Integrating Alternative Assets into Your Investment Policy: A Technical Guide for Institutional Investors

Introduction: The Strategic Imperative of Integrating Alternative Assets into the IPS

A. The Shifting Institutional Landscape

The investment landscape for institutional investors is undergoing a significant transformation. Allocations are increasingly shifting beyond the confines of the traditional 60% equity / 40% bond portfolio structure. A growing number of institutions, including pension funds, sovereign wealth funds, endowments, and foundations, are strategically incorporating a diverse range of alternative assets into their portfolios. This category broadly encompasses private equity (PE), venture capital (VC), private debt, real estate, infrastructure, and hedge funds.

Pioneering approaches, such as the endowment model exemplified by Yale University, have demonstrated the potential benefits of substantial allocations to alternatives, often exceeding 50% of the portfolio. Other large institutions are following suit; data indicates that 86% of institutional investors now utilise alternatives, with average allocations reaching 23%. Public pension funds like CalPERS, for instance, have formally increased target allocations to private equity and private debt as part of their strategic asset allocation adjustments.

This secular trend is underpinned by several key drivers. Institutions are pursuing alternatives in search of enhanced returns, seeking potential alpha generation and the illiquidity premium associated with less accessible markets. Diversification remains a primary motivator, as many alternative assets historically exhibit lower correlation to traditional public equity and fixed income markets, potentially reducing overall portfolio volatility. 

Real assets, such as infrastructure and certain real estate strategies, offer potential inflation hedging characteristics. Furthermore, alternatives provide access to a significantly broader investment opportunity set, including exposure to private companies that constitute a large portion of the global economy. Consequently, the perceived limitations and evolving risk-return dynamics of the conventional 60/40 portfolio have spurred fiduciaries to explore more nuanced and diversified approaches.

The increasing prevalence and magnitude of alternative asset allocations necessitate a fundamental re-evaluation of the Investment Policy Statement (IPS). Traditionally, the IPS has served as the primary governance document for portfolios dominated by liquid, publicly traded securities. Standard frameworks often rely on the assumption that asset classes possess relatively stable and readily quantifiable risk characteristics, return expectations, and correlations – inputs suitable for traditional portfolio optimisation techniques like Mean-Variance Optimisation (MVO). 

However, alternative investments frequently challenge these assumptions. They introduce complexities such as illiquidity, subjective and lagged valuations, non-normal return distributions (e.g., J-curve effect), significant dispersion in manager performance even within the same strategy, and a general lack of transparency compared to public markets. Therefore, merely adding alternative asset classes as new line items within an existing IPS structure is inadequate. The entire governance framework, risk management protocols, and policy guidelines embedded within the IPS must evolve to effectively accommodate the unique nature of these investments.

 

B. Why the IPS Must Evolve

The Investment Policy Statement (IPS) is the cornerstone of institutional investment management, serving as the formal governing document that outlines the institution’s investment objectives, constraints, and governance structure. It provides essential guidance for portfolio managers and fiduciaries, ensuring that investment decisions align with the institution’s long-term mission and risk tolerance. Crucially, the IPS instills discipline, particularly during periods of market stress or volatility, by offering a pre-agreed, objective course of action and preventing emotionally driven decisions that could undermine the long-term strategy.

A comprehensive institutional IPS typically encompasses several core components: scope and purpose (defining the investor and context); governance (detailing roles, responsibilities, the IPS review process, authority for hiring/firing advisors, and risk management oversight); investment objectives (including return requirements and risk tolerance); constraints (such as time horizon, liquidity needs, legal and regulatory requirements, tax considerations, and any unique circumstances like ESG mandates or specific investment exclusions); portfolio parameters (defining asset allocation targets and ranges, policy benchmarks, and rebalancing procedures); and risk management protocols (including monitoring procedures, performance measurement standards, and reporting requirements).

Operating with an IPS that has not been updated to explicitly and comprehensively address the integration of alternative investments introduces significant fiduciary risk. Such an outdated document can inadvertently foster ad-hoc decision-making regarding alternative allocations, leading to inadequate management of the unique risks associated with these assets, particularly illiquidity and valuation complexities. It may also result in insufficient governance oversight for complex fund structures and manager relationships, potentially creating a divergence between the portfolio’s actual risk profile and the institution’s formally stated risk tolerance.

This heightened risk stems from several factors. Firstly, alternatives introduce distinct risk factors – illiquidity, operational complexity, valuation subjectivity, potentially higher fees, and substantial manager selection risk – that are often poorly captured by the traditional risk metrics (like standard deviation) and governance processes outlined in legacy IPS documents designed primarily for liquid assets. 

Secondly, the absence of clear, documented policy guidelines specific to alternatives can leave fiduciaries, such as board or investment committee members, vulnerable to challenges regarding the prudence of their decisions and adherence to the stated investment strategy, especially if alternative investments underperform or experience difficulties during market downturns. 

Thirdly, the regulatory environment surrounding private markets is evolving, with increasing scrutiny on areas like valuation practices and transparency. Having well-defined, documented policies within the IPS becomes essential not only for effective governance but also for demonstrating compliance and prudent oversight to regulators and stakeholders.

Characterising Alternative Assets for Policy Development

Developing effective IPS guidelines requires a nuanced understanding of the specific characteristics, risk-return profiles, and portfolio roles of different alternative asset classes.

A. Private Equity (PE) & Venture Capital (VC)

Private equity broadly refers to equity or equity-like investments made in companies that are not publicly traded on a stock exchange. PE encompasses several distinct strategies:

  • Buyout: Typically involves acquiring controlling stakes in mature, established companies, often utilising leverage (debt financing) alongside equity capital. The focus is often on improving operations, financial restructuring, or market position before exiting the investment.
  • Growth Equity: Targets established companies poised for significant expansion, providing capital to scale operations, enter new markets, or fund acquisitions. Leverage is typically lower than in buyouts, and investments may involve minority or majority stakes.
  • Venture Capital (VC): Focuses on providing capital to early-stage companies with high growth potential but often unproven business models or limited revenue. Investments are usually made in exchange for minority stakes, often through multiple funding rounds (seed, early-stage, later-stage) as the company develops. VC is generally considered higher risk than buyout strategies due to the early-stage nature of the companies involved.

 

Key characteristics relevant for IPS development include pronounced illiquidity, with typical fund structures involving limited partnerships with lifespans of 10 years or more and restrictions on investor redemptions. PE and VC offer the potential for higher returns compared to public markets, driven by factors such as the illiquidity premium, access to unique growth opportunities, and value creation through active management by the General Partner (GP). 

While often cited for diversification benefits due to potentially lower correlation with public markets, the degree of correlation can vary and is subject to debate. PE investments exhibit a characteristic “J-curve” return profile, where initial years show negative returns due to capital calls funding investments and management fees being charged on committed capital, before potential positive returns are realised later in the fund’s life as investments mature and are exited. A critical factor is the significant dispersion in performance among managers, even within the same strategy, making manager selection paramount. Historically, access has been concentrated among institutional investors and high-net-worth individuals capable of tolerating illiquidity and complexity.

Given these distinct characteristics, the IPS must adopt a granular approach rather than treating PE as a monolithic category. Policy guidelines concerning risk tolerance parameters, sub-allocation targets and ranges, liquidity expectations, and the focus of due diligence efforts should be differentiated between buyout, growth equity, and venture capital strategies. The underlying drivers of risk and return vary significantly: VC performance hinges heavily on the successful growth and eventual high valuation multiples of early-stage companies, facing substantial operational risk (i.e., the risk of portfolio company failure). Buyout strategies, conversely, often rely on financial engineering (including the use of leverage, which introduces financial risk) and operational improvements within more mature, established businesses, typically involving controlling stakes. 

