The Role of Alternative and Private Market Investments in Diversified Portfolios

By Scott Welch, CIMA®, Chief Investment Officer & Partner

Reviewed by Carter Mecham, CMA®, IACCP®

Alternative Investments

In the wake of the “melt up” in the stock market over the past 18-24 months, it may seem a strange time to write about alternative investments. We refer you to Rule #s 1, 2, 3, 7, and 9 above.

We hesitate to even use the term “endowment model” because of the disregard it has witnessed over the past several years. But it is time-tested, and it works – if applied appropriately. And, of course, it depends on your investment objectives and your time horizon.

At Certuity, our objectives are to deliver consistent performance over full market cycles, with reduced volatility. In baseball terms, we seek to hit singles and doubles while rarely striking out. This approach is not for everyone, and we respect that, but that’s where we stand. 

We believe in the power of compounding – if you don’t lose as much in down markets you don’t have to make as much in up markets to still come out ahead.

Source: Nationwide IMG Competitive Intelligence Team, September 2023.

Let’s Define Terms

What does “the endowment model” mean for HNW and UHNW families? In our minds, it means the following:

• Global diversification across traditional long-only asset classes (stocks and bonds)
• A reasonable time horizon (5-10 years)
• The intelligent allocation to both active and passive investment strategies, to optimize fees and taxes, and
• The prudent use of both alternative and private market investments to achieve better diversification and higher potential return.

Let’s first focus on the broad umbrella of what we define as “alternative investments”:

• Managed Futures (CTAs)
• Long-Short / Hedged Equity
• Global Macro 
• Diversified Arbitrage / Event Driven
• Market Neutral
• Options-Based

So, what do we mean by “alternatives?” In our opinion, alternative investments are simply less constrained active management strategies.

In other words, there is nothing particularly “alternative” about them, they just have greater flexibility to take on leverage and illiquidity.

For illustration purposes only.

As illustrated below by JP Morgan, the inclusion of these types of strategies offers the potential for comparable / better returns with less volatility. 

Source: JP Morgan Asset Management “Guide to Alternatives,” as of November 2024. You cannot invest in an index and past performance does not guarantee future results.

In addition to the compounding argument, we also believe this diversification has investor behavior implications – many investors fear losing money more than they enjoy making money and, so, a more consistent / lower volatility portfolio may increase their likelihood of staying invested – which is critical to long-term success.

Another way of illustrating the potential diversification benefits of alternatives is to show the relative performances of various strategies versus the performance of the traditional “60/40” stock and bond portfolio during those market periods when traditional portfolios were at their “worst.”

Source: Franklin Templeton Institute, “2024 Alternative Investment Outlook: Challenge Creates Opportunities”, February 2024. You cannot invest in an index and past performance is no guarantee of future results.

OK, But Why Should I Be Thinking About Alternatives Now?

The phrase “all-weather” refers to building portfolios that generate consistent performance regardless of the underlying economic and market regimes.

The simple schematic below illustrates the four primary phases of the economic cycle, based on whether the economy and inflation are increasing or decreasing.

We can then overlay this schematic with which types of investment strategies have the potential to perform best during which phase of the economic cycle.

Definitions: “Capital Growth” = Equity strategies, “Income” = Rate and Credit strategies, “Real Assets” = commodities, precious metals, real estate, MLPs, etc., “Volatility Management” = alternative and private investment strategies. For illustration purposes only – does not represent investment advice.

Given the difficulty of timing the market or knowing exactly where you are in the economic cycle, this illustrates the potential benefits of diversifying across all the various investment strategies (i.e., the endowment model).

Portfolio Construction Questions

If you accept that alternatives have a place in diversified portfolios, the question then becomes, “How do I include them?”

In our opinion, some alternative strategies (long-short, hedged equity, market neutral, options-based, etc.) tend to have a higher correlation to the broader equity markets, and so should be funded out of the traditional equity allocation.

Others (global macro, managed futures, event-driven, etc.) tend to have a lower correlation to equities, and so should be funded out of the traditional fixed income allocation.

Access to these strategies depends on the nature of the investor. Hedge funds (a less regulated investment vehicle typically established as a limited partnership) are accessible to “Qualified Purchasers” or QPs, generally defined as HNW investors and families with $5 million or more in investable assets (not including a primary residence). 

Hedge funds typically have less constraints on the degree of leverage and illiquidity they can deploy, and so have a better opportunity to take advantage of the historical performance premiums those characteristics have delivered.

Non-QP investors have access to other, more regulated strategies, including ETFs, mutual funds and other less liquid but still registered structures, such as Registered Investment Companies (RICs) and interval funds.

