There’s an Easier Way to Win in Alternatives

Betting on small funds over large managers gives investors better odds of outperformance, writes columnist Chris Schelling.

Illustration by II (Michael Nagle/Bloomberg)

Illustration by II

(Michael Nagle/Bloomberg)

With retail investors joining the tide of capital flowing into the largest managers, investing in private equity is about to get even more competitive. But it’s still possible to win — if investors play the game right.

Today, U.S. capital markets total about $100 trillion in investable assets. The rise of the retail investor means institutions now account for less than half of this, and that share is falling. It is projected that by 2030, individual investors will control roughly 60 percent of assets under management across the investment industry.

Currently, retail investors have very little in the way of alternative investments. Analysts estimate that anywhere from 2 to 10 percent of individual investors’ dollars are allocated to alternative investments. This is in contrast to institutions that have been investing in the space for decades, with the average pension having committed 25 to 35 percent to alternatives. Alts-heavy endowments and foundations often have allocations in the 35-to-50 percent range.

This relative underallocation by retail investors presents an opportunity for Wall Street sales desks that are increasingly — and aggressively — peddling their wares to this market. Or more often to their advisers.

And it’s working. Accredited investors — or those with investable assets greater than $1 million or with incomes above $200,000 — are committing more and more to hedge funds and private equity funds, often turning to tech-enabled alts platforms like iCapital or CAIS to help manage their exposure.


Against this backdrop of democratization for the masses, where the little guy finally gets access to the same sort of professional alternative investments that the institutions have used for decades, a somewhat surprising trend is emerging. Despite the emergence of smaller investors, more money seems to be flowing to the biggest managers than ever before.

Blackstone Group said in April that three funds designed for individual investors are now attracting $4 billion to $5 billion of inflows a month. In May, Carlyle CEO Kewsong Lee claimed that over the past year or so the firm had raised 10 to 15 percent of its capital from individual investors. And recent comments from KKR suggest that it expects to see up to half of total fundraising come from the retail channel in the not-too-distant future.

But it isn’t just anecdotal. Data from Pitchbook’s first-quarter 2022 private equity fundraising report also shows that big funds are dominating the fundraising landscape.

So far in 2022, nearly 50 percent of the total funds actively seeking to raise capital from investors are funds with a target of $100 million or less. This percentage is up substantially from 2010. However, of the total capital being raised, merely 1.4 percent of it is going to the smaller funds. And that number has been cut in half over the same time period.

This trend is somewhat puzzling given that small investors can cut small tickets, unlike the big institutions, whose $100 million minimum check sizes often constrain the universe of funds that they can choose from. It’s hard to invest $100 million in a $75 million fund.

But it’s even more confounding in light of the fact that most of the research I’ve encountered — in fact, almost all of it — demonstrates that smaller funds tend to outperform larger ones. (For examples, see here, here, here, and here.) You would think smaller investors would want to invest in smaller funds, all else being equal.

Given these fundraising dynamics, it’s probably an even more attractive time to be looking toward the smaller end of the market. The vacuum of capital being allocated to small managers portends still better future returns, as fewer and fewer dollars are chasing the same opportunity set.

It’s just a less competitive game right now.

Let me present a thought exercise as an analogy. Let’s say I am as good at chess as I am at checkers. All else being equal, my odds of winning should be the same in both games — but I can imagine a scenario where I lose every game of chess and win every game of checkers.

Consider what would happen if I went over to the University of Texas campus and challenged the chess team champion to five straight matches, then proceeded to play checkers with my son’s 7th-grade classmates at their middle school. Okay, so maybe I could eke out a draw at UT, or, more likely, give up a stalemate or two to the middle-schoolers.

But the point remains: I have much better odds of winning games where the competition is easier, without my actually having to be better at the games in an absolute sense.

Of course, nothing in the investment industry is without competition. In fact, it’s probably the most competitive and cutthroat industry in the world. But one thing I’ve realized in my career is that not all market participants are equally sophisticated, and not all markets are equally competitive. The moment everyone in the investment industry starts doing the same thing — piling into the same investment strategies and asset classes — is precisely the time that expected returns go down and risk goes up.

However, when you find an area relatively less trafficked by other investors, and hence less well capitalized, there’s a much lower probability of running into grandmasters on the other side of the table.

Christopher M. Schelling is the director of alternative investments for Venturi Private Wealth. As an institutional investor, he has allocated roughly $5 billion and met with more than 3,500 managers across hedge funds, real assets, private credit, and private equity.