These fundamental differences influence expected return profiles, volatility patterns, correlation behaviour, cash flow timing (J-curve shape and duration), and the specific expertise required from fund managers. Consequently, the IPS needs to reflect these distinctions to ensure appropriate strategy selection, risk management, and performance evaluation within the PE allocation.

 

B. Real Estate & Infrastructure

This category encompasses investments in tangible, physical assets. Real estate investments can take various forms, including direct ownership of properties, investments in public or private Real Estate Investment Trusts (REITs), or participation in equity or debt funds focused on property. Investment strategies within real estate are typically categorised along a risk-return spectrum:

  • Core: Focuses on high-quality, stabilised, fully leased properties in prime locations, generating predictable income streams with low leverage and minimal operational risk.
  • Core-Plus: Similar to core but involves properties requiring minor improvements or having some leasing risk, aiming for slightly higher returns through modest value enhancement.
  • Value-Add: Targets properties requiring significant physical renovation, repositioning, or operational improvements to increase occupancy and rental income, involving moderate to high leverage and risk, with returns balanced between income and capital appreciation.
  • Opportunistic: Involves the highest risk, focusing on development projects, major redevelopments, or distressed assets, often with little initial cash flow and high leverage, aiming for substantial capital appreciation.

 

Infrastructure investments involve the basic physical structures and facilities essential for societal functioning, such as transportation networks (roads, airports, ports), energy systems (power generation, transmission, pipelines), communication networks (towers, fiber optics), water and waste systems, and social infrastructure (hospitals, schools). These assets often benefit from stable, predictable cash flows derived from long-term contracts, regulated tariffs, or inelastic demand for essential services.

Key characteristics for both real estate and infrastructure include their potential to provide stable income streams, act as a hedge against inflation (particularly assets with inflation-linked revenues), and offer diversification benefits due to potentially low correlations with financial assets. Core strategies generally exhibit lower volatility compared to public equities. However, direct investments and private funds are typically illiquid, and infrastructure projects can be subject to regulatory, political, and operational risks. Institutional allocations to infrastructure have seen considerable growth, reflecting its increasing recognition as a distinct asset class.

For these real asset classes, the IPS must clearly articulate the institution’s objectives and risk appetite by defining the acceptable position along the risk spectrum (Core, Core-Plus, Value-Add, Opportunistic). A generic policy statement simply allowing “Real Estate” or “Infrastructure” is insufficient, given the wide variation in risk and return profiles across strategies. The policy should explicitly link the chosen strategy focus to the institution’s overall goals – for example, prioritising Core/Core-Plus for stable income generation and inflation sensitivity, or incorporating Value-Add/Opportunistic strategies to target higher total returns through capital appreciation, accepting the associated higher risk. 

Furthermore, the IPS should establish guidelines for achieving adequate diversification within these asset classes, potentially specifying limits on concentration by geographic region, property type/sector (e.g., office, industrial, residential, renewable energy, transport), and investment strategy to mitigate idiosyncratic risks.

 

C. Hedge Funds

Hedge funds represent a diverse universe of investment strategies characterised by their flexible mandates, often employing techniques such as short selling, derivatives, and leverage, with the primary goals of generating alpha (skill-based returns independent of market movements) and/or providing diversification benefits to a broader portfolio. Common strategy categories include:

  • Equity Hedge (Long/Short): Taking long and short positions primarily in equities, aiming to generate returns from stock selection while potentially managing market exposure.
  • Event-Driven: Seeking to profit from specific corporate events such as mergers, acquisitions, bankruptcies, or restructurings.
  • Relative Value: Exploiting perceived pricing discrepancies between related securities (e.g., convertible arbitrage, fixed income arbitrage).
  • Global Macro: Making directional bets on broad market movements across equities, bonds, currencies, and commodities based on macroeconomic forecasts.
  • Managed Futures (CTAs): Typically, systematic trend-following strategies trading futures contracts across various asset classes.
  • Multi-Strategy: Funds that allocate capital across several different hedge fund strategies.

 

Key characteristics include historically lower regulatory oversight compared to traditional funds (though this is evolving), the potential for low correlation to traditional markets and downside protection (highly dependent on the specific strategy), significant complexity and often opacity regarding underlying positions and processes, typically higher fees involving both management and performance components (carried interest), and varying liquidity terms, including initial lock-up periods and restrictions on redemptions (gates). 

A critical feature is the wide dispersion in performance among managers, even those pursuing ostensibly similar strategies, highlighting the importance of manager skill and selection. It’s also noteworthy that strategy classifications can differ significantly among various data providers and index compilers.

The pronounced heterogeneity within the hedge fund universe means that the IPS cannot effectively govern these investments by treating them as a single, uniform asset class. Doing so would obscure the true underlying risk exposures and diversification properties of the allocation. Instead, the policy must clearly define the specific roles intended for the hedge fund allocation within the overall portfolio context – for example, is the primary goal to enhance absolute returns, provide diversification against equity market downturns, generate uncorrelated income streams, or offer specific tail-risk hedging?. The IPS should then mandate a robust framework for classifying, selecting, and monitoring hedge fund strategies that directly align with these defined roles. Relying solely on manager-provided strategy labels is insufficient. 

More effective approaches might involve grouping strategies based on their primary risk drivers (e.g., equity risk, credit risk, interest rate risk, manager skill) or their expected behaviour relative to traditional markets (e.g., market-independent strategies, convex/divergent strategies offering downside protection). This ensures that the chosen managers and strategies genuinely contribute to the portfolio’s objectives as intended by the policy, rather than introducing unintended risks or correlations.

Integrating Alternative Assets into Your Investment Policy: A Technical Guide for Institutional Investors Acclimetry

The Institutional Investment Policy Statement: A Governance Cornerstone

A. Revisiting Essential IPS Components

The Investment Policy Statement (IPS) serves as the foundational document for governing institutional investment programmes. Drawing heavily on established best practices, such as those articulated by the CFA Institute, a comprehensive IPS provides a structured framework encompassing critical elements of investment management and oversight. Key components typically include:

  • Scope and Purpose: This section identifies the specific entity (e.g., pension fund, endowment) and assets governed by the IPS, establishing the context and overall mission driving the investment programme.
  • Governance: Crucially, the IPS delineates the structure of oversight, defining the roles, responsibilities, and authority of all involved parties – including the governing board, investment committee, internal investment staff (such as the Chief Investment Officer), external consultants, and investment managers. It specifies processes for policy review and updates, the hiring and termination of advisors/managers, and oversight of risk management functions.
  • Investment Objectives: This defines the desired outcomes of the investment programme. It includes specific return requirements (which can be quantitative, like a target rate of return, or qualitative, like capital preservation or growth) and, critically, the institution’s risk tolerance, encompassing both the ability and willingness to assume risk.
  • Constraints: These are the limitations within which the investment objectives must be pursued. Common constraints include the investment time horizon (often long-term or perpetual for institutions), liquidity requirements (cash needed for spending, benefits, or capital calls), legal and regulatory frameworks, tax considerations, and any unique circumstances specific to the institution, such as ethical exclusions, socially responsible investing (SRI) mandates, or specific prohibitions on certain asset types.
  • Portfolio Parameters / Investment Guidelines: This section translates objectives and constraints into actionable portfolio guidelines. It details the strategic asset allocation (SAA) targets and permissible ranges for each asset class, identifies the policy benchmarks used for performance comparison, outlines the rebalancing methodology, and specifies allowable and restricted securities, strategies, or investment vehicles.
  • Risk Management: Beyond defining risk tolerance, this section outlines the procedures for monitoring portfolio risk, measuring performance against objectives and benchmarks, and reporting on both risk and return. It specifies the metrics used for risk evaluation.
  • Duties and Responsibilities: While covered under Governance, this often warrants explicit detail, ensuring no ambiguity regarding who is accountable for specific tasks like SAA determination, manager selection, trade execution, and compliance monitoring.
  • Review and Updates: The IPS should stipulate the process and frequency for its own review and potential amendment, ensuring it remains a relevant and effective governing document.

