Institutional investors continue to allocate a significant and growing fraction of their portfolios to alternative investments such as hedge funds, private equity, and real estate, notwithstanding the challenges these relatively illiquid assets posed to them during the financial crisis. I suspect that investors now pay considerable attention to their liquidity needs and factor these needs into their decision to invest in alternative investments. I am fairly confident, though, that most investors do not fully appreciate the consequences of a second feature of alternative investments.They typically charge performance fees. It turns out that the expected return of a group of funds that charges performance fees is less than the average of the funds’ expected returns. And it’s also true that an individual fund’s standard deviation or the standard deviation of a group of funds,net of performance fees,understates risk. Together, these oversights lead investors to allocate more to alternative investments than they should, if they base their allocations on expected return and risk.