Alternatives in a Portfolio: When and Why to Include Them

How alternatives differ from traditional assets

Alternative investments use return drivers and structures that are often unavailable in public stocks and bonds. Examples include direct property income, commodity price movements, private company growth, and arbitrage strategies used by hedge funds. Because their performance is driven by different economic forces, alternatives can lower overall portfolio volatility and reduce drawdowns during some market stress events. The U.S. Securities and Exchange Commission (SEC) outlines regulatory differences and investor protections for many alternative products (see SEC guidance: https://www.sec.gov).

In my work as a financial planner, I’ve seen alternatives help clients in three ways: smoothing portfolio returns through low correlation, adding sources of income (e.g., rental cash flow), and providing exposure to opportunities not available in public markets (e.g., late-stage private deals). Those benefits only materialize when alternatives are chosen and sized to match goals, time horizon, and liquidity needs.

Who should consider alternatives

• Accredited investors and many institutional investors have the breadth of options available to them; the SEC defines accredited investor status and additional qualification pathways on its site (SEC: accredited investor rules). Note that accredited criteria include net worth and income thresholds while also recognizing professional qualifications (https://www.sec.gov).
• Retail investors can access alternatives via liquidized products (ETFs and mutual funds that hold alternative strategies or asset classes), REITs, interval funds, and some crowdfunding platforms; these vehicles have lower minimums but vary in risk and fees.
• Alternatives are generally better suited for investors with a longer horizon and higher risk tolerance because many strategies involve illiquidity, leverage, or manager-specific risk.

Common types of alternatives and how they behave

• Real estate (direct property, REITs, private real estate funds): income + appreciation, inflation sensitivity, moderate-to-low public-market correlation for private property. REITs are liquid and traded like stocks; private real estate is illiquid but can offer higher income and tax complexity.
• Private equity and venture capital: long-term capital appreciation from private companies. Typically illiquid, high-return/high-risk, and subject to manager selection.
• Hedge funds and long/short strategies: aim for absolute returns and downside protection through leverage, derivatives, and short positions. Returns vary widely by strategy and manager.
• Commodities (gold, oil, agriculture): used for inflation hedging or tactical exposure; prices can be volatile and are influenced by supply/demand and geopolitical factors.
• Liquid alternatives (mutual funds/ETFs that follow alternative strategies): offer more liquidity and lower minimums but can come with strategy drift or higher fees than index funds.

When to include alternatives: objective-based rules

Include alternatives only when a clear objective exists. Common goals include:

• Diversification and correlation reduction: To lower portfolio sensitivity to equity market swings when alternatives offer distinct return drivers.
• Income generation: Real assets and certain private credit strategies provide predictable cash flows.
• Inflation protection: Real assets and commodities often perform better in inflationary periods.
• Access to unique returns: Private markets can offer returns uncorrelated to public indices but require longer lockups.

A practical rule of thumb: start small and test. Many advisors recommend an initial allocation of 5–15% of portfolio value to alternatives, increasing only if the strategy performs as expected and liquidity requirements are met.

How to implement alternatives (step-by-step)

1. Define the role: Are you seeking income, diversification, inflation protection, or return enhancement? Match the instrument to the role.
2. Match liquidity to needs: Don’t allocate illiquid alternatives if you need short-term access to capital.
3. Evaluate fees and structure: Prefer simpler fee structures where possible; be wary of high ‘2-and-20’ arrangements in private funds.
4. Do manager and product due diligence: Examine track record, capacity, fee history, alignment of interests, and independent audits. Ask for side letters and fee offsets where possible.
5. Size conservatively and rebalance: Begin at a modest percentage, monitor performance, and rebalance back to target bands to retain intended risk exposures.
6. Consider tax placement: Some alternatives generate ordinary income or complex pass-through tax items; discuss tax-efficient account placement with a tax professional.

Due-diligence checklist for alternative investments

• Strategy clarity: Can the manager explain why this strategy should work in different market conditions?
• Historical returns and downside scenarios: Seek downside metrics (max drawdown, recovery time) and stress-test assumptions.
• Fee transparency: Confirm all fees, carried interest, and potential additional expenses.
• Liquidity and gate provisions: Understand lockups, redemption windows, and suspension clauses.
• Legal and reporting structure: Review offering documents and audited financial statements.
• Alignment of interests: Does the manager invest their own capital alongside investors?

Risks and common mistakes

• Illiquidity mismatch: Putting long-term, illiquid alternatives into a portfolio that needs near-term access to cash.
• Overconcentration: Loading too much of the alternatives sleeve into a single manager, strategy, or sector.
• Fee drag: High management and performance fees can materially reduce investor returns.
• Overestimating diversification benefits: Some alternatives correlate with equities during stressed markets; correlation is not static.
• Underestimating operational and regulatory complexity: Private funds can have limited transparency and different reporting standards.

How to measure success

• Attribution relative to stated goal: Did the alternative help reduce volatility, provide income, or offer uncorrelated returns as intended?
• Risk-adjusted performance: Compare alpha, Sharpe ratio, and downside capture rather than headline returns alone.
• Liquidity and cash-flow needs: Did the investment meet expected cash distributions without forced sales?

Tax and regulatory reminders

Alternative investments often have tax consequences that differ from stocks and bonds. For example, private funds and pass-through real estate may produce ordinary income, short-term gains, or complex K-1 reporting. Consult the IRS and a tax advisor about potential passive activity rules and entity-level taxation (IRS: https://www.irs.gov). The SEC provides investor guidance on private placements, accredited investor status, and regulatory safeguards (SEC: https://www.sec.gov).

Practical allocation examples (illustrative, not advice)

• Conservative investor with long horizon: 5% alternatives (primarily liquid alts and REITs).
• Growth-oriented investor: 10–15% alternatives (blend of private equity, REITs, and some commodities).
• Institution or high-net-worth investor with private access: 15–30% alternatives (includes private equity, private credit, and direct real assets).

Implementation vehicles and accessibility

• Public: REITs, commodity ETFs, liquid alternative mutual funds and ETFs.
• Private: Closed-end funds, private equity and venture funds, private real estate or credit funds (often require accredited status).
• Hybrid: Interval funds and registered private funds that offer some liquidity terms.

Related reading on diversification and allocation

• See our glossary entry on Portfolio Diversification for baseline allocation concepts and rebalancing strategies: Portfolio Diversification.
• For actionable diversification practices across asset classes, read Diversification Best Practices Across Asset Classes: Diversification Best Practices Across Asset Classes.

Final practical tips

• Start with a small allocation and track how the alternatives affect overall portfolio risk and after-fee returns.
• Focus on manager selection for private strategies; for public alternatives, prioritize cost and transparency.
• Keep liquidity needs and tax consequences front and center when allocating capital.

Professional disclaimer: This article is educational only and does not constitute individualized investment advice. Investment suitability varies by personal financial situation, tax status, and investment horizon. Consult a licensed financial planner and tax advisor before making investment decisions. For regulatory definitions and investor protections, visit the SEC (https://www.sec.gov) and, for general consumer guidance, the Consumer Financial Protection Bureau (https://www.consumerfinance.gov).

Author note: Over 15 years advising individual and institutional clients, I’ve recommended modest alternative allocations when they addressed a clear portfolio gap—never as a wholesale replacement for diversified public market exposure. When alternatives work, they do so as complements to a disciplined asset allocation and rebalancing plan.