Introduction to Alternative Investments
Why alternatives are different
Alternative investments - hedge funds, private equity, real assets, structured products - share traits that break standard portfolio math: limited liquidity, negotiated fees, appraisal-based or infrequent pricing, leverage, and concentrated exposures. Know the taxonomy and the underlying return drivers: manager skill, illiquidity premium, leverage, and diversification or insurance value.
Measurement and its distortions
Because many alternatives are appraised or priced infrequently, reported returns are smoothed. Serial correlation inflates Sharpe ratios and understates measured correlation with public markets, so an alternatives index can look better diversified than it is. Backfill bias (only good funds enter databases), survivorship bias (failed funds disappear), and self-selection bias all flatter index returns. Due diligence must cover operations, valuation policy, service providers, and fee terms - not just returns.
Fees
Typical structures are '2 and 20': a management fee on assets plus an incentive fee on profits, often with a high-water mark and sometimes a hurdle. Always compare net-of-fee returns to the correct benchmark; gross returns are marketing.
Traps
Assuming alternatives always raise the Sharpe ratio; treating an appraisal-based index as a market return; ignoring unfunded commitments when measuring portfolio liquidity; and crediting an illiquidity premium as manager alpha.
Worked rule of thumb
Build a liquidity budget: if a portfolio must be able to fund 10% of assets within one year, cap illiquid alternatives so that locked capital plus unfunded commitments stays below that figure.