Asset Allocation for Alternative Investments

Beyond the frontier

Amid a wave of investment product innovation over the last several decades, one critical element to investment success has been left behind: asset allocation models. Almost as if suspended in time, they are the same today as they were a half century ago. That’s when Nobel Laureate Harry Markowitz introduced the notion of the “efficient frontier”, which explored the trade-off between risk and return.

Back then, Elvis dominated the airwaves, and the efficient frontier signaled that the 60/40 portfolio—60% stocks and 40% bonds—was the optimal portfolio for most investors. Fast forward to today, most asset allocation for alternative investments still focuses on risk/return assumptions developed in 1952. Elvis has since left the building. Isn’t it time to update these one-dimensional models to capture the unique attributes of alternative investments, like illiquidity?

California beach homes from abpove.

What are illiquid alternatives?

Think of illiquid alternatives as assets that are not quickly and easily traded  because they lack a well-developed public market matching buyers and sellers. Examples might include:

  • real estate
  • private equity
  • private loans
  • hedge funds
  • real assets, like timberland, farmland, and other commodities
  • artwork

Due to the lock-up requirements of these illiquid assets, many investors tend to have a long-term, conservative bias in their alternative investments portfolio allocation. 

Round Peg, Square Hole

What makes illiquid alternative investments so tough to model?

Traditional alternative investment allocation models fail to capture the unique attributes of these investments. That’s problematic because alternatives’ distinctive characteristics—like return drivers, leverage, return relationships, and risk—are they key inputs to any model.

Getting the inputs right

Let’s start with return drivers. Each alternative asset class has drivers of return that differ from traditional stocks and bonds, and from other alternatives. For example, sources of return on private credit include the interest payments on floating rate loans, which are very different from returns on private equity that come from the recapitalization or sale of a company. Further complicating matters, those unique drivers give rise to return patterns that are dissimilar to patterns of other asset classes. This creates a diverse return relationship, or correlation, with other assets.

Illiquid alternatives also tend to use leverage, although the amount differs depending on the asset. And leverage is just one of several distinct risks that alternatives take on. Ultimately, the failure to properly account for variables like leverage, correlation, and risk skews the alternative investments portfolio allocation derived from most conventional asset allocation models.

Temporary Image

Alternative investments are not a monolith

Asset allocation models must capture their differences.

Private Real Estate Partnership

  • Illiquid (e.g., ten-year lockup)
  • Valuations based on mark-to-market (with a lag)
  • Lower correlation to broad equity market

A Long/Short Hedge Fund Investing in Public Traded Real Estate

  • More liquid (quarterly redemptions permissible)
  • Greater transparency into valuation
  • Higher correlation to broad equity market

Shouldn't your asset allocation model account for these differences?

woman harvesting a plant

Calling them "diversifiers" isn't enough

As they explore their asset allocation for alternative investments, many investors lump all their illiquid assets together and assume they’ll play a diversification role.

But this catch-all can be misleading. Consider a model that optimizes for returns, without distinguishing between varying levels of return in private markets. For example, private equity typically aims for 20% returns. That’s a far cry for private debt, which generally seeks a steady rate of return in the high single digits.

The same applies to leverage. Some strategies use zero leverage, some use significant leverage. How does your modeling capture that? Unlike with traditional stocks and bonds, these kinds of idiosyncrasies are very time-consuming to model when sizing an alternative investments portfolio allocation. 

Bernstein’s Alternatives Impact Analysis (AIA) solves for many of the problems that plague traditional models when sizing an alternative investment allocation.

AIA is born

Bernstein’s Alternatives Impact Analysis (AIA) model is a multi-asset analytics platform that is flexible, broad, and transparent. Its layered analysis is designed to assist investors in making long-term allocation decisions across all possible investment choices.

AIA uses multiple layers to improve outcomes of asset allocation by:

  • marrying traditional assets with an alternative investment allocation
  • avoiding mismatch in cash use and asset allocation
  • allocating to cash-flow oriented investments where appropriate, but not at the cost of overall growth
  • explicitly understanding the liquidity characteristics of the portfolio
  • understanding and planning for unlikely, but exceptionally bad outcomes to avoid portfolio “shock”


These five steps form the backbone of Bernstein's Alternatives Impact Analysis model

image of infographic

What risks should I consider?

