Our guide to building out an alternative investment portfolio

If you have followed our views on markets in recent years, you likely know our perspective on alternative investments: We believe they have the potential to deliver greater long-term returns than publicly traded stocks and bonds, while also providing important portfolio diversification. Although high-risk and for a more sophisticated investor,  perhaps that is why you should consider getting invested, if not already in alternative investment strategies.

The next step would be ensuring you have a comprehensive plan in place to help achieve your wealth goals so that we can help you strategize alternative investment portfolio exposure and allocation. As you may have already observed, building a portfolio of alternative investments involves a few more steps than buying stocks or bonds. Investing in a way that meets your needs and objectives starts with crafting the right approach, then applying it with consistency. 

We sometimes see investors get overwhelmed when they go it alone. Without a solid approach, their results can be scattershot, with outcomes including portfolios with higher levels of risk, returns that don’t meet their needs, unintended concentration or simply missed opportunities.

For decades, we’ve worked with ultra-high-net-worth clients to plan and build portfolios of alternatives that are right for them. We help you to turn those crucial investments into the foundation of a fully diversified portfolio. Here are some important steps to consider.

Get invested gradually

In deciding how to build out your alternatives portfolio, important considerations will include your overall wealth, your spending needs, your risk tolerance and your time horizon. There is no universal rule for how much to invest in alternatives or how your portfolio should look.

For investors who are newer to alternatives, we find it often makes sense to start with a relatively smaller allocation and slowly ramp up over a period of three to five years. This helps diversify sources of return. And because the alternatives market is less liquid, building alternative exposure gradually over time is easier than reducing it.

Typically, we advise clients who have committed to investing in private markets to devote between 15% and 30% of their investible funds to alternatives and other long-term illiquid assets. A client with more income-oriented or conversative risk objectives, or who needs access to more cash, may target a lower allocation, or devote more of their investments to strategies considered to be income-generating, such as private credit or real estate. 

By contrast, an investor who is looking to provide for multiple generations into the future, or fund an endowment or foundation, might allocate more to alternatives. They might also invest larger portions of their wealth in long-term growth assets that can deliver greater potential returns. Our recent survey of Family Office clients found that family offices commit an average 45% of their investment portfolios to private investments, weighted heavily toward private equity and private real estate.

Your objectives determine your strategy

While the full design of your portfolio should reflect your needs, interests and comfort level, some general principles apply. We think investors should consider investing at least 50% of their alternatives portfolio in private equity as an “anchor” that aims to provide the highest median return—that is, this piece could provide steady and reliable returns.

From there, the rest of the portfolio is generally divided between three segments. 

• Growth equity and venture capital strategies may deliver higher potential returns to your portfolio than the “anchor,” but come with more risk. 
• Private credit strategies can help generate income and mitigate risk. 
• Finally, real assets—namely, real estate and infrastructure—provide important diversification and the potential for inflation mitigation, while still contributing to your overall returns.

As we’ve discussed, the makeup and size of each of those components will vary according to your goals. In most cases, though, we advise that each of these segments comprise less than 30% of your overall portfolio.

The end result is somewhat similar to the traditional portfolio design of 60% stocks and 40% bonds: The largest piece provides price appreciation over time with potential upside, and the rest provides a steadier cash flow and diversification to broad equity market or macroeconomic risk.

However, the details will vary based on your objectives and interests. We might advise a client with a greater tolerance for risk to allocate more capital to private equity, or guide clients seeking thematic exposure to areas of leading innovation—such as artificial intelligence, cybersecurity and biotech—to larger exposures to growth equity and venture capital.

Other clients focused on income might focus on private credit and real estate strategies, as these typically generate more yield and reduce the dispersion of their returns. Clients who are more tax-sensitive may allocate less to income-oriented strategies where returns generate ordinary income as opposed to long-term capital gains. If a client has generated wealth through real estate investments, we might advise them to concentrate their real asset exposure in infrastructure instead of traditional real estate, or minimize their real asset exposure.

How to invest, and find the right approach 

There are two common types of private investment funds. You might be most familiar with drawdown funds, which generally invest capital over five years and have terms of 10 years. Over the course of that term, investors could get their principal back as well as their gains. This is one reason you should consider investing gradually over multiple years: It ensures you stay invested as drawdown funds conclude.

The other type is called an evergreen fund. These invest your capital upfront and reinvest the profits. While the evergreen market is still relatively nascent, and the universe of evergreen strategies is much more limited than drawdown funds, their popularity is growing. 

Depending on how you invest, we recommend regular meetings—typically quarterly or semiannually—where you and an advisor discuss the options and fund managers available to you, and where and how you would like to invest your capital. Once you’ve decided how much to allocate to alternatives and what strategy to take, it’s time to decide how best to execute your plan. Investors usually do this in one of four ways:

• If you want the greatest degree of customization and want to consider the largest number of possible strategies, you can create your portfolio “à la carte”—with the goal of building a private investment portfolio over 3–5 years that allocates to 15–25 managers across sub-sectors. This is the most time-consuming option, as clients will generally commit capital to between five and seven drawdown funds every year to diversify their investments across managers and strategies. This approach is most often used by large family offices, endowments and foundations.
• If you feel you do not need that level of engagement, a good option is a fund-of-funds approach. This outsources the building of the portfolio to a manager who specializes in building a portfolio that allocates to multiple strategies. Those strategies can target multiple sectors, or just one. A fund-of-funds usually allocates to drawdown funds and is managed on an annual basis. This generally means one investing decision per year instead of five to seven in an à la carte strategy.
• Evergreen-only strategies might suit you if you favor a simpler process, as evergreen funds continually reinvest their proceeds instead of winding down after a fixed term. However, periodic reviews are needed to ensure the portfolio still meets the client’s needs. 
  
  Evergreen strategies tend to have lower minimum investments than drawdown funds, and this appeals to many investors who are new to alternatives. However, there are fewer choices of funds than in the drawdown space, and returns are typically also somewhat lower than in less-liquid drawdown strategies—as allocations to more liquid assets dilutes some of the premium return generated in illiquid investments.
• Most clients choose a mix of the above. This often means making their largest investment and “anchor” a fund-of-funds, with smaller allocations to a few other strategies depending on their needs and preferences. Often, clients will allocate to additional drawdown strategies to potentially enhance returns or add exposure that they don’t get in their “anchor” allocation, and then allocate to evergreen strategies to enhance income or accelerate capital deployment. This approach can simplify the planning process while maintaining individualized strategic flexibility.

We can help

Even the most experienced investors can easily be overpowered by the array of alternative classes, strategies and vehicles now on offer. And all the information in the world is not useful unless it is applied to an individual’s particular circumstances. 

We are committed to working with our clients to help them explore all the ways they might achieve their long-term objectives.

For a thoughtful analysis of what steps you might want to take and when, reach out to your J.P. Morgan team.