Alternatives (Private Credit, Hedge Funds)

Alternative investments—hedge funds, private equity, private credit—promise outperformance and diversification. For institutional investors with scale, some deliver. For retail investors, fees overwhelm any alpha, leaving indexing superior.

Key takeaways

• Alternatives charge 1–2% management fees plus 10–20% performance fees; this is a structural headwind
• Private equity returns lagged public equities from 2015–2022 after fees
• Private credit has genuinely outperformed in recent years, but liquidity risk is real
• Hedge fund outperformance is real in hedging (downturns, tail risk), but costs are high
• Retail access to true alternatives is expensive; most should stick to liquid index alternatives

What alternatives are

Alternatives is an umbrella term for investment strategies that do not fit neatly into stocks or bonds. It includes:

• Hedge funds: Actively managed portfolios using leverage, short-selling, and derivatives. They aim to deliver positive returns in all market conditions.
• Private equity: Funds that buy companies, improve them, and sell them for profit. Typical holding period is 5–10 years.
• Private credit: Loans made to private companies or real estate, structured outside traditional banking.
• Venture capital: Investments in early-stage companies with high failure rates but outsized winners.
• Real assets: Timberland, infrastructure, commodities, which promise diversification and inflation hedging.

These strategies share a characteristic: they are less liquid and less transparent than public equities or bonds. You cannot sell your private equity stake on a whim. You often cannot see the portfolio's contents in real time. You pay active management fees, often with performance fees on top.

The pitch is compelling: alternatives offer diversification (low correlation to stocks and bonds), downside protection (in hedge funds), and outsized returns (in private equity and venture capital). For decades, institutional investors have allocated 10–25% to alternatives, seeking exactly these benefits.

But institutional access and retail access are different worlds.

The fee problem

Hedge funds typically charge 2% management fees plus 20% performance fees. Private equity charges 2% management fees plus 20% performance fees. Private credit charges 1–2% plus 15–20% performance fees. These are enormous compared to index funds, which charge 0.03–0.20%.

To illustrate the impact: suppose a hedge fund delivers 10% gross returns (before fees). After charging 2% management fee and 20% of the 10% gain as performance fee, the net return is 10% - 2% - (0.20 × 10%) = 7.8%. The fund kept 2.2% of the 10% return. If the market index returned 10% for the year, the hedge fund net return is 7.8% vs 10% for the index.

Over 20 years, this compounds. If both the hedge fund and the index average 10% gross returns, the index grows $1 million to $6.7 million. The hedge fund, after fees, grows to $4.1 million. The investor is $2.6 million poorer by holding the hedge fund.

This is not a hypothetical. From 2008–2022, hedge funds underperformed the S&P 500 by a cumulative 3–5% per year after fees, despite significant experience and resources. The data is clear: active management at hedge fund cost is a bad deal for most investors.

The only way alternatives can justify their fees is if they deliver alpha: returns above their benchmark that exceed the fees. For hedge funds, this would mean beating the stock/bond index by more than 2–3% per year after fees. For private equity, it would mean beating the stock market by more than 2–3% per year after fees. The evidence suggests this happens occasionally, for top-quartile managers, but not consistently. And retail investors almost never get access to top-quartile alternatives; they get access to average or below-average alternatives through mutual funds or advisors.

Private equity returns: the reality after fees

Private equity has marketed itself as delivering 4–6% higher returns than public equities. Academic studies have supported this. But these studies often use data from top-tier venture capital and leveraged buyout funds with access limited to institutions and the very wealthy.

For a typical investor gaining access through a PE mutual fund or an alternative allocation sleeve managed by their advisor, returns are closer to public equity benchmarks. And because they are illiquid—you cannot sell them quickly if you need cash—they carry a liquidity discount. A $100,000 investment in a private equity fund in 2015 that generated 10% returns would have been worth $160,000 by 2023. A $100,000 investment in the S&P 500 in 2015 would have been worth $200,000+ by 2023. The public equity investment was less risky (more liquid) and generated higher returns.

This does not mean private equity never outperforms. In certain cycles—especially after a market crash when valuations are depressed—buying private companies at cheap valuations and improving operations can deliver exceptional returns. But these windows are unpredictable, and most retail investors lack the expertise to time entry into PE funds.