 

The IPS functions as a vital strategic guide, promoting consistency in decision-making, establishing clear lines of accountability among fiduciaries and managers, and ensuring that the investment portfolio remains aligned with the institution’s overarching mission and financial requirements. It is intended to be a customised document tailored to the specific circumstances of the institution, not a generic template.

 

B. The IPS as a Framework for Discipline and Long-Term Strategy

A fundamental purpose of a well-constructed IPS is to instil and maintain investment discipline, committing the institution and its fiduciaries to a coherent, long-term strategy. By establishing clear objectives, constraints, and guidelines in advance, the IPS serves as a critical bulwark against ad-hoc strategy revisions or reactive, emotionally driven decisions, particularly during periods of market turmoil or underperformance. It provides an objective, pre-agreed framework for navigating uncertainty.

This disciplinary role of the IPS becomes even more crucial as institutional portfolios incorporate larger allocations to alternative investments. The inherent characteristics of many alternatives – particularly their long investment horizons, significant illiquidity, and potentially delayed performance feedback loops (such as the J-curve effect in private equity) – can severely test investor patience and resolve. 

Market downturns can exacerbate these challenges; for example, the “denominator effect” occurs when the value of liquid public market assets falls sharply while private asset valuations lag or decline less, causing the percentage allocation to illiquid private assets to rise, potentially breaching policy ranges and creating pressure for corrective action. Similarly, periods where private market returns lag booming public markets can lead to questions about the strategy.

In such scenarios, a robust and well-communicated IPS acts as the essential “battle plan”, reminding fiduciaries and stakeholders of the long-term strategic rationale for including alternatives and the pre-defined policies for managing them. Illiquidity makes reactive selling of alternatives during crises either impossible or highly value-destructive, often requiring sales at significant discounts in the secondary market. 

Furthermore, lagged or smoothed valuations in private markets can create misleading short-term performance comparisons against volatile public market indices. The IPS provides the necessary framework to resist behavioural biases and maintain strategic focus, preventing potentially harmful actions like attempting premature exits or abandoning the alternative investment programme based on short-term market noise or temporary relative underperformance.

Modifying the IPS for Alternative Investments: Key Policy Adjustments

Integrating alternative assets effectively requires specific modifications and additions to the standard IPS framework. These adjustments ensure the policy adequately addresses the unique characteristics and risks of these investments.

 

A. Refining Investment Objectives and Constraints

1. Aligning Return Expectations and Risk Tolerance

Alternative investments are pursued primarily for their potential to enhance portfolio returns and provide diversification. This potential, however, comes with a distinct set of risks that differ from those of traditional public market assets. These include significant illiquidity, operational and structural complexity, reliance on manager skill (manager risk), challenges in valuation, and often higher fee structures. The fundamental risk-return tradeoff principle holds: accessing potentially higher rewards necessitates accepting higher levels of uncertainty and different forms of risk.

The IPS must clearly articulate the institution’s return objectives (e.g., target absolute return, real return target over inflation, contribution to overall portfolio return) and define its risk tolerance. For institutions, risk tolerance might be framed in terms of acceptable volatility of surplus (assets relative to liabilities), the probability of incurring losses over a specific period, or the potential impact of investment performance on spending capabilities or funded status.

When incorporating alternatives, the IPS requires specific adjustments in this area. 

Policy Adjustment:

 

  • Explicitly state the strategic rationale for including alternative investments, linking their expected contribution (e.g., return enhancement, diversification, inflation protection) directly to the institution’s overall investment objectives.
  • Define risk tolerance specifically in the context of alternatives. This definition must go beyond traditional volatility measures to acknowledge and articulate the institution’s tolerance for:
    • Illiquidity: The inability to access capital for extended periods.
    • Complexity: The operational and structural intricacies of private funds.
    • Valuation Uncertainty: The reliance on models and appraisals rather than market prices.
    • Manager Risk: The potential impact of poor manager selection or execution.
    • J-Curve Effect: The tolerance for initial negative returns in certain strategies, like PE/VC.
    • Higher Fees: Acceptance of management and performance fee structures common in alternatives.
  • Quantify risk tolerance for the alternative allocation where feasible. This could involve setting maximum drawdown limits for the alternatives sleeve, defining acceptable tracking error ranges relative to relevant private market benchmarks, or establishing thresholds based on liquidity stress tests.

 

Defining risk tolerance for alternative investments necessitates moving beyond standard deviation as the primary metric. Volatility measures are often unreliable for illiquid assets due to smoothed or infrequently updated valuations, which can understate true economic risk. The more pertinent risks for Limited Partners (LPs) often relate to factors like the failure of a chosen manager to execute their strategy, significant operational breakdowns at the fund or manager level, or the adverse consequences of being forced to sell illiquid holdings in distressed market conditions. 

Therefore, the IPS must reflect the governing body’s considered tolerance for these less easily quantifiable, yet critically important, risks. This involves incorporating qualitative assessments of the institution’s comfort level with opacity, long-term commitments, and the potential for significant dispersion in outcomes. 

Furthermore, the policy could mandate the use of scenario analysis or stress testing to explore the potential impact of illiquidity risk under adverse conditions, such as modelling the probability of being unable to meet spending needs or capital calls due to locked-up capital. This provides a more robust understanding of the potential consequences of the illiquidity constraint.

 

2. Explicitly Defining Liquidity Needs and Lock-up Tolerances

A defining characteristic of many alternative investments, particularly private equity, venture capital, private real estate, and infrastructure funds, is their inherent illiquidity. Traditional closed-end fund structures typically involve long lock-up periods, often extending 10 years or more, during which investors have limited or no ability to redeem their capital. 

Capital is called by the GP over an investment period of several years as investment opportunities arise, and distributions back to LPs occur unpredictably later in the fund’s life as underlying assets are sold. Even hedge funds, while generally more liquid than private equity, often impose initial lock-ups and may restrict redemptions through gates during periods of market stress. Newer semi-liquid or evergreen fund structures offer more frequent redemption opportunities (e.g., quarterly), but these are still subject to limitations, notice periods, and potential gating mechanisms, meaning they are not truly liquid. 

The IPS must rigorously address the institution’s liquidity needs and constraints in light of these characteristics. Institutions require liquidity for various purposes, including operational expenses, grant making (for foundations), benefit payments (for pension funds), and, crucially, meeting future capital calls from their private market commitments.

 

Policy Adjustment:

  • The IPS must clearly and explicitly state the institution’s overall liquidity requirements and its tolerance for holding illiquid assets.
  • Establish a minimum required allocation to highly liquid assets. This might be defined based on the frequency with which assets can be converted to cash (e.g., daily or monthly liquidity). Some institutions adopt rules of thumb, such as ensuring post-stress liquid assets cover at least three times annual cash needs (spending plus projected capital calls).
  • Define a maximum permissible allocation to illiquid assets. Illiquidity might be defined based on a time horizon (e.g., assets not expected to be convertible to cash within one year).
  • Articulate the policy regarding the management of cash set aside for future capital calls. This involves deciding whether to hold these funds in highly liquid, low-risk instruments (like cash or short-term bonds) or to invest them in public market proxies (like equity ETFs or high-yield bonds) to seek higher returns, while explicitly acknowledging the risks associated with the latter approach (i.e., potential need to sell proxies at a loss to meet calls).
  • Provide guidelines on acceptable fund terms related to liquidity, such as maximum lock-up periods, acceptable gate provisions, and required redemption notice periods for semi-liquid funds.
  • Consider incorporating regular liquidity stress testing as part of the ongoing risk monitoring framework mandated by the IPS.

