What are Alternative Investments?
Alternative investments encompass all investment classes that fall outside the traditional categories of stocks, bonds, and cash. These investments are characterized by their private nature, limited liquidity, and often more complex structures compared to publicly traded instruments.
Unlike traditional investments that can be traded daily on public markets, alternative investments are usually traded directly with the issuer or through private funds such as hedge funds, private equity funds, or real estate funds. These investments do not have formal secondary markets or exchanges, making them significantly less liquid than traditional securities.
Key Characteristics
Alternative investments are distinguished by several unique properties that create both opportunities and challenges for allocators:
Illiquidity as a Feature: Most alternative investments are structured as closed-end funds or limited partnerships that accept and invest capital over a predetermined period, usually 10-12 years. This structure ensures stable capital commitments but limits investor flexibility.
Higher Access Thresholds: Alternative investments often require higher minimum investments and more extensive due diligence procedures compared to traditional investments. These barriers reflect the complexity and specialized nature of this investment class.
Potential for Superior Returns: Historically, many alternative investments have offered superior long-term returns compared to public investments, as well as attractive diversification opportunities through low-correlated assets. This premium compensates investors for the relative illiquidity and higher complexity.
The Core Asset Classes
Private Equity
Private equity forms the largest and fastest-growing component within alternative investments. This investment class focuses on acquiring significant ownership interests in private companies, with the goal of creating value through active involvement in management.
Private equity has realized an impressive net annual return of 11.0% over the period 2000-2023, which is 4.8% above the returns of public equities. According to Preqin, private equity assets are expected to grow from their current level to $9.11 trillion by 2025, representing a doubling driven by strong institutional demand and the ongoing search for uncorrelated returns.
Technology, healthcare, and renewable energy dominate private equity activity in 2025, with these sectors reflecting broader market trends and societal priorities. Retail investors are gaining increasing access to private equity through innovative fund structures, making the asset class attractive to a broader audience.
Hedge Funds
Hedge funds are alternative investment vehicles that use advanced investment strategies to generate positive returns regardless of market conditions. These funds employ techniques such as long and short positions, leverage, derivatives, and arbitrage to create alpha.
The hedge fund industry encompasses a broad spectrum of strategies, each with unique risk-return profiles. Long/Short Equity represents the most classic hedge fund strategy where funds buy stocks expected to rise and short stocks expected to fall. Market Neutral strategies balance long and short positions to eliminate overall market exposure, while Global Macro analyzes major global trends, interest rates, currencies, and inflation to execute trades.
Hedge funds are expected to grow from $3.58 trillion to $4.28 trillion by 2025, representing steady but modest growth. This growth reflects the maturity of the industry and increasing competition for alpha generation.
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Real Estate Investments
Real estate alternative investments provide access to property markets through various structures, from direct ownership to specialized funds. This asset class combines income generation with potential capital growth and offers natural inflation protection.
The average American home had a 10-year ROI of 41.7% in 2023, while low-rise apartment buildings achieved an average 9.0% one-year ROI. Data Centers delivered 11.2% returns in 2024 and have become the most sought-after real estate sector, while Manufactured Housing generated 11.7% total returns in 2024.
However, closed-end real estate funds recorded negative returns with a pooled IRR of -1.1% through the third quarter of 2024. Many real estate valuations are approaching their bottom, creating opportunities for value-oriented investors.
Private Credit and Venture Capital
Private credit has evolved into a rapidly growing component within alternative investments, driven by demand for alternative funding sources. Private debt is expected to grow from $848 billion at the end of 2020 to $1.46 trillion by 2025, representing an annual growth of 11%.
Venture capital focuses on investments in early-stage companies with high growth potential. Venture capital shows a median return of approximately 14%, with top performers able to achieve up to 35% while the lower bound can drop to -5%. Preqin predicts an annual growth rate of 11.1% for venture capital until 2029, with artificial intelligence being a key driver of this growth.
Commodities
Commodities offer direct exposure to physical assets such as gold, oil, and agricultural products. This asset class serves as a natural hedge against inflation and offers diversification benefits through low correlation with traditional assets.
Commodities diversify both equities (with a correlation of 0.27) and bonds (with a correlation of -0.07). Commodity returns consist of three main components: collateral return (usually 3-month Treasury bills), spot return (price change of the physical commodity), and roll return (price difference between near and far contracts).
