Alternative investments have the potential to enhance portfolio returns and reduce risk, but it isn’t easy to determine which alternative works best—and how much of it to own. To get accurate answers, it’s necessary to look beyond traditional asset-allocation approaches.

The typical asset-allocation approach focuses on risk/return trade-offs in a one-dimensional way that fails to capture alternatives’ unique attributes—including illiquidity, leverage, the lack of relevant indices, difficulty in rebalancing and tail risk—that don’t have relevant public market equivalents. To get the alternatives formula right, investors need to incorporate new risk factors in portfolio construction.

Understanding the Nature of Alternatives

To design an effective asset allocation, it’s critical to fully understand the diverse types of alternatives investors have to choose from. These include real estate, private equity and credit, hedge funds and real assets such as timberland and commodities—each with its own benefits and drawbacks.

Alternative strategies can invest in private markets, have unique return drivers and possess diverse return relationships with broad markets (known as betas). They may also use differing amounts of leverage and take on distinctive levels of risk. And they can be illiquid, requiring investors to have a long-term bias.

Even strategies in the same alternative category can behave quite differently, but there are commonalities among some alternatives—notably, return drivers, betas, correlations, leverage and risk—that allow for more precise classifications that can help in asset-allocation design.