 

The institution’s tolerance for illiquidity is not static; it should be directly linked to its liability profile and spending requirements. This connection must be formalised within the IPS. Institutions facing predictable and relatively inflexible liabilities, such as mature defined benefit pension plans with significant near-term payout obligations, inherently have a lower tolerance for illiquidity. 

Their IPS must reflect this through stricter constraints on illiquid asset allocations and robust protocols for managing cash flows to ensure benefit payments can always be met. Conversely, institutions with very long or perpetual time horizons and greater flexibility in their annual spending rates, such as many endowments or foundations, can typically tolerate higher levels of illiquidity. 

This allows them to allocate more capital to potentially capture the illiquidity premium offered by private markets. The IPS must accurately capture this difference in institutional capacity to bear illiquidity risk, ensuring the allocation strategy is congruent with the organisation’s fundamental financial obligations and operational flexibility.

 

B. Establishing Strategic Allocation Targets and Ranges

1. Methodologies for Setting Targets

The Strategic Asset Allocation (SAA) is arguably the most significant determinant of long-term portfolio risk and return. It represents the intended long-term mix of assets designed to achieve the institution’s objectives within its constraints. The IPS should clearly assign responsibility for determining the SAA and specify the process and inputs used.

Incorporating alternative investments into the SAA process presents challenges for traditional methodologies. 

Mean-Variance Optimisation (MVO), the classic approach, relies heavily on estimates of expected returns, volatilities, and correlations for each asset class. These parameters are notoriously difficult to forecast accurately for alternatives due to limited historical data, valuation smoothing, changing market regimes, and manager dispersion. MVO outputs can also be highly sensitive to small changes in these input assumptions, potentially leading to unstable or unrealistic allocations.

Recognising these limitations, institutions are adopting more sophisticated or alternative frameworks for SAA determination involving alternatives:

  • Factor-Based Allocation: This approach moves beyond traditional asset class labels to analyse the portfolio’s exposure to underlying risk factors (e.g., equity beta, interest rate duration, credit spread, inflation sensitivity, liquidity risk) that drive returns across both traditional and alternative assets. This can reveal hidden risk concentrations and provide a more fundamental understanding of portfolio diversification.
  • Liability-Driven Investing (LDI) Principles: While originating in pension funds, LDI concepts can be adapted for other institutions by treating spending needs as liabilities. The portfolio might be segmented into a liability-hedging portion (using stable assets to match near-term cash outflows) and a growth-seeking portion (including alternatives).
  • Stochastic Modelling / Monte Carlo Simulation: These techniques simulate thousands of potential future market paths and portfolio outcomes based on probabilistic inputs, rather than relying on single-point estimates. This allows for a better understanding of the range of potential outcomes, the likelihood of achieving objectives, and the potential impact of tail risks, illiquidity, and non-normal return distributions.
  • Established Institutional Models: Some institutions adopt frameworks like the “Endowment Model,” characterised by high allocations to alternatives and active management (often outsourced), or the “Canada Model,” which also features high alternatives exposure but emphasises internal management capabilities.

 

Policy Adjustment:

  • The IPS should specify the primary methodology or framework that the institution will use to determine its SAA, explicitly acknowledging the challenges of incorporating alternative assets.
  • Mandate the documentation of key long-term capital market assumptions used for alternatives (expected returns, risks, correlations), while acknowledging the inherent uncertainty in these estimates.
  • Require the SAA process to explicitly consider the unique characteristics of alternatives, potentially mandating the use of factor analysis, stochastic modelling, or LDI principles alongside or instead of traditional MVO.
  • Assign clear responsibility for developing and approving the SAA methodology and assumptions.

 

Given the difficulties in precisely modelling alternative assets using traditional SAA tools, the IPS should frame the SAA process not as a static, one-time optimisation exercise, but as an ongoing, dynamic, and adaptive framework. The inherent uncertainties surrounding alternative asset returns, correlations, and especially cash flow timing (due to illiquidity and GP discretion) mean that the SAA requires regular review and potential adjustment based on evolving market conditions, changes in the institution’s circumstances, and actual portfolio experience. 

The IPS should therefore mandate periodic reviews of the SAA methodology and underlying assumptions. Tools like commitment pacing models and stochastic simulations are instruments for this ongoing planning and adaptation process, not just for setting the initial allocation. The policy should require their systematic use and the integration of their outputs into the regular SAA review cycle.

 

2. Policy Portfolio Definition

Once the SAA methodology is established, the IPS must clearly define the resulting policy portfolio, specifying the target allocation percentages and permissible ranges around those targets for each asset class. These ranges provide necessary flexibility for portfolio managers to make tactical adjustments based on market opportunities and accommodate natural drift in allocations between rebalancing periods. For example, CalPERS recently adjusted its SAA, increasing the target for Private Equity to 17% (with a range of 12-22%) and Private Debt to 8% (range not specified in the snippet but implied).

The policy portfolio serves as the strategic blueprint for the investment programme and the primary benchmark against which overall portfolio performance and risk exposures are measured.

 

Policy Adjustment:

  • Clearly enumerate all permissible asset classes within the SAA, specifically identifying the distinct alternative asset categories being utilised (e.g., Private Equity, Venture Capital, Private Debt, Core Real Estate, Value-Add/Opportunistic Real Estate, Infrastructure, Hedge Funds/Diversifying Strategies).
  • For each asset class and potentially key sub-strategies (e.g., distinguishing between PE Buyout and VC, or Core vs. Opportunistic Real Estate), specify the long-term target allocation percentage.
  • Define the minimum and maximum permissible allocation percentage (the policy range) around each target.
  • Identify the specific policy benchmark chosen for evaluating the performance of each asset class and sub-strategy. Acknowledging the limitations of standard published benchmarks for some alternatives, the policy might specify custom benchmarks or peer group comparisons where appropriate.
  • Document these targets, ranges, and benchmarks formally. Best practice suggests placing this detailed allocation framework in an appendix to the main IPS document. This allows the SAA to be updated based on periodic reviews without necessitating a full redrafting and re-approval of the entire IPS narrative, streamlining the governance process.

 

Appendix A: Strategic Asset Allocation Targets, Ranges, and Benchmarks

Asset Class Category

Sub-Asset Class / Strategy

Target Allocation (%)

Minimum Allocation (%)

Maximum Allocation (%)

Policy Benchmark

Public Equity

Global Equity

35

30

40

MSCI ACWI

 

Domestic Equity

(Sub-target)

(Sub-range)

(Sub-range)

S&P 500

 

International Developed Equity

(Sub-target)

(Sub-range)

(Sub-range)

MSCI EAFE

 

Emerging Market Equity

(Sub-target)

(Sub-range)

(Sub-range)

MSCI Emerging Markets

Fixed Income

Core Fixed Income

25

20

30

Bloomberg U.S. Aggregate Bond Index

 

Inflation-Linked Bonds

(Sub-target)

(Sub-range)

(Sub-range)

Bloomberg U.S. TIPS Index

 

High Yield / Credit

(Sub-target)

(Sub-range)

(Sub-range)

Bloomberg U.S. Corporate High Yield Index

Private Equity

Total Private Equity

17

12

22

Custom PE Benchmark (e.g., Cambridge Associates)

 

Buyout

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Buyout Benchmark

 

Venture Capital

(Sub-target)

(Sub-range)

(Sub-range)

Relevant VC Benchmark

 

Growth Equity

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Growth Equity Benchmark

Private Debt

Total Private Debt

8

5

11

Custom Private Debt Benchmark

 

Direct Lending

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Direct Lending Benchmark

 

Distressed / Special Situations

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Distressed Debt Benchmark

Real Assets

Total Real Assets

15

10

20

Blended Real Assets Benchmark

 

Real Estate (Core/Core-Plus)

(Sub-target)

(Sub-range)

(Sub-range)

NCREIF Property Index (NPI) or similar

 

Real Estate (Value-Add/Opp.)

