Should Alternative Investments Be Part of Your Portfolio?

Aug 13

Written By ProffittGoodson

Quick Take

Alternative investments represent investments that are not public market equity, fixed income, or cash. This can include real estate and commodities as well as private equity, private credit, and hedge funds.

They introduce significant complexity, cost, and risk that are not always transparent to the investor.

The main issues with private investments revolve around high cost, lack of liquidity, and complex structures that often create conflicts of interest between managers and investors in these vehicles.

Skill or Subterfuge?

It seems that hardly a day passes without someone promoting the latest private equity, private credit, or hedge fund opportunity. What was once the exclusive domain of large institutional investors—such as university endowments and public pension funds—is now increasingly being offered to individual investors by major firms like Blackstone and Goldman Sachs. Investors likely will soon have private investment options in 401(k)s.

These funds are often marketed as providing better diversification, lower risk, and the potential for superior returns. But do they live up to that promise? Are they genuinely appropriate for individual investors or even small to mid-sized institutions? Or is this a case of larger institutions having already filled their allocation and now seeking to pass off risk—or illiquidity—to smaller, potentially less informed investors?

Understanding Alternative Investments

Alternative investments encompass any assets outside of traditional public equities, bonds, and cash. This broad category includes assets like real estate and commodities, as well as private strategies such as private equity, hedge funds, and private credit. While these investments can offer portfolio diversification and potential for higher returns, they also introduce significant complexity, cost, and risk that are not always transparent to the investor.

Key Drawbacks of Alternatives

One of the most immediate concerns is cost. Traditional exchange-traded funds (ETFs) might charge as little as 0.03% per year in fees, while alternative funds often carry annual costs of 7% or more. In fact, one study found that fees can consume up to 26% of total committed capital in private investment vehicles. While lower-cost options may eventually emerge, the majority of alternatives today are, in our view, unjustifiably expensive.

Volatility is another area where alternative investments can be misleading. Because private investments are not marked-to-market regularly, they often appear less volatile than public markets. But this is largely an illusion. Without frequent pricing or valuation updates, the actual risk of these investments is obscured. Comparing the perceived volatility of private and public assets is, essentially, comparing apples to oranges.

Liquidity is a third critical issue. If the global financial crisis of 2008–09 taught us anything, it’s that access to liquidity matters deeply—especially in a downturn. Investors in alternative vehicles are typically subject to long lock-up periods and restricted redemption options. Even when redemptions are technically available quarterly, there are often fund-level limits—such as caps of 5% of assets per quarter. In times of stress, when all investors want out, these limitations can trap capital precisely when it’s needed most.

The Agency Problem: A Structural Risk

Perhaps the most foundational concern with alternative investments is the presence of agency problems. These arise when fund managers (agents) are tasked with acting in the best interest of their investors (principals) yet have financial or professional incentives to prioritize their own goals. These misalignments are more common—and more dangerous—in alternatives due to their illiquidity, lack of transparency, and complex structures.

In private equity, for example, long lock-up periods give managers a high degree of discretion over portfolio company performance, and limited partners have minimal visibility in between reporting cycles. Fee structures (such as a 2% management fee and 20% carried interest) may encourage risky bets or early exits to trigger performance bonuses. Additionally, fund managers may engage in “empire building” by raising oversized funds or selectively presenting performance data during fundraising.

Private credit introduces a different set of agency risks. Managers originate loans that are highly customized and lack secondary market pricing, making performance difficult to evaluate. In some cases, managers may lower underwriting standards to generate higher returns or fees, transferring risk to investors. Structuring and origination fees further incentivize deal-making volume over quality.

Hedge funds, too, face acute agency issues. Their environments are highly opaque and fast-moving, and investors often lack insight into shifting strategies or leverage levels. The performance-based “2 and 20” fee model encourages option-like behavior, where managers benefit from upside gains while being insulated from losses. This can lead to risk-shifting or style drift—such as deviating from long/short equity to distressed debt—without clear investor disclosure. In poor-performing periods, hedge fund managers can impose redemption gates or lock-ups, limiting investor exits and compounding the impact of poor performance.

Why These Risks Are Amplified in Alternatives

These problems are not unique to private investments, but they are more difficult to detect and resolve in this space. Alternatives often lack consistent valuation, investor rights are typically weaker, and the capital commitment is longer. With fewer mechanisms to hold managers accountable—such as redemption pressure or daily price transparency, agency problems can persist for years without clear resolution.

When Alternative Investments May Be Appropriate

Despite these concerns, there are cases where private investments may play a role—particularly for wealthy families or high-net-worth individuals who meet specific criteria. Generally, these investors should have at least $10 million in investable assets, which allows for sufficient diversification across illiquid vehicles and cushions the impact of multi-year lock-up periods.

They should also possess a long-term horizon, ideally 7 to 10 years or more, and have the willingness to tolerate liquidity constraints, valuation uncertainty, and managerial discretion. For some, private investments may align with goals such as enhancing yield (as in private credit), pursuing non-correlated returns (as in hedge funds), or engaging in legacy and estate planning through long-duration assets.

However, private investments are not appropriate for investors who need short-term liquidity, desire daily transparency, or have a low risk tolerance. The complexity, cost, and lack of accountability embedded in these strategies make them unsuitable for most individual investors—particularly those with limited portfolio scale or shorter time horizons.

Final Thoughts

In our view, most alternative investments carry more risk and complexity than their marketing suggests. While there may be legitimate use cases for wealthy investors with substantial, patient capital, we believe the average investor should approach these offerings with significant caution. As always, we’re here to help evaluate whether a particular investment strategy is aligned with your unique needs and long-term objectives.