Beginning in the latter part of that decade, a few of the large endowment funds in the US made initial forays into non-US stocks, real estate, and private equity which were followed in the 1980s and thereafter by allocations to hedge funds, distressed securities, real assets such as timber and energy investments, and many other categories.

Today, the average endowment in the US is invested as follows: US equities ; international equities ; fixed income accounts ; cash ; and alternative investments – totaling the full 100 per cent of the portfolio.

Many foundations, pension funds, and high net worth individuals have followed suit by meaningfully shifting the emphasis in their portfolios away from the traditional asset classes. So what are alternative investments? Why have so many investors allocated capital to them? Are there difficulties investing in them? And what should we expect from them going forward?

Alternative investments defined

Unfortunately there isn’t a universally accepted description of “alternatives” which has resulted in the default definition that this category consists of all investment classes with the exception of stocks, bonds, and cash. This is not a very satisfactory construct because it includes both liquid and illiquid investments, strategies that use leverage and others that do not, strategies that are offered in the partnership format and others that are delivered via separate accounts or mutual funds, and so on.

In other words, “alternatives” represents an amazingly broad universe of investment strategies with widely varying characteristics including considerable divergence in risk and return.

So while we will discuss the generic pros and cons of alternatives, it is critical to evaluate each specific strategy on its own merits. The three most commonly held broad categories are: private equity, real estate, and hedge funds, although each of these consists of a large number of sub-categories and many underlying strategies.

Private equity consists of two broad sub-categories. Venture capitalists invest in relatively young companies with the expectation that they will grow rapidly allowing either a sale or public offering at a very attractive multiple of cost.

Buyouts represent the purchase of more mature companies, frequently employing leverage, with the expectation of material operational and financial improvements and a successful exit. As will be discussed in more detail in the next section, the rationale for including them in a portfolio is primarily return enhancement.

While real estate is superficially relatively straightforward, it is important to realize that there are many sub-strategies including sector or geographically focused funds, core property funds, “value added” funds, distressed property funds, and so on. Real estate should provide attractive returns, diversification, and potentially, an inflation hedge.

Finally, the hedge fund category is actually a catch-all that includes many strategies. In most cases, hedge funds take both long and short positions in securities which limit their sensitivity to broad market movements. By doing so, hedge funds focus on the manager’s skill in exploiting discrepancies between the valuations of similar or related securities. This category is typically included in a portfolio in order to reduce volatility.