In today’s turbulent economic environment, just about everyone is looking for ways to limit portfolio volatility and reduce potential losses if financial markets suffer another steep drop. One possible solution is to include “non-traditional” assets—hedge funds, long/short funds, private equity, real estate, commodities—in your investment mix. Such assets further diversify a traditional stock and bond portfolio, and broad diversification can help smooth out returns. But much of the hype about alternatives ignores some basic realities of these investments.

While you may not have heard of David Swensen, who since 1985 has been the chief investment officer of the Yale University endowment, he is well known among investment professionals for his great track record and as a long-time proponent of alternative investments. Although Yale also suffered major losses during the 2008 market meltdown, that didn’t shake Swensen’s conviction that investments in private equity and hedge funds offer several advantages over publicly traded stocks and bonds. His pioneering notion, now often referred to as the Yale or “endowment” model, that such allocations could reduce risk and enhance returns has since been embraced by many endowments and pension funds.

Yale and Harvard, which has also followed the endowment model for years, both racked up losses about on par with those of other investment approaches in 2008. But the schools’ investments have outperformed market averages over the long haul, and many individual investors continue to be drawn to the idea of alternative investments. Yet these assets come with special risks attached.

• With private investments, you may have to tie up your money for extended periods in exchange for a chance of higher returns. But illiquidity can compound your problems in a downturn if you can’t afford to wait for a turnaround.
• Private investments generally depend on financial leverage and tend to prosper when interest rates are low. In leveraged buyouts, for example, investors use large amounts of debt to buy companies, hoping to resell them at a profit to another company or to the public. If credit is difficult to get or rates are high, that formula may backfire.
• In the largely unregulated world of hedge funds and private equity, telling good deals from bad requires extensive due diligence, and it may not be worth the trouble, given that there are now mutual funds and exchange-traded funds that may mimic the behavior of private investments.

This alternative approach emphasizes the importance of seeking risk-adjusted return. If you would like to explore the suitability of such assets for your portfolio, please call to set up an appointment.