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Opportunistic RE Benchmark

 

Infrastructure

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Infrastructure Benchmark (e.g., Preqin)

Diversifying Strategies

Total Diversifying Strategies

5

0

10

HFRX Global Hedge Fund Index or Absolute Return

 

Market Neutral / Relative Value

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Market Neutral Benchmark

 

Global Macro / Managed Futures

(Sub-target)

(Sub-range)

(Sub-range)

Relevant Macro/CTA Benchmark

Cash & Equivalents

Cash

0

0

5

3-Month T-Bill Index

Total Portfolio

 

100

  

Policy Benchmark (Weighted Average)

(Note: Specific targets, ranges, and benchmarks are illustrative and must be customised for each institution based on its SAA process.)

This structured approach provides essential clarity on the intended long-term portfolio composition, sets clear boundaries for investment activities, establishes the basis for rebalancing decisions, and facilitates performance attribution, fulfilling core requirements of the IPS.

 

C. Formalising Illiquidity Management Protocols

Given that illiquidity is a defining feature of many alternative investments, the IPS must establish formal protocols for managing its implications.

 

1. Managing Capital Calls and the J-Curve

Private equity and venture capital funds operate on a capital commitment model. LPs commit a certain amount of capital, which the GP then “calls” or draws down over an investment period, typically lasting three to six years, as suitable investments are identified and funded. This process results in the characteristic J-curve effect, where the fund’s net asset value (NAV) and reported returns are initially negative. 

This occurs because management fees are often calculated on total committed capital from the outset, and early investments require time to mature and generate value, while initial setup and transaction costs are also incurred. Distributions of capital back to LPs are generally uncertain in timing and magnitude, typically occurring in the later years of the fund’s life as investments are successfully exited. The total amount of committed capital that has not yet been called represents the LP’s “unfunded commitment,” a future liability requiring careful liquidity planning.

Managing this cash flow uncertainty and the initial J-curve drag is a critical operational challenge for LPs. Various strategies can be employed to potentially mitigate the J-curve, such as investing in secondary funds or co-investments, which may provide earlier cash returns, or using income generated from other portfolio assets (like CLO equity, if suitable) to help fund capital calls.

 

Policy Adjustment:

  • The IPS must mandate specific processes for diligently tracking and managing the institution’s aggregate unfunded commitments across all alternative investment funds.
  • Establish clear guidelines for maintaining sufficient liquidity to meet anticipated capital calls, linking directly back to the overall liquidity constraints defined elsewhere in the IPS (Section IV.A.2).
  • Define the institution’s policy regarding the investment strategy for capital held awaiting calls. Options range from holding cash or cash equivalents (safest but potentially dilutes returns) to investing in short-duration bonds or even public market proxies like equity ETFs or high-yield bonds. If the latter is permitted, the policy must explicitly acknowledge the associated risk, namely, the potential need to liquidate these proxies at unfavourable prices if calls coincide with market downturns.
  • The IPS should acknowledge the existence of the J-curve effect and set realistic performance expectations for the alternative investment programme, particularly during the initial years of building out the allocation. This manages stakeholder expectations and reinforces the long-term nature of the strategy.

 

2. Commitment Pacing Strategies and Cash Flow Forecasting

To manage the build-out and maintenance of a target allocation to illiquid alternatives over time, institutions employ commitment pacing strategies. A pacing model or plan forecasts the amount of new fund commitments to be made each year (the “commitment pace”) to gradually reach the desired allocation level, considering expected capital call schedules and distribution patterns from both new and existing funds. 

Effective pacing helps achieve diversification across different “vintage years” (the year a fund begins investing), mitigating the risk of over-concentrating capital in potentially unfavourable market environments. Cash flow forecasting complements pacing by projecting the expected timing and magnitude of future cash inflows (distributions) and outflows (capital calls) for the entire alternatives portfolio. 

Various modelling methodologies exist, ranging from simpler deterministic models to more complex probabilistic (stochastic) models, and can be built using top-down assumptions (e.g., based on historical fund behaviour, like the Yale model) or bottom-up analysis (based on individual fund or even portfolio company projections).

Systematic pacing and forecasting are indispensable tools for managing liquidity risk and achieving strategic allocation goals in illiquid asset classes. Numerous specialised software platforms and consulting services are available to support these complex modelling efforts.

 

Policy Adjustment:

  • Mandate the development, maintenance, and regular use of a formal commitment pacing plan and a cash flow forecasting model for the institution’s alternative investment portfolio.
  • Specify the required frequency for updating these models (e.g., the pacing plan reviewed annually alongside the SAA, the cash flow forecast updated quarterly or semi-annually).
  • Outline the key inputs and assumptions the models must incorporate, such as target allocations, fund terms (investment periods, expected lifecycles), historical cash flow data, current market conditions, diversification objectives across strategies and vintage years, and potentially different economic scenarios.
  • Clearly assign responsibility within the governance structure (e.g., investment staff, overseen by the committee) for developing, maintaining, and reporting on the outputs of these models.

 

It is crucial that commitment pacing and cash flow forecasting are not conducted in isolation. These planning tools must be integrated with the institution’s overall portfolio liquidity management and stress testing framework. A pacing plan might indicate a certain level of new commitments is needed to reach the target allocation under baseline assumptions. However, cash flow forecasts, particularly for distributions, are inherently uncertain and sensitive to market conditions. 

A significant market downturn could simultaneously suppress distributions from existing funds, reduce the market value of liquid assets held to meet future calls, and potentially even accelerate capital calls if GPs identify attractive distressed investment opportunities. Therefore, the IPS should require that the outputs of pacing and forecasting models be stress-tested under various adverse scenarios. This ensures that the planned pace of new commitments does not inadvertently compromise the institution’s ability to meet all its obligations (operational spending, benefit payments, and capital calls) during periods of market stress, providing a more holistic and robust assessment of liquidity risk.

 

3. Addressing Semi-Liquid Structures and Secondaries

Beyond traditional closed-end funds, the alternative investment landscape includes structures offering different liquidity profiles. Evergreen or semi-liquid funds provide mechanisms for periodic subscriptions and redemptions (e.g., quarterly), offering investors greater flexibility and potentially avoiding the J-curve effect since capital is often deployed more quickly. 

However, this liquidity is not guaranteed; redemptions are typically subject to limits, notice periods, and the fund manager’s ability to meet requests, potentially through gates or suspensions in times of stress. These structures may also involve different fee arrangements (e.g., fees on NAV rather than committed capital) and potential “cash drag” from holding liquid assets to meet redemption needs.

The secondary market offers another avenue for managing exposure and liquidity. This involves transactions where existing LP interests in private funds are bought and sold, or GP-led transactions where assets from an older fund are rolled into a new continuation vehicle. Secondaries can provide buyers with access to more mature, potentially de-risked assets, potentially shortening the J-curve and accelerating distributions. 

Sellers may use the secondary market to exit commitments before fund termination, albeit potentially at a discount to NAV, especially in unfavourable market conditions. Co-investments, which involve investing directly into portfolio companies alongside a GP, also offer different cash flow dynamics, typically requiring upfront funding rather than phased capital calls.

