Go Big or Go Home: The Case for an Evolution in Risk Taking

Abstract

Alternative investments — private equity, real estate and hedge funds — have natural advantages in risk and return over traditional stock and bond investments. A large allocation to alternatives relative to current institutional practice is needed for a material contribution an institutional investor’s bottom line. Investors should consider whether moving toward an Efficiency portfolio with an emphasis on low cost passive management, or an Opportunity portfolio with heavy reliance on value added through active management — especially alternative investments — is most appropriate for them. We argue that investors who can tolerate the cost, complexity and illiquidity should consider Opportunity-type allocations of 40% of their return-seeking assets to private equity, non-core real estate, and hedge funds. Success with traditional active investments is best found through conviction — rejection of “closet indexing” in its various forms.

Keywords: alternative investments, hedge funds, private equity, real estate, active management, passive management, indexing, performance persistence, fees, compensation

JEL Classification: G00, G10, G11, G14, G23