Determining the right allocation percentage for alternative investments has always been a challenge for many investors. With their unique characteristics such as lower liquidity, higher management fees, and less regulation, alternative investments require careful consideration in portfolio construction. This article provides insights into best practices on allocation approach and percentage based on investment objectives, and tips on aligning expected returns. There are also discussions around different alternative investment strategies and structures like direct investing versus fund investing that investors should take into account. By optimizing allocation methodology, investors can maximize the diversification and risk-adjusted return benefits of alternative investment higher_word.
Consider investment objectives, return expectations, and risk tolerance in allocation decision
The appropriate allocation percentage for alternative investments depends on an investor’s specific investment objectives, expected risk and returns, and risk tolerance. A common pitfall is allocating based on arbitrary percentages without linking to return expectations. For instance, a 2-5% allocation to alternatives may not move the needle on overall portfolio returns. Investors targeting higher portfolio returns may need to allocate 20-50% to alternative investments designed to yield sufficiently high returns. It is key to do the math on required returns from each asset class to achieve overall portfolio return targets.
Utilize alternative investments for diversification, crisis period gains, and less correlation
While past performance is no guarantee of future results, some alternative investments like managed futures and global macro have historically performed well during equity bear markets and economic crises. This diversification benefit only kicks in at higher allocations of 20%+. Additionally, given alternative investments have lower average correlation to traditional assets, a higher allocation percentage may potentially improve risk-adjusted returns.
Evaluate investment structures: direct vs fund investing
Investment structure impacts level of control, liquidity, expertise needed, fees, and minimums. Direct investing provides more control but requires hands-on expertise and due diligence. Fund investing leverages manager expertise at the cost of fees. Hybrid co-investment structures balance control and expertise. When optimizing allocation, investment structure suitability based on investor skills and preferences should be considered alongside percentages.
Conduct portfolio rebalancing regularly
As market conditions change, the relative valuations and risks associated with stocks, bonds and alternative investments also shift over time. Regular rebalancing across asset classes based on initial strategic asset allocation and risk tolerance allows investors to sell high and buy low while maintaining a consistent risk profile.
In summary, determining the right alternative investment allocation percentage requires aligning expectations with portfolio objectives, investment horizons, and risk appetite. A methodical approach coupled with periodic rebalancing helps ensure alternative investments contribute meaningfully to overall portfolio performance. Finding the sweet spot on allocation percentage requires understanding structures, expected returns, diversification needs, and individual preferences.