Portfolio Design: A Modern Approach to Asset Allocation

VERDICT ON ALTERNATIVE INVESTMENTS

No doubt asset allocation is improved with the addition of alternative investments. The adoption of alternatives will not guarantee Yale-size returns because other investors do not have the advantages of the Yale Endowment. But alternatives do shift the efficient frontier in a northwesterly direction. This chapter has documented this shift by examining the alpha* of portfolios with and without alternatives. Investors can improve their risk-adjusted performance with alternatives. They can reduce risk for a given return or increase return for a given risk. So alternatives are clearly desirable.

David Swensen expressed the view that ordinary investors could achieve a lot of this gain from diversification by sticking with conventional alternatives, real estate, and TIPS. In Swensen’s portfolio for the ordinary investor, 20 percent of the allocation is given to real estate. The analysis above showed real estate investments do raise risk-adjusted returns, but the gain is small.

Diversifying beyond real estate to hedge funds and other alternatives is desirable, at least for those investors who are wealthy enough. But alternatives are no panacea for high net worth investors. Unless investors have access to the best managers, hedge funds or other alternatives are going to provide only modest improvement to the portfolio. The shift to the northwest is limited, or if excess returns are measured at a given level of risk, the alpha* is positive but relatively ...