 

Policy Adjustment:

  • The IPS must explicitly state whether investments in semi-liquid/evergreen funds, secondary fund interests (LP-led or GP-led), and co-investments are permissible for the institution.
  • If these structures are allowed, the policy should outline specific criteria, guidelines, or limits governing their use. This might include setting a maximum allocation percentage to semi-liquid funds, defining the strategic rationale for using secondaries (e.g., accelerating deployment, managing vintage year exposure, opportunistic buying), or establishing specific due diligence requirements tailored to these structures (e.g., assessing redemption mechanisms and gate provisions in evergreen funds, evaluating pricing and alignment in GP-led secondaries).
  • The policy should acknowledge that these structures present different risk, return, liquidity, and fee trade-offs compared to traditional primary fund commitments, and require specific analysis and monitoring.

 

D. Enhancing Governance and Oversight for Alternatives

The complexity, opacity, and unique risks associated with alternative investments necessitate a more robust and specialised governance and oversight framework than typically required for traditional assets.

 

1. Defining Roles (Committee, Staff, Consultants)

As outlined previously, the IPS must clearly delineate the roles and responsibilities of all parties involved in the investment process. This includes specifying who holds ultimate fiduciary responsibility (typically the board or investment committee), who is responsible for day-to-day management and execution (internal staff led by the CIO), and the role of external advisors or consultants. The level of delegation and the specific model adopted (e.g., significant reliance on external consultants versus building internal expertise, reflecting the Endowment vs. Canada models) should be clearly articulated.

 

Policy Adjustment:

  • Reinforce and clarify the specific duties related to the alternative investment programme for each governance entity and key individual. Examples include:
    • Investment Committee: Approval of the overall alternative investment strategy, target allocations and ranges, specific policies related to alternatives (liquidity, valuation, risk), approval of individual commitments exceeding a defined threshold, oversight of overall programme risk and performance, review and approval of the IPS itself.
    • Investment Staff (CIO & Team): Sourcing potential managers and investment opportunities, conducting comprehensive investment and operational due diligence, formulating recommendations for commitments, negotiating fund terms, actively monitoring existing investments and managers, managing portfolio liquidity and commitment pacing, overseeing data management and reporting related to alternatives.
    • Consultants: Providing strategic advice on alternative asset allocation, assisting with manager sourcing and due diligence (especially for specialised strategies), providing independent performance analytics and benchmarking, advising on industry best practices.

 

Establish clear delegation of authority limits. For instance, specify the maximum commitment size that investment staff can approve without requiring explicit Investment Committee authorisation.

The specialised nature of alternative investments – encompassing complex fund structures, diverse and often opaque strategies, nuanced due diligence requirements covering both investment merit (IDD) and operational integrity (ODD), intricate valuation methodologies, and distinct market dynamics – demands a higher level of expertise than general investment management. Fiduciary duty requires that those responsible for overseeing these assets act with the requisite degree of care, diligence, and skill. 

For complex assets like alternatives, this implies that fiduciaries (committee members) and delegates (investment staff) must either possess the necessary specialised knowledge or ensure they have access to qualified external advice. Therefore, the IPS should mandate specific expertise requirements or the engagement of specialised external advisors for those individuals and bodies charged with governing and managing the alternative investment programme. Explicitly requiring this commitment to specialised knowledge within the IPS strengthens the governance framework and helps ensure that decisions are well-informed and prudently made.

 

2. Mandating Rigorous Due Diligence (IDD/ODD)

Due diligence is arguably the most critical risk management tool when investing in alternatives, given the significant impact of manager selection on outcomes and the relative opacity of private markets. The wide dispersion in returns among managers, even within the same strategy category, underscores that simply allocating to an asset class is insufficient; selecting skilled and operationally sound managers is paramount. Due diligence encompasses two key areas:

  • Investment Due Diligence (IDD): Assessing the manager’s investment strategy, philosophy, process, team capabilities, competitive advantages, historical track record, and alignment of interests.
  • Operational Due Diligence (ODD): Evaluating the manager’s business stability, operational infrastructure, compliance policies and procedures, internal controls, cybersecurity, valuation processes, service providers, and potential conflicts of interest. ODD focuses on mitigating risks unrelated to the investment strategy itself, such as fraud, operational errors, or regulatory breaches. Qualitative factors, such as the manager’s culture, integrity, and transparency, play a crucial role in both IDD and ODD assessments.

 

Industry bodies like the Institutional Limited Partners Association (ILPA) for private equity and the Alternative Investment Management Association (AIMA) for hedge funds provide standardised Due Diligence Questionnaires (DDQs) that serve as valuable frameworks and checklists for investors. These help ensure comprehensive coverage and facilitate comparison across managers. Importantly, findings from ODD can be significant enough to override a positive assessment of a manager’s investment skill.

 

Policy Adjustment:

  • The IPS must mandate a thorough, systematic, and documented due diligence process for the selection and approval of all alternative investment managers and funds.
  • Specify that the due diligence process must comprehensively cover both IDD and ODD components.
  • Reference the use of relevant industry-standard frameworks and questionnaires (e.g., ILPA DDQ for PE/VC/Private Debt, AIMA DDQ for hedge funds) as baseline requirements for the diligence process. The policy may also encourage or require supplemental, customised questions beyond the standard templates.
  • Define the key criteria that must be met for manager selection and final investment approval, linking back to the objectives and constraints outlined in the IPS.
  • Require formal documentation of the due diligence findings and the rationale for each investment decision.

 

Due diligence should not be viewed solely as a pre-investment activity. Given the long duration of typical alternative investment fund commitments (often 10+ years) and the potential for significant changes in a manager’s strategy, team composition, operational environment, or regulatory landscape over that time, ongoing monitoring and periodic reassessment are essential components of prudent fiduciary oversight. Initial due diligence provides a critical snapshot, but circumstances can evolve. 

Therefore, the IPS should explicitly require not only rigorous upfront DD but also clearly defined protocols for ongoing due diligence and monitoring throughout the life of each investment. This might involve requirements for periodic ODD reviews (e.g., every 2-3 years), regular checks on strategy adherence, monitoring key person events, and re-underwriting the investment thesis based on updated information. Formalising this requirement for continuous oversight within the IPS aligns with industry best practices and ensures that potential issues are identified and addressed proactively, rather than relying solely on the initial assessment made years earlier.

 

3. Establishing Manager Monitoring, Reporting, and Review

Effective oversight requires robust processes for monitoring alternative investment managers and their funds after the initial commitment is made. The IPS should establish the framework for this ongoing monitoring, including performance measurement standards and reporting requirements. 

This involves defining appropriate benchmarks for comparison and regularly evaluating performance against those benchmarks and stated objectives. Industry standards, such as the ILPA reporting templates for private equity fees, expenses, and performance metrics, provide valuable guidance for standardising information received from GPs. Technology platforms play an increasingly important role in aggregating data, facilitating analysis, and supporting the monitoring process.

Monitoring alternatives presents unique challenges due to factors like the lack of readily available market prices, lagged valuation reporting, the complexity of fund structures, and historically non-standardised reporting formats from managers.

 

Policy Adjustment:

  • Mandate specific reporting requirements for alternative asset managers, detailing the expected frequency (e.g., quarterly), content (e.g., performance data, NAV reporting, underlying portfolio company information where applicable, exposure breakdowns, risk metrics, commentary on activity, updates on operational matters), and format of reports. Reference industry standards like ILPA for private equity where appropriate.
  • Define the internal process for systematically reviewing manager reports. This includes verifying data, assessing performance against benchmarks and objectives, monitoring adherence to the fund’s mandate and investment guidelines, and checking for compliance with IPS constraints. Assign responsibility for this review process.
  • Specify the frequency of formal reviews conducted with each manager (e.g., annual review meetings).
  • Outline objective criteria for escalating concerns, such as placing a manager on an internal “watchlist,” and define the potential triggers and process for considering the termination of a manager relationship.
  • Require reporting that goes beyond simple performance numbers to include key qualitative updates and quantitative metrics relevant to risk management, such as changes in strategy or key personnel, leverage levels, liquidity profile of the fund, significant portfolio events, and material operational or compliance issues.