These are viable strategies, but investors should be aware that regulatory constraints on illiquidity and leverage may dampen their potential return profile versus hedge funds.

There are “multi-strategy” structures available at both the hedge fund and retail product levels, and these are practical approaches for investors seeking a “one stop” solution, or as the “anchor” position to a core / satellite portfolio construction approach.

For illustration purposes only.

The importance of taking a multi-strategy or diversified approach can be illustrated by an alternative investment “performance quilt chart.” Like traditional products, strategy performance can vary widely year by year, and it is difficult to predict which will perform best. This is why “multi-strategy” solutions can be an excellent “first stop” in allocating to non-traditional strategies.

Source: The Eaton Vance “BEAT Report,” January 2025, data through November 2024. You cannot invest in an index and past performance is no guarantee of future results.

The economy is resilient but seems to be slowing down, inflation is sticky but moving in the right direction (assuming the Fed doesn’t make future rate policy mistakes), and interest rates are volatile but, in our opinion, more likely to increase than decrease as we move into and through 2025 (at least at the long end of the yield curve).

Using the economic cycle illustrated above, this suggests we are somewhere between a “soft landing” recession and an “economic recovery.”

But much is uncertain, and we think resilience should be a primary portfolio objective as we move through 2025.

Given that, it seems appropriate to analyze and discuss the inclusion of alternative investments into current portfolios, for both diversification purposes and to access lower correlated potential drivers of return.

Private Investments

Let’s now examine why we like the inclusion of private market investments into diversified portfolios.

First, the number of publicly traded companies has fallen precipitously over the past several years.

Source: Torsten Slok, Apollo Academy, data through December 2023.

For a variety of reasons, mostly increased regulatory, compliance, and reporting requirements, more currently private companies are either delaying or cancelling plans to go public, and more currently public companies are choosing to go private.

This is one reason more advisors and investors are seeking access to the private markets (for the purposes of this white paper, we will define that as private equity, private credit, private infrastructure, and private real estate). We recognize there are a myriad of sub-sectors within each of these categories, but we will focus on the broader categories.

Historically, these markets were mostly limited to institutional investors and Ultra High Net Worth families. This is because these strategies were available primarily through Limited Partnerships (LPs), which are accessible only to “Qualified Purchasers” (QPs), defined loosely as investors with $5 million or more in investable assets.

What is the appeal of the private markets to these investors? One reason is the increasing number of investment opportunities available as the number of private companies increases.

A second reason is the (typically) deep due diligence offered by the General Partner (sponsor) of the LP.

But a third (and primary) reason is the historical outperformance of private versus investments. And the primary two reasons for that outperformance are illiquidity and leverage. 

LPs generally have much more strict redemption availability – the entire purpose is to lock the money up for lengthy periods of time so the underlying manager can deploy assets more strategically and with a longer investment time horizon.

Here are the historical “illiquidity premiums” associated with Private Equity and Private Credit.

Source: iCapital. Data through October 31, 2024. You cannot invest in an index and past performance is no guarantee of future results. 

Source: iCapital. Data as of October 31, 2024. You cannot invest in an index and past performance is no guarantee of future results. “Leverage Loans” are typically floating rate bank loans, while “Direct Lending” represents the Private Credit market.

Another attraction of the Private Credit market is, simply, availability – more banks are tightening their lending standards and so borrowers need to seek debt capital elsewhere – increasing the supply of candidates for Private Credit sponsors to pick from.

Source: St. Louis Fed (FRED), data through October 2024.

We can see the appetite for private investments by looking at how the institutional (i.e., QP) universe, specifically pension plans and endowments, are allocating capital.

Source: Public Plans Data, through fiscal year 2023.

Source: 2023 NACUBO – Commonfund Study of Endowments – 2023, as February 2024.

Note that both generally follow the “endowment model” made famous by David Swensen while managing the Yale endowment. Because of the “infinite” time horizon of institutional investors, illiquidity generally is not an issue (though it was during the Great Financial Crisis of 2008-2009), and it makes sense to reduce the allocations to public equity and fixed income (especially fixed income) and instead allocate to their private market counterparts.

Over time, this approach has paid off very well (though some years are better than others, as with all types of investment approaches).

OK, But What About Non-Institutional Investors?

Another interesting observation is how “Family Offices” are allocating to non-traditional investment strategies.

Here is a recent snapshot:

Source: Campden Wealth / RBC The North America Family Office Report, 2024.

Note that roughly 35% of the average family office portfolios are allocated to non-traditional investments.

One of the ongoing trends in private investing is “democratization” – making private investments more available to retail investors. One reason driving this evolution is the desire by many private asset managers to diversify their investor bases away from large endowments, institutions, and sovereign wealth funds.

