Strategic Asset Allocation with Alternative Illiquid Investments

Abstract

In Strategic Asset Allocation with Alternative Illiquid Investments (2024), Knicker and Braun develop a framework that bridges the gap between traditional portfolio theory and the growing importance of illiquid alternatives. By creating synthetic return series for ten alternative asset classes, they enable the inclusion of private market investments — such as private equity, venture capital, and infrastructure — into standard portfolio optimization models. The paper introduces Time-to-Break-Even as a novel liquidity measure and applies Expected Shortfall for more robust tail-risk assessment. Empirical analysis based on 5,000 alternative funds demonstrates that alternatives enhance portfolio efficiency across all investor risk profiles.

Introduction

Institutional portfolios, particularly those of U.S. endowments, increasingly allocate large shares to illiquid alternatives, sometimes up to 50%. However, traditional Markowitz-style models rely on liquid return series and correlations, which are unavailable or distorted for private markets. This paper addresses that shortcoming by developing a synthetic modeling approach that allows illiquid assets to be evaluated and optimized alongside liquid ones.

Methodology

The authors construct replicating portfolios of liquid instruments designed to mimic the cash flow characteristics of illiquid assets. Using data from over 5,000 funds spanning 30 years, they generate continuous synthetic price and return series for ten alternative asset classes.

Key innovations include:

• Replicating Portfolios: Synthetic time series of alternatives built from liquid risk factors (e.g., equity growth, credit spreads).
• Expected Shortfall: Used instead of volatility to better capture downside risk.
• Time-to-Break-Even (TBE): A new liquidity metric measuring how long it takes for investors to recover their committed capital, typically 8–11 years for private markets.

Findings

• Alternatives improve efficiency: Even conservative portfolios benefit from a small allocation to alternatives.
• Dynamic role of alternatives: As risk tolerance increases, allocations shift from fixed income and equities toward alternatives, which can dominate high-risk portfolios.
• Liquidity as a key factor: Liquidity preferences strongly affect portfolio composition — investors with low tolerance for illiquidity favor private debt and secondaries, while those with high tolerance tilt toward private equity and venture capital.
• Alternative-only optimization: Within the alternatives universe, optimal mixes depend on investor objectives: risk-tolerant investors lean toward private equity and venture capital, while liquidity-sensitive investors prefer private debt.

Implications for Investors and Policy

The study shows that incorporating illiquid assets requires extending classical optimization to three dimensions: risk, return, and liquidity. For asset managers, this means:

• Moving beyond volatility-based measures to more realistic downside and liquidity metrics.
• Recognizing the structural diversification benefits of alternatives, even for low-risk portfolios.
• Customizing allocations based on both liquidity horizons and institutional constraints.

Conclusion

This paper provides a practical, data-driven framework for integrating illiquid alternative assets into long-term portfolio design. It captures the real economic relationships between public and private markets and highlights liquidity as a decisive factor in strategic asset allocation. The methodology offers investors a robust tool to align portfolios with their risk, return, and liquidity objectives, connecting modern portfolio theory with the realities of alternative investing.