 

E. Instituting Robust Valuation Policies

The valuation of privately held, illiquid assets is inherently more complex and subjective than valuing publicly traded securities. Valuations typically rely on financial models, comparable company analysis, precedent transactions, and management judgment, rather than observable market prices. 

Valuations are also performed less frequently, often quarterly, leading to potential lags in reflecting true economic value. This subjectivity creates potential valuation risk and can introduce conflicts of interest for fund managers, particularly if management or performance fees are calculated based on the reported Net Asset Value (NAV) of the fund. Recognising these challenges, financial regulators globally are increasing their scrutiny of private asset valuation practices.

Industry best practices strongly advocate for institutions and fund managers to establish and adhere to a clear, comprehensive, and documented valuation policy. Such a policy should aim to ensure consistency, transparency, and objectivity in the valuation process. Key elements of a robust valuation policy include defining the valuation methodologies appropriate for different asset types, specifying the sources and verification procedures for valuation inputs and assumptions, establishing a clear governance structure (e.g., an independent valuation committee or the use of third-party valuation specialists), defining the frequency of valuations, and outlining procedures for handling material events that might require ad-hoc valuations between regular cycles.

 

Policy Adjustment:

  • The IPS itself, or a separate, formally referenced Valuation Policy document, must require adherence to recognised industry valuation standards and guidelines (e.g., the International Private Equity and Venture Capital Valuation Guidelines – IPEV Guidelines).
  • Mandate clear documentation within the policy (or supporting procedures) of the specific valuation methodologies to be employed for different types of alternative assets held by the institution or its managers.
  • Require formal procedures for sourcing, verifying, documenting, and potentially back-testing the key inputs and assumptions used in valuation models.
  • Define a clear governance structure for overseeing the valuation process. This should emphasise independence, potentially through the establishment of an internal valuation committee with defined composition and rights, or by outlining the role and scope of engagement for independent third-party valuation firms.
  • Specify the required frequency for formal portfolio valuations (e.g., quarterly) and establish triggers and procedures for conducting ad-hoc valuations when material events occur that could significantly impact asset values between scheduled reporting dates.
  • Require transparency regarding the valuation policies and procedures used, both internally and in disclosures to relevant stakeholders.

 

Given the inherent subjectivity and potential conflicts associated with valuing private assets, simply having a documented valuation policy may not be sufficient to fully mitigate risks and satisfy fiduciary obligations. The accuracy of reported NAVs directly impacts performance measurement, fee calculations, and potentially strategic asset allocation decisions based on perceived portfolio weights. 

Therefore, the IPS should go a step further and mandate periodic independent review or audit of the valuation processes employed, whether internally or by external managers. This independent validation provides crucial assurance that the documented policies are being consistently applied, that methodologies remain appropriate, that inputs are reasonable, and that the overall process is objective and aligns with industry best practices. As regulatory focus on private market valuations intensifies, demonstrating such robust, independently verified valuation governance becomes increasingly important for institutional fiduciaries.

The Role of Technology and Analytical Support

Effectively managing a portfolio with significant allocations to alternative investments requires sophisticated tools and analytical capabilities beyond those typically used for traditional public market portfolios.

 

A. Leveraging Platforms for Modelling, Monitoring, and Risk Management

A growing ecosystem of specialised software platforms and technology solutions is available to assist institutional investors in navigating the complexities of alternative investments. Prominent providers mentioned in the context of institutional alternative investment management include Acclimetry, Anaplan, Vidrio, and SEI, among others. These platforms offer a range of functionalities designed to address the specific challenges of private markets:

  • Data Aggregation and Management: Automating the extraction of data from unstructured GP reports (e.g., capital call notices, distribution notices, financial statements, performance reports) and standardising it for analysis is a core capability.
  • Portfolio Monitoring: Providing tools to track investment performance, NAV evolution, exposures (by strategy, geography, sector, vintage year), risk metrics, and portfolio company data across various alternative asset classes.
  • Analytics and Reporting: Enabling advanced analytics such as performance attribution, peer group benchmarking (often using proprietary datasets), look-through analysis into underlying holdings, and the creation of customised dashboards and reports for internal and external stakeholders.
  • Modelling and Forecasting: Supporting critical planning functions like cash flow forecasting, commitment pacing modelling, scenario analysis, and portfolio-level stress testing, incorporating the unique dynamics of illiquid assets.
  • Due Diligence Support: Providing access to market data, benchmarks, and analytical tools to aid in the evaluation and underwriting of potential new fund commitments or secondary transactions.
  • Workflow Automation: Streamlining operational processes such as document management, tracking document delivery, and processing capital calls and distributions.
  • Whole Portfolio View: Increasingly, platforms aim to integrate data and analytics across both public and private market holdings, providing a unified view of total portfolio exposures and risk.

 

Policy Adjustment:

  • While the IPS should generally avoid mandating specific software vendors, it should explicitly require the institution to utilise appropriate systems and technology to effectively manage, monitor, and analyse its alternative investment portfolio. The level of sophistication required should be commensurate with the size, complexity, and strategic importance of the alternatives allocation.
  • The policy should emphasise the need for technological capabilities that specifically address the challenges of alternatives, including robust data aggregation from diverse sources, advanced analytics suitable for illiquid assets, and risk modelling that incorporates factors beyond standard volatility.

 

B. Ensuring Data Integrity and Transparency

The foundation of effective monitoring, risk management, and decision-making in alternative investments is high-quality, reliable data. However, obtaining and managing this data presents significant hurdles. Information from GPs often arrives in unstructured formats (e.g., PDFs), reporting templates vary widely, and the level of granularity provided can be inconsistent. 

This makes the process of collecting, cleaning, standardising, and validating data complex and resource-intensive. Technological advancements, including Artificial Intelligence (AI) and specialised data extraction tools, are increasingly being employed to automate these processes and improve data accuracy and timeliness. Transparency regarding fees, expenses, performance, and underlying holdings remains a key principle advocated by LPs and industry bodies.

 

Policy Adjustment:

  • The IPS should establish clear standards for data management pertaining to alternative investments. These standards should emphasise the requirements for data accuracy, timeliness, granularity (seeking look-through data into underlying fund holdings where feasible and appropriate), and consistency across the portfolio.
  • Require the implementation of formal processes for data validation, reconciliation against source documents (e.g., GP reports, custodian statements), and quality control.
  • Mandate that all internal and external reporting related to the alternative investment portfolio relies on this verified and reconciled data foundation.

 

The increasing sophistication and centralisation of alternative investment data management, often involving specialised third-party technology platforms, introduces new considerations for governance. While these platforms offer significant benefits in efficiency and analytical power, they also concentrate sensitive portfolio information and rely on complex data flows. 

Consequently, the IPS, as the primary governance document, should also acknowledge and require the management of risks associated with this technological reliance. This includes establishing policies and procedures related to data governance (defining data ownership, access controls, and usage policies) and cybersecurity specific to the alternative investment data ecosystem. Ensuring the integrity and security of this data requires robust controls not only during extraction and processing but also throughout its storage, transmission, and usage. Fiduciary duty extends to safeguarding all institutional assets, and in the modern context, this unequivocally includes the critical data representing those assets and underpinning their management.

