Alternative investment strategies, especially private equity, venture capital and hedge funds, have increased institutions’ portfolio returns and reduced risk over the past 20 years, according to a white paper issued last week by Commonfund Institute, an institutional investment management firm.

Moreover, the paper says, the fundamental principles that have contributed to historically higher returns among alternative investment strategies remain largely unchanged today.

Commonfund’s president and CEO, Verne Sedlacek, who wrote the white paper, notes in his introduction that Commonfund has been a strong advocate of allocations to alternatives to enhance returns and, for certain strategies, to provide diversified sources of alpha.

It began investing in hedge funds on behalf of its clients in 1982. Today, more than half of its $25 billion in assets under management are in alternatives.

Sedlacek’s paper discusses several factors that have driven the success of alternative strategies.

The white paper asserts that alternatives are not an asset class, but rather an amalgamation of investment strategies that are included in a portfolio for specific purposes: growth, deflation hedge, inflation hedge and diversification/uncorrelated alpha.

Institutions that allocate capital to alternatives report higher performance compared with those that allocate solely to traditional assets, the paper says.

Nonprofits of all types and sizes have significant allocations to alternatives. The 2012 NACUBO-Commonfund Study of Endowments found that allocations to alternatives increased to 54% for 831 institutions representing $406 billion in assets in fiscal 2012, up from a 23% allocation in fiscal 2001.

Pension funds, though at much lower allocations, have also shifted assets toward alternatives in order to boost investment performance and dampen volatility.

The white paper examines why the “endowment model” of investing has become synonymous with increasing allocations to hedge funds, private real estate, private equity and venture capital and other less liquid or illiquid strategies compared with public markets.

The endowment model, it says, assumes that long-term asset pools — endowments, foundations, long-term reserves or pension funds — can outperform investors with shorter time horizons by providing capital to less efficient, more complicated and illiquid sectors of the capital markets.

Sedlacek stresses that manager selection is critical. Indeed, he asserts that allocations to alternatives should be only for investors that can access top-tier managers, since the distribution of returns among alternative managers is far greater than it is among traditional managers.

Alternatives offer investors a variety of benefits, according to the paper. Venture capital and private equity are designed to provide enhanced returns relative to public equity markets at the “cost” of liquidity.

Hedge funds seek to dampen portfolio volatility, protect against market declines and provide uncorrelated return streams over market cycles.

Private equity offers a greater alignment of interests between investors and the users of capital.

According to the paper, private equity has evolved into a global investment business. The techniques of U.S. private equity have been expanded outside the U.S., allowing substantial assets to be raised for investments in developed countries and more recently in emerging markets.

Further, there is a natural illiquidity premium in private equity investing. Since private investments cannot be easily liquidated, they should offer investors a higher return than similar investments in a public market.

Active management is an important aspect of creating value justifying the illiquidity premium, and skill matters, according to the paper. The illiquidity premium is able to add an average 3% returns per year over 10 years net of fees, and makes a substantial difference to a long-term pool of assets.

Check out Alternatives to the Rescue? on ThinkAdvisor.