Strategic Asset Allocation with Alternative Investments: An Integrated Approach

This piece was published in the August 2025 issue of the Journal of Porfolio Management. Download the full piece here.

Key findings

• In the vast majority of cases, performance of alternative investments is closely linked to that of their public counterparts; recognizing this connection is a necessary step toward self-consistent strategic asset allocation.
• It is much easier to forecast risk properties of idiosyncratic investments such as hedge funds and private equity vehicles than their future returns; a version of Bayesian shrinkage applied to returns could be used to recognize this empirical fact.
• Historical evidence points to private assets such as private equity and credit being well-modeled as leveraged versions of their public counterparts, but without the short-term excess volatility component embedded in public prices. A long-horizon modification of the traditional strategic asset allocation framework enables a consistent treatment of this phenomenon and harmonizes return/risk properties across long-only and alternative assets.

Abstract

Quantitative techniques for incorporating alternative investments and particularly private assets into strategic asset allocation (SAA) remain unsettled and insufficiently covered in the literature. This article attempts to bridge this gap by offering a broad framework for such portfolio construction tasks. The framework incorporates a range of techniques the authors see as crucial, including alpha/beta separation, Bayesian shrinkage, return unsmoothing, long-horizon risk estimation, and event-risk constraints.

Several books have been written about quantitative aspects of hedge fund investing, with multiple chapters in each dedicated to portfolio construction (see, for example, Lhabitant 2004 and Molyboga and Swedroe 2023). The legitimate questions are, what new can be added to this well-studied matter, and can a single relatively short article add value to extensive volumes already written? We hope that the answer is yes to both questions.

The purpose of this article is to provide a practical guide on how to construct portfolios that include alternative investments. Instead of reviewing an exhaustive list of available techniques, we will start by pointing out what makes portfolio construction with alternatives so challenging and how those challenges narrow the number of quantitative tools one can use effectively. We will also discuss how an allocator can think of alternatives in a broad portfolio and translate these considerations into an actionable asset allocation process across traditional long-only assets, hedge funds, private equity, and private credit. While reviewing several approaches popular among practitioners, we will take an in-depth dive into an approach we call integrated strategic asset allocation, or integrated SAA. Despite being straightforward to implement, the integrated SAA methodology reflects fundamental properties of these asset classes and how they interact with the traditional ones. This, in our view, makes integrated SAA highly appropriate for asset allocation practitioners.

The rest of the article is structured as follows. First, we delve into the theoret-ical aspects of hedge fund return decomposition. Next, we briefly review various approaches practitioners use for asset allocation with alternatives, followed by an in-depth explanation into integrated SAA. We then address another challenge asso-ciated with alternative investments—and particularly with private assets—and that is the smoothness of their returns. We discuss several unsmoothing techniques, including those that can simultaneously unsmooth and determine factor exposures. After covering unsmoothing, we discuss differences and commonalities between public and private asset returns, emphasize importance of time horizon for risk estimation, and introduce methodological ways to make it consistent across asset classes. Then we describe dual-horizon integrated SAA as a way to incorporate long-only assets, hedge funds, and private equity and credit into the same portfolio in a self-consistent, intellectually coherent fashion. Finally, we summarize and conclude.