In this example, the black curve depicts an efficient portfolio consisting of different weightings of stocks and bonds. In this case, a portfolio of 80% stocks and 20% bonds has returned nearly 7.5% over the past 20 years — but the expected risk is somewhat high. Conversely, a portfolio of 80% bonds and 20% stocks exhibits less risk. However, the expected return is lower. The orange curve shows the effect of adding a 20% allocation to alternative investments (in equal weightings of real estate, private equity, managed futures and senior secured loans). As shown, including alternative investments shifts the curve upward and to the left. Based on the historical data used in the chart above, for any given level of risk, the return was higher. While the above example is meant to illustrate the potential benefits alternative investments can bring to traditional investments, returns will vary depending on which alternative investments are included, their weightings, risk profiles and the investment time frame. Because alternative investments tend to have lower correlations to traditional investments and may offer higher yields, they can potentially reduce overall volatility and could help a portfolio perform better through varying market conditions.
A number of large endowments have allocated a large percentage of assets to alternative investments. Yale University, which posted an 11.5% return for 2015, is one of the most often cited examples. Between 2005 and 2015, Yale’s average return was 10%, while U.S. stocks returned an average of 7.9% and U.S. bonds returned an average of 4.4%.7.
Yale’s strong performance is believed to be due to its willingness to allocate a sizable portion of its portfolio to alternative investments, which, as of June 30, 2015, comprised approximately 74% of its overall portfolio. Citing “their return potential and diversifying potential,” Yale reinforced its support of an investment strategy that emphasizes a heavy allocation to nontraditional asset classes in its 2015 endowment update. Although a portfolio composed of a 74% allocation to alternative investments may be appropriate for a large endowment like Yale’s, such a sizable allocation may not be appropriate for an individual’s portfolio. While large institutions have been raising their allocations to alternative investments, individuals have far different liquidity needs and investment goals than large university endowments. Historically, alternatives have been relatively difficult for individuals to access due to large minimum investment requirements, strict suitability rules, lower liquidity levels and long lock-up periods. In response to rising investor demand, however, managers have introduced alternatives packaged in structures like mutual funds, liquid alternative funds, closed-end funds and business development companies.