rethinking Alternative Roles

Given these challenges, what legitimate roles remain for alternative assets in portfolios? Rather than automatic allocations justified by diversification myths, alternatives should meet specific criteria.

True Alpha Sources

Alternatives justify inclusion when providing genuine alpha excess returns beyond what factor exposures explain. Some hedge fund strategies exploit inefficiencies unavailable in public markets: merger arbitrage capturing deal spreads, credit relative value exploiting mispricing, systematic macro trading trend and carry patterns.

But investors must rigorously evaluate whether returns truly reflect alpha versus hidden beta exposure. Many hedge funds simply provide levered equity exposure dressed in complex structures. Replicating factor portfolios can achieve similar returns at fraction of the cost.

Access to Unique Exposures

Certain alternative investments provide exposure to assets or strategies truly unavailable through public markets. Venture capital accesses pre-IPO technology companies. Private infrastructure offers direct ownership of essential assets. Certain real assets provide commodity exposure with embedded operational value-add.

These unique exposures can justify alternative allocations if they address specific portfolio needs and investors have access to quality managers. But uniqueness alone is insufficient. The exposure must fill a genuine gap in portfolio construction and offer appropriate risk-adjusted returns.

Illiquidity Premium Capture

Investors with long time horizons and stable cash flows can intentionally harvest illiquidity premiums. By committing capital for extended periods, they should earn excess returns compared to liquid equivalents. But this requires discipline: meaningful allocation sizes to move portfolio returns, access to quality managers actually generating premiums, and operational capacity to manage complex illiquid portfolios.

Implementation Considerations

Investors determining alternative allocations should follow structured frameworks rather than following conventional wisdom or peer benchmarking.

Define Specific Objectives

Articulate precisely what each alternative investment should accomplish. Is the goal absolute returns uncorrelated with markets? Exposure to specific risk factors? Illiquidity premium capture? Each objective implies different appropriate strategies and manager selection criteria.

Vague goals like "diversification" or "return enhancement" provide insufficient direction. Without clear objectives, evaluating success becomes impossible and mission creep allows suboptimal allocations to persist.

Assess True Costs

Calculate total cost including management fees, performance fees, fund expenses, and opportunity costs from illiquidity. Compare these all-in costs to achievable returns to determine whether the investment offers positive expected value after accounting for risks.

Maintain Liquidity Discipline

Establish explicit limits on total portfolio illiquidity based on liability structures and cash flow needs. As illiquid commitments accumulate, maintain adequate liquid reserves to fund new commitments, meet distributions, and capitalize on opportunities.

Avoid the trap of over-committing to illiquid assets during calm periods only to face forced selling during crises. Maintaining liquidity discipline requires passing on attractive-seeming opportunities to preserve portfolio flexibility.

The Path Forward

Alternative assets can add value to portfolios, but not through automatic diversification benefits claimed by industry marketing. Successful alternative allocation requires skepticism of conventional wisdom, rigorous analysis of true costs and benefits, and disciplined implementation focused on specific objectives.

Investors should question whether they genuinely have access to top-quartile managers who generate sufficient alpha to justify fees and illiquidity. Most would benefit from reducing alternative allocations and redeploying capital to lower-cost public strategies that offer similar or superior risk-adjusted returns.

For those with genuine access and appropriate infrastructure, targeted alternative allocations to quality managers pursuing differentiated strategies can enhance portfolio outcomes. But these should represent conscious strategic choices based on rigorous analysis, not default allocations driven by diversification myths or peer pressure.