Performance and Risk Considerations
Historical Performance Analysis
Alternative investments have proven capable of delivering superior long-term returns compared to traditional assets. Over the 23-year period ending June 30, 2023, private equity allocations by state pensions realized an 11.0% net annual return, which was 4.8% higher than the 6.2% annual return that would otherwise have been achieved by investing in public equities.
The real estate sector shows significant performance variation between subsectors. Industrial properties achieved an average 1-year ROI of 9.50%, low-rise apartments 9.00%, and multi-family homes 7.60%. This variation reflects different market dynamics and supply-demand ratios within the real estate market.
Alternative investments offer not only higher absolute returns but also improved risk-adjusted returns through their low correlation with traditional assets. These diversification benefits are crucial for modern portfolio construction, with allocators seeking assets that add value in different market scenarios.
Primary Risk Factors
Alternative investments bring unique risks that allocators must carefully evaluate. Liquidity risk represents one of the most prominent risk factors, as many alternative assets cannot be easily bought or sold on the open market. Investments in private equity or real estate can lock up capital for extended periods, potentially from several years to more than a decade.
Valuation challenges present another significant concern, as determining the true value of alternative investments can be difficult. Unlike more traditional assets, many alternative investments do not have a standardized market value, particularly evident in sectors such as collectibles, art, or certain private companies.
Alternative investments often come with higher fees compared to traditional asset classes, including management fees, performance fees, transaction fees, and sometimes hidden costs. These investments are also exceptionally complex and typically not heavily regulated, making due diligence incredibly important for investors.
Economic Sensitivities
Economic growth sensitivity affects investor returns that depend on assets and investments exposed to the global economy. Interest rate sensitivity is particularly relevant for fixed income assets that tend to decline in price as interest rates rise, with longer maturity assets being more sensitive to rate changes.
Inflation can have a negative impact on investments by decreasing purchasing power. Failing to anticipate and account for inflation can mean that the actual return on an investment is lower than expected. Leverage dynamics can increase the potential for returns but also increase volatility and potential losses.
Due Diligence and Selection
Comprehensive Due Diligence Framework
Effective due diligence forms the basis of successful alternative investment allocation. A systematic approach helps allocators mitigate risks and identify investment opportunities that align with their objectives.
Investment strategy evaluation requires thoroughly understanding the investment approach and assessing whether it aligns with investment objectives and risk tolerance. This includes analysis of strategic focus, geographic spread, sector concentration, and expected holding periods.
Track record analysis involves evaluating the performance history of the investment manager or firm. This analysis should go beyond pure return figures and examine risk-adjusted performance, performance in different market cycles, and consistency of results.
Manager Selection Criteria
At Confluence Group, we take a rigorous approach to fund manager vetting. Each strategy, both discretionary trading and systematic trading, undergoes extensive track record verification, compliance framework checks, and operational due diligence.
We verify credibility and track record with discretion, with each candidate vetted through detailed analysis, private references, and structural checks. Our relationships are built to last, with risk management, diversification, and shared values taking priority over short-term profits.
Operational Due Diligence
Legal and regulatory compliance ensures that alternative investments meet relevant laws and regulations. Risk management practices evaluation examines how investment managers identify, monitor, and mitigate risks, which is essential for protecting investor capital in complex structures.
Valuation methodologies must be robust and transparent, given the challenges around valuing alternative investments. Fee transparency assessment examines whether fees and expenses are reasonable and transparent, including management and performance fees, transaction costs, and potential hidden charges.
Investment structure analysis investigates whether terms are fair and beneficial for investors, including liquidity terms, redemption procedures, governance structures, and investor protection mechanisms.
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Allocation Strategies
Institutional Allocation Trends
Institutional investors allocate an average of 25% to alternatives, significantly higher than other investor types. This higher allocation reflects their longer investment horizon, professional investment capabilities, and access to specialized managers.
Private equity is most common in the institutional market, with 80% of institutions investing in the category (72% of pension funds and 86% of non-profits). Real estate follows as a close second, with 74% of institutions invested in the category.
Interestingly, 34% of pension funds and 23% of non-profits invest in digital assets/cryptocurrencies, with 38% of corporate DB plans and 35% of endowments having already included digital assets in their portfolios.
Family Office Allocation Patterns
Family offices show a clear shift toward more alternative investments. Currently, about a third of family office wealth is invested in equities, cash accounts for about 10%, and real estate remains relatively stable at 12%.