When sizing an alternative investment allocation, any model must account for risks at the overall portfolio level. We break these risks down into three areas—liquidity shortfall, allocation drift, and portfolio drawdown:

Liquidity shortfall risk (LSR) refers to the likelihood of running out of accessible money at some point over the next 10 years. If an investor spends from a portfolio, we avoid allocations that have even a small probability of running out of cash.

Allocation drift risk (ADR) is the degree to which asset weights drift over time. Drift will likely occur in any portfolio with illiquid investments; as the illiquid investment changes in value, it will make up an increasing or decreasing percentage of the overall portfolio. Recalibrating drift is difficult because when their weights rise, illiquid investments cannot be sold to rebalance the portfolio.

Portfolio drawdown risk (PDR) looks at the probability that your portfolio value will fall due to market conditions. We typically model minor (5%) and major (20%) losses of portfolio value when we determine asset allocation.  

Paddling in open water

Sizing Starts with Spending

While Bernstein’s Alternatives Impact Analysis addresses each of these risks, let’s explore Liquidity Shortfall Risk in particular. Here, the model aims to optimize for an alternative investment portfolio allocation that does not put an investor’s spending at risk.

Consider that an average investor tends to spend about 3% of their portfolio per year. But spending needs are very individualized—some spend 5% or even more—and that need for cash influences how much illiquid alternatives can be held in a portfolio. At a 3% spending rate, an allocation to alternatives would be higher than an allocation for a 5% spender, and significantly higher than someone who uses 7%. Why? Because the more you spend, the less capacity you have to take on illiquidity that often comes with an alternative investment allocation.

Below we model scenarios for an investor who is a qualified purchaser with a 5% annual spending requirement to show the impact of alternatives on portfolio return and risk (Display). 

Allocation Output Display


In our analysis, the investor who has no allocation to alternatives gives up 20 basis points of return each year, with a higher level of risk (as measured by the Probability of a 20% loss) relative to someone with a small alternative investment allocation (5%). On the other extreme, the investor with a 40% alternative investment portfolio allocation expects to receive an average annual return of 7% but has a 5% chance of running out of liquidity—a risk we view as being too high to be acceptable.

Using our asset allocation for alternative investments, the right portfolio for this investor would be 10% exposure to alternatives. At this level, the portfolio has no liquidity shortfall risk, acceptable (12%) drift risk, and a 14% chance of a 20% drop over 10 years—marginally lower than with no exposure. And at this 10% allocation, the investor’s expected average annual return is 5.7%, 40 basis points higher per year than without alternatives.

Too much, too little, or just right?

The benefits of an alternative investment allocation at a 5% spend rate are obvious, and for the average 3% spender, the advantages can be even greater. What might an even higher alternative investment portfolio allocation look like for this more conservative spender?

Below we plot expected returns and allocation drift risk for two different levels of spending and alternatives exposure (Display). At a 20% allocation, a conservative spender could expect an average annual return of 6.5%, with no liquidity shortfall risk and only 14% drift—versus 19% drift for the 5% spender. Put another way, by allocating 20% instead of 10% to alternatives, the investor enjoys higher return potential (80 basis points more per year) with only modestly more risk—both from an allocation drift and probability of a 20% loss standpoint.

Allocation Output Display


Conversely, greater spending needs may make alternatives too risky. At a 7% spend rate, for example, even a small alternative investment allocation (5%), yields a 10% chance of a liquidity shortfall.

Each investor’s circumstances need to be considered to determine the optimal asset allocation for alternative investments. Being too cautious can mean sacrificing valuable returns but being overly aggressive can increase the chances of running out of liquidity or enduring a large drawdown. Striking the right balance offers the best chance to an alternative investment portfolio allocation that achieves the best of both worlds.

Featured Content

For the most part, asset allocation for alternative investments is still driven by rules of thumb, rather than a precise approach. Our research shows there’s a better way.

How much illiquid alternatives should you have in your portfolio? It depends. Alex Chaloff, Co-Head of Investment Strategies, explains more in this podcast episode.

Alternative investments are known for attractive risk-adjusted returns and diversification principles. But did you know there’s a hidden bonus? Alternatives provide an excellent source of wealth transfer opportunities.