A university endowment allocated 35% to alternatives in 2007. When the GFC hit, it needed cash for PE capital calls but could only raise it by selling public equities at fire-sale prices. It sold secondary PE interests at 60 cents on the dollar. Alternatives eventually delivered, but only for investors who survived the path.
Diversification: alternatives exhibit lower correlations with public markets. But this benefit is overstated. Stale pricing (quarterly appraisals) smooths returns, making correlations appear lower than true economic correlations.
Return enhancement (alternatives earn premiums for illiquidity, complexity, and manager selection risk. The PE illiquidity premium has historically been 200-400 bps over public equity. But dispersion is enormous) top-quartile PE funds outperform public markets by wide margins, while bottom-quartile funds underperform even after accounting for the premium. Manager selection is the dominant variable.
Inflation hedging: real assets (real estate, infrastructure, commodities) provide inflation protection. Real estate rents adjust with inflation. Infrastructure often has contractual CPI-linked revenue. Commodities are direct inflation index inputs.
Common mistakes
- Using raw Sharpe ratios for alternatives. Appraisal smoothing inflates Sharpe ratios by 40-70%. Always unsmooth before comparing alternatives to public markets.
- Claiming all alternatives diversify. PE has 1.0-1.3 equity beta. Real estate has moderate equity correlation in crises. Only certain hedge fund strategies (macro, CTA, short bias) provide genuine diversification during equity drawdowns.
- Ignoring the J-curve in PE return expectations. A new PE allocation will show negative returns in years 1-3. Boards that panic and redeem during the J-curve lock in losses. Set expectations upfront.
Bottom line
- Alternatives serve diversification, return enhancement, or inflation hedging: PE enhances return, real assets hedge inflation, hedge funds vary by strategy
- Bonds and alternatives mitigate equity risk through different mechanisms; in a 2022-style inflationary drawdown the stock-bond hedge fails and diversifying hedge funds fill the gap
- Data problems distort alternative statistics: appraisal smoothing understates volatility 30-50%, survivorship bias inflates hedge fund returns 200-400 bps
- MVO over-allocates to alternatives because smoothed data looks low-risk and low-correlation; use risk factor decomposition to avoid double-counting equity beta
Exam shortcut
When a vignette adds alternatives to a portfolio, immediately decompose into factor exposures. PE at 1.3x equity beta means the public equity reduction is partially offset. Check whether the portfolio actually diversified or just relabeled. For PE allocation questions, always include unfunded commitments in the effective allocation. For data bias questions, the three to name are smoothing (vol), survivorship (returns), and backfill (returns).
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Learning objectives
- alt investments
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