Private equity investment has grown significantly to about 21%, while fixed income investments have declined to about 15% of total family office investment. Research indicates a consistent year-over-year increase in family office allocation to direct, private equity deals, with approximately 80% of family offices invested in private equity.
Technology investment is also rising as family offices seek opportunities to benefit from the digital revolution. Blockchain, crypto, and digital assets are increasingly on the investment radar as family offices look to support future leaders of the digital revolution.
Strategic Asset Allocation Models
Many allocators use a core-satellite approach where a core allocation to proven alternative strategies is combined with satellite allocations to more specialized or emerging opportunities. This approach balances stability with innovation.
Effective alternative investment allocation requires careful risk budgeting, with allocators evaluating total portfolio risk and determining how much risk budget is available for alternative investments. Given the illiquid nature of many alternatives, allocators must carefully plan their liquidity needs through staggered commitments and adequate liquidity buffers.
Within alternative investments, diversification across strategies is crucial, including diversification between asset classes and within asset classes across different strategies, vintage years, and geographic regions.
Future Market Outlook
Industry Growth Projections
The alternative investments industry faces a period of unprecedented growth. Industry estimates project private markets growing from $13 trillion today to more than $20 trillion by 2030, driven by various structural factors.
Regionally, Asia-Pacific will be a key driver of global growth, with assets under management targeting the region increasing with a CAGR of 25%, to nearly $5 trillion by the end of 2025. North America will still own half of total global alternatives and have $8.6 trillion in assets in five years.
Private equity and private debt will be the largest drivers of growth, increasing by 16% and 11% annually, respectively. Private equity will be the fastest-growing asset, coming to make up about half of the total alternatives industry by the end of 2025, increasing to $9.11 trillion.
Technological Transformation
The race to develop next-generation AI technology continues to accelerate. To support rapid growth in AI adoption, substantial investment in supporting infrastructure, particularly data centers and power, is crucial. This massive investment requirement creates opportunities for experienced infrastructure investors.
Digital assets are expected to grow significantly as part of the alternative investment landscape, reflecting ongoing digital transformation and growing acceptance of blockchain-based assets by institutional investors.
Market Development Trends
A significant trend is the democratization of access to alternative investments. Once limited to wealthy investors, the door to these investments is now open to a broader public, allowing more people to benefit from the advantages through new technologies and platform solutions.
Sustainable investing in the alternative asset space marries environmental, social, and governance (ESG) criteria with traditional financial analysis. This trend reflects growing consciousness around sustainability and investors' desire to align their portfolios with their values.
GPs are increasingly innovating and exploring alternative sources of capital, such as separately managed accounts, co-investments, and partnerships. These alternative forms of capital have given a multi-trillion-dollar boost to global private equity AUM, while retail accessibility continues to improve through multiple channels and vehicles.
Conclusion
Alternative investments have definitively established themselves as an essential component of modern portfolio construction. For allocators seeking diversification, superior returns, and access to unique market dynamics, alternatives offer unparalleled opportunities.
The industry faces unprecedented growth, with projections pointing to a doubling of assets under management in the coming years. This growth is driven by structural changes in the global economy, technological innovation, and investors' ongoing search for uncorrelated returns.
Success in alternative investments requires more than just allocation - it requires expertise, careful due diligence, and a long-term perspective. At Confluence Group, we understand that capital deserves care and relationships demand trust. In a world driven by speed and volume, we focus on quality.
We exist to connect allocators with exceptional strategies and managers - not just efficiently, but meaningfully. Through our rigorous vetting processes, institutional standards, and commitment to discretion and compliance-readiness, we help allocators navigate the complex landscape of alternative investments.
For allocators ready to strengthen their portfolios with alternative investments, the fundamentals are strong: alternatives funds continue to offer investors strong, uncorrelated long-term returns, even through sustained low-interest rate environments and volatile market cycles. With the right partners and a thoughtful approach, alternative investments can lay the foundation for lasting wealth creation and portfolio resilience.
Disclaimer
Investing in alternative strategies involves risk. Past performance is not indicative of future results. The value of investments can go down as well as up, and you may not get back the amount originally invested. These opportunities are intended for sophisticated or qualified investors who understand the risks involved. Please seek independent financial advice before making any investment decisions.