Hedge funds and downside protection

Hedge funds make a different promise: downside protection. They use short-selling, options, and other hedges to deliver positive returns even when stock and bond markets crash. This is theoretically appealing. A portfolio that is up 6% when the market is up 15% and down only 2% when the market is down 20% has delivered value through risk reduction.

Hedge funds have genuinely outperformed in certain periods. During the 2008 crisis, some hedge funds returned positive numbers while the S&P 500 fell 37%. During the 2022 bear market, some hedge funds delivered smaller losses than the broader market. This diversification is real.

But here is the problem: you pay for this protection in normal markets. Hedge funds that are fully hedged deliver 4–6% returns in bull markets while the S&P 500 delivers 10%+. Over a 30-year career with only 2–3 major crashes, the opportunity cost of missing 20–30% of the bull market returns exceeds the benefit of avoiding 30–40% of the crash losses.

A more efficient approach: hold a diversified stock-and-bond portfolio and use behavioral discipline to hold it through crashes. Research on returns to different investor types shows that investors who simply buy and hold a broad index and rebalance annually end up with higher returns than investors who trade actively. Downside protection via hedges is less valuable than downside discipline via psychology.

Private credit: a genuine outlier?

Private credit—loans to private companies, commercial real estate, and middle-market leveraged buyouts—has genuinely outperformed in recent years. After the 2008 crisis, traditional bank lending dried up. Private credit funds stepped in, earning 6–8% returns when risk-free rates were near zero. From 2015–2023, private credit funds delivered returns in the 5–8% range, outperforming public bonds which yielded 1–3%.

The reason is simple: private credit fills a market gap. Private borrowers cannot tap public bond markets, so they borrow from private credit funds at spreads higher than public bonds. A $10 million loan to a private company might yield 6%, while a comparable public bond yields 2%. The 4% spread compensates for illiquidity and default risk.

Is this sustainable? Perhaps, but the risk is concentrated. As rates rise and the credit cycle turns, private credit funds will experience defaults and losses. From 2023–2024, as higher rates stressed private borrowers, some private credit funds reported defaults. Liquidity—the ability to exit if you need cash—is constrained. If many private credit funds need to sell assets simultaneously, prices fall sharply.

For a young investor with a 40-year horizon and stable income, a 5–10% allocation to private credit is defensible. But only if you are comfortable with illiquidity and can tolerate a 20–30% drawdown. And only if you have access to truly top-tier private credit funds, not mid-tier alternatives offered through mutual funds.

Real assets and the inflation case

Real assets—timberland, farmland, infrastructure, energy assets—are pitched as inflation hedges and diversifiers. The logic: real assets have hard values (a forest has timber, a farm has crops, a pipeline has contracted cash flows) that maintain value or appreciate in inflation. Moreover, they have low correlation to stocks and bonds.

The evidence is more nuanced. Timberland has delivered decent returns (6–8% historically), but these are not adjusted for management fees. Infrastructure assets have delivered 5–6% after fees, which is below equity returns. Some real assets have correlation to equities during crises, negating the diversification benefit.

For most retail investors, real asset exposure through REITs or commodity-linked equities is more accessible and cheaper than direct real asset ownership. And it is more liquid.

When alternatives make sense

Alternatives make sense for institutional investors with $100 million+ and skilled staff to evaluate managers. They make sense for wealthy individuals with sufficient liquidity to allocate 5–10% to illiquid strategies. They do not make sense for most retail investors trying to build a portfolio from $50,000 to $1 million.

If you are tempted by alternatives, ask these questions:

1. Can I afford to lock this money up? If you might need it in 5 years, alternatives are wrong.
2. Am I accessing top-quartile managers? If you are getting alternatives through a mutual fund or advisor who does not have a track record of top-quartile selection, skip it.
3. Do I understand the fees? If you do not know the exact fee structure, it is probably too high.
4. Is the diversification benefit real? Plot the alternative's returns against your other holdings. If it has high correlation to equities in downturns, it is not providing the protection you think.

If you answer "no" to any of these, stick with index funds.

The alternatives decision tree

Related concepts

• ./01-what-is-asset-allocation.md
• ../../passive-investing/README.md

Next

Next we'll look at cash equivalents—T-bills and money market funds—and the 2023–2024 cash boom that gave conservative investors 5%+ yields.