Implementation, Monitoring, and Review

A. Policy Guidelines for Rebalancing Portfolios with Illiquid Assets

Portfolio rebalancing is the process of periodically adjusting asset allocations back towards their strategic targets as defined in the IPS. This discipline ensures the portfolio’s risk profile remains consistent with the intended strategy and prevents allocations from drifting too far due to differential market performance. 

Common rebalancing methods involve selling assets that have become overweight and buying those that are underweight, or strategically directing new cash flows (contributions or distributions) towards underweight asset classes.

Rebalancing presents significant challenges when dealing with illiquid alternative investments. Unlike publicly traded securities, private equity, private debt, or direct real estate/infrastructure holdings cannot be easily bought or sold on demand to adjust exposures precisely. Over-allocations or under-allocations can persist for extended periods due to the inability to transact, combined with factors like lagged valuations or significant market movements in liquid asset classes (leading to the denominator effect).

 

Policy Adjustment:

  • The IPS must explicitly acknowledge the practical difficulties of rebalancing illiquid alternative asset allocations.
  • Define the rebalancing methodology, clearly specifying the target allocations and the permissible ranges (correlating with the SAA ranges defined in Section IV.B.2). Deviations beyond these ranges should trigger a formal review and consideration of corrective action.
  • Prioritise the use of portfolio cash flows as the primary mechanism for rebalancing alternatives where feasible. This involves strategically directing new commitments towards underweight alternative strategies and potentially using distributions received from maturing alternative investments to fund other parts of the portfolio or reduce overweights elsewhere.
  • Outline the process for addressing significant or persistent deviations from target ranges that cannot be corrected solely through cash flow management. This process should emphasise a long-term, strategic perspective, explicitly discouraging forced selling of illiquid assets, particularly in unfavourable market conditions, due to the high likelihood of realising substantial discounts. Potential actions might include:
  • Adjusting the pace or direction of future commitments within the alternative asset programme (linking back to the commitment pacing plan, Section IV.C.2).
  • Strategically utilising the secondary market for portfolio adjustments (buying or selling LP interests), but only if this is explicitly permitted by the IPS (Section IV.C.3) and deemed economically advantageous.
  • Making temporary, compensating adjustments to allocations within the liquid portion of the portfolio to manage overall portfolio risk, while accepting the temporary deviation in the illiquid sleeve.

 

Reinforce the long-term nature of the alternative investment strategy, allowing for wider tolerance bands or longer periods to correct deviations compared to liquid asset classes.

 

B. Establishing a Process for Regular IPS Review and Updates

The IPS is not intended to be a static document, created once and then archived. To remain effective as a governing framework, it must be treated as a “living document” that is subject to regular, systematic review and periodic updates. Best practice suggests reviewing the IPS at least annually to reaffirm its relevance or identify areas needing amendment.

Updates to the IPS should be driven by significant changes in the institution’s circumstances (e.g., mission, liability profile, funding status, risk tolerance), material shifts in the long-term capital market environment, or fundamental changes in investment strategy. Modifications should not be made reactively in response to short-term market volatility or performance fluctuations. While annual reviews are recommended, a more substantial refresh or revision of the IPS might be appropriate every few years, perhaps coinciding with major market cycles (e.g., every 3-5 years) or following a comprehensive Asset-Liability Management (ALM) study.

 

Policy Adjustment:

  • The IPS document itself must clearly outline the process for its own review and amendment.
  • Specify the required frequency of review (at least annually is standard practice).
  • Identify the party responsible for initiating and overseeing the review process (typically the Investment Committee or governing board).
  • State the key factors that should be considered during the review. This includes assessing the continued alignment of the IPS with the institution’s mission, its current financial situation and liability structure, the prevailing long-term market outlook, the performance and risk characteristics of the existing portfolio (including the alternatives allocation), and any changes in relevant legal or regulatory requirements.
  • Emphasise the importance of ensuring that the institution’s actual investment practices and operational procedures remain consistent with the language and guidelines stipulated in the IPS. If practices have evolved, either the practices should be brought back into alignment with the policy, or the policy should be formally amended to reflect the new reality.

Conclusion: Towards a Future-Proof IPS for Alternative Investing

A. Summary of Best Practices for Institutional Fiduciaries

The increasing integration of alternative assets into institutional portfolios demands a corresponding evolution in the Investment Policy Statement. Moving beyond frameworks designed primarily for liquid markets requires fiduciaries to adopt a more sophisticated, nuanced, and risk-aware approach to policy development and governance. Key best practices highlighted in this guide include:

 

  1. Explicit Characterisation: Clearly define and differentiate the various alternative asset classes (PE, VC, Real Estate, Infrastructure, Hedge Funds, Private Debt) and their sub-strategies within the IPS, recognising their distinct risk/return profiles and portfolio roles.
  2. Refined Objectives & Constraints: Articulate the specific rationale for including alternatives and define risk tolerance beyond volatility, incorporating tolerance for illiquidity, complexity, valuation uncertainty, and manager risk. Explicitly link liquidity constraints and illiquidity tolerance to the institution’s liability profile and spending needs.
  3. Robust SAA Framework: Adopt SAA methodologies (e.g., factor-based, stochastic modelling, LDI-informed) capable of handling the complexities of alternatives. Clearly define target allocations, permissible ranges, and appropriate benchmarks for each alternative asset class/strategy, potentially in an appendix for easier updates. Treat the SAA as a dynamic, adaptive process requiring regular review.
  4. Formalised Illiquidity Management: Mandate protocols for managing capital calls, tracking unfunded commitments, and holding liquidity. Require the use of commitment pacing plans and cash flow forecasting models, integrated with overall portfolio liquidity stress testing. Define policy regarding the use of semi-liquid structures and secondaries.
  5. Enhanced Governance & Oversight: Clearly define roles and responsibilities specific to alternatives, mandating requisite expertise or access to specialised advice. Mandate rigorous, documented initial and ongoing due diligence (IDD and ODD) for all managers/funds, referencing industry standards (ILPA, AIMA). Establish clear manager monitoring, reporting requirements, and review processes. Address technology-related risks like data governance and cybersecurity.
  6. Strong Valuation Policies: Require adherence to recognised valuation standards (e.g., IPEV), documented methodologies, independent oversight (e.g., valuation committee, third-party providers), defined frequency, and mandate periodic independent review or audit of valuation processes.
  7. Leverage Technology Appropriately: Require the use of suitable technology platforms for data aggregation, monitoring, analytics, and modelling specific to alternatives, ensuring data integrity and transparency.
  8. Disciplined Implementation & Review: Define realistic rebalancing procedures for illiquid assets, prioritising cash flow utilisation and avoiding forced selling. Establish a formal process for regular (at least annual) review and updating of the IPS to ensure its continued relevance and alignment with actual practice.

 

B. Reinforcing the IPS as a Guide for Disciplined Long-Term Success

Successfully navigating the world of alternative investments requires more than just identifying potentially attractive opportunities; it demands a robust governance framework capable of managing complexity, mitigating unique risks, and maintaining strategic discipline over long time horizons. 

The Investment Policy Statement is the bedrock of this framework. By thoughtfully modifying the IPS to incorporate the specific considerations outlined in this guide, institutional investors can create a policy document that is truly fit-for-purpose in today’s evolving investment landscape. A well-crafted, actively maintained, and rigorously implemented IPS provides the essential roadmap for confidently pursuing the potential benefits of alternative assets – enhanced returns, diversification, and inflation protection – while managing the associated challenges of illiquidity, complexity, and opacity. 

Ultimately, a future-proof IPS serves as a critical tool for fiduciaries, enabling them to guide the investment programme with discipline and foresight, ensuring alignment with the institution’s long-term mission and financial objectives.

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