Alternative Investments and The Individual Investor

My previous post about alternative investments and the Yale experience drew considerable readership and a few questions.  In various talks, Dave Swensen has characterized alternative investments, e.g. real estate, commodities, and private equity, as offering higher returns in order to compensate investors for risk and for their illiquidity.   This makes them perfect vehicles for investors like the Yale Endowment which, as Swensen says, is built to be indefinitely lived and which should not have liquidity needs. 

In the previous post, we noted that the liquid part of the endowment offers a substantial cushion even in the unlikely event that the fund were to have liquidity needs.  So, an investor like the Yale Endowment is perfectly suited to maximize alternative investments in particularly illiquid vehicles like private equity.  To the extent that Yale has a long history with private equity fund managers, who in turn are attracted to Yale's size and appetite, Yale should be able to enjoy a higher return and lower risk profile for its alternative investments than other institutional investors.

Now, take the case of institutional investors like state pension funds.  As we noted before, they neither have the experience, competence or appetite for risk that the Yale Endowment does.  And, most importantly, state retirement funds may very well face liquidity issues in the future.  A significant body of academic research shows that the unfunded pension liability of state funds in Ohio, Illinois and Texas for example, will ultimately require large tax increases to pay for the tails in actuarial lives of current retirees as well as for future retirees.What if the taxpayers revolt?  What if these funds somewhere down the road are restructured into two-part vehicles combining a DB element with a DC element?  I'm not saying that this will happen, simply because of our politics.  However, unlikely doesn't mean improbable. Political forecasters do worse than economic forecasters, after all. As Dana Carvey's George H.W. Bush would say, "Gotta be prudent!" 

State pension funds cannot afford to reach for return in the way the Yale Endowment does.  Finally, the last group which is completely ill-suited for alternative investments is the average individual investor, who could easily be subject to unexpected events like a catastrophic, uninsured illness or unplanned for long-term care.

In what seemed to my readers to be a contradiction, Dave Swensen has advocated portfolio construction for individual investors from traditional asset classes, using low-cost index funds.  Alternative investments are a no-no for these investors, he says.  In fact, it's not a contradiction at all.