Another reason is for more traditional asset managers to be able to offer higher priced solutions in the face of ever-compressing fees in the traditional long-only world.

But doing so required developing a new investment structure that was accessible to non-QP investors. 

Enter the tender offer, interval funds, and “Registered Investment Companies” (RICs), sometimes referred to collectively as “Evergreen” strategies. 

These structures, like ETFs and mutual funds, are regulated under the Investment Company Act of 1940, and therefore generally are more liquid and generate a more investor-friendly 1099 tax form, versus the dreaded “K-1” associated with most LPs.

But they do not have daily liquidity like ETFs and mutual funds. The most common liquidity interval is quarterly and, even then, it is not “on-demand.” Rather, the investor submits a “tender request” asking for liquidity, which the sponsor may honor, deny, or limit based on the status of the underlying portfolio.

Because of this “semi-liquidity” and the perceived increased complexity of the underlying strategies, these investments are not available to everyone, but rather to “Accredited Investors” (AIs), defined as investors with gross income exceeding $200,000 in each of the two most recent years or joint income with a spouse or partner exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

So, while these structures are not available to mass market investors, they do dramatically expand the potential investor base for private investments.

Here is a summary of the three most common non-ETF, non-mutual fund (i.e., non-daily liquidity) structures.

Source: Source: iCapital, Hamilton Lane, as of Nov. 8, 2023. For illustration purposes only.

Our opinion is that private equity strategies are better suited to traditional “drawdown” LP structures, because of the longer time horizon generally required to capture the full value of the underlying investments.

On the other hand, private credit fits nicely into the Evergreen structure because the money is put immediately into work, and the investments begin to generate yield almost immediately. 

Infrastructure and Real Estate, depending on the nature of the underlying investment objectives (growth or income) can fit naturally into either the LP or Evergreen structures.

Current Investment Opportunities

These are the areas we currently are most interested in:

• Sports investing: This has become a “hot” space in private equity, and we are active participants, as we believe they offer the opportunity (with the right sponsor and teams or leagues) for a diversified potential source of return.
• Venture Capital (which has had a rough couple of years but therefore may offer much more attractive “entry point” valuations for new investments).
• Private Credit generally, but specifically more “niche-y” sectors, which compete directly with bank lending, which, as mentioned earlier, has seen the availability of credit diminish (at least for low or unrated borrowers).
• Infrastructure, particularly energy production and transmission, as we believe the exponential increase in demand for energy resulting from the evolution of Artificial Intelligence and its associated data centers represent an interesting investment opportunity.
• Certain sectors of the Real Estate market, such as distressed commercial property lending for the more risk-tolerant investor. 

On a broader level across all these categories, there has been a resurgence of interest in “Secondaries.”

This refers to the active market where the original investors seek to liquidate certain of their current holdings prior to the anticipated maturity or liquidity date. This may be for a variety of reasons, including simply that they believe there may be better opportunities in the current market environment, and want to free up liquidity to take advantage of that.

These secondary sales typically are offered at a discount to the current valuation of the underlying investment, and so may represent interesting opportunities for less risk-tolerant investors who nonetheless can generate attractive returns.

Here are some recent levels of discounts across the broader private markets.

Source: Franklin Templeton’s “2025 Private Markets Outlook”, as of December 2024.

Return Expectations

One important comment about LP vs. Evergreen investing. While Evergreen facilities enjoy greater flexibility than their ’40 Act ETF and mutual fund brethren, they face far more liquidity and leverage constraints than their LP cousins.

Investors, therefore, should not expect the same level of performance over time as they might achieve in a similar strategy wrapped in an LP structure.

Manager Access / Selection

Another aspect of investing in the private markets is manager selection. History indicates that the top decile / quartile performing managers tend to consistently be the top decile / quartile managers.

Median level managers tend to deliver median level returns, which frequently does not justify the illiquidity and fee characteristics of investing in private versus public markets.

As illustrated below, the dispersion between the best and worst performing managers in the public markets is incredibly narrow (an argument for passive investing in these spaces), but the dispersion between best and worst in the private markets is gaping.

Source: JP Morgan “Guide to Alternative,” as of Q3 2024. You cannot invest in an index and past performance is no guarantee of future results.

Summary and Conclusions

Regardless of the motivation, many investors are seeking to increase their allocations to both alternative and private investments of all types, for both performance and diversification purposes.

The growth of “Accredited Investor-Friendly” tender offer structures makes the alternative and private markets accessible to a much wider potential investor base and is driving increased interest from advisors and investors alike. 

These types of investments are not for everyone, but they represent an another interesting “tool in the toolbox” in the construction of diversified portfolios.

We hope you find this analysis useful. As always, please do not hesitate to contact us with any questions.