Alternatives 101 – Part 1

Breaking News – Stocks and Bonds are not the only investment vehicles out there!

The recent volatility in equity markets and the historically low-interest-rate environment has highlighted the shortcomings of these traditional assets alone when building a well-diversified investment portfolio. More and more investors are now exploring alternative investments such as Private Equity, real estate, and commodities to generate acceptable returns while diversifying their portfolio.

From fine wine to art, wind farms to venture capital, alternative investments have become less ‘alternative’ over the years. In particular, the demand for private assets has increased substantially as investors strive to boost returns, generate incremental income, and provide diversification. From 2007 to 2020, the alternatives market has more than tripled, increasing from $2.5 Trillion to over $8 trillion and is expected to reach $14 Trillion by 2023.

Projected Increase in Alternative Assets

Once a domain exclusive to institutional and ultra-high net worth investors, alternative investments are now being explored by retail investors looking to increase their portfolios risk-adjusted returns.

Before adding any investments from this growing asset class to your portfolio, you must first understand; what are alternative investments, where do the opportunities lie, and what are there potential pitfalls?

What is an alternative investment?

Historically speaking, an individual’s investment portfolio would be made up of three main traditional asset classes.

With all this in mind, an alternative investment is simply any type of asset that does not fall into one of these three traditional asset classes.

Traditional assets vs. Alternative assets

Will Martin, ‘THINK ALTERNATIVE(LY)… INVEST DIFFERENT’ (Three Bell Capital, SEPTEMBER 30, 2017) <https://www.three-bell.com/think-alternatively/> accessed 15 October 2020

Traditional assets are primarily made up of publicly listed stocks and bonds, characterized as:

• Highly Liquid
• Publicly traded
• High correlation to markets

Alternative assets are assets that sit outside the scope of the three main asset classes mentioned above. These investments look to exploit the inefficiencies in markets by focusing on less publicly traded markets.

• Typically, less liquid
• Assets often held in private markets
• Low correlation to markets
• Focused on inefficient markets

Benefits and drawbacks

By their very nature, alternative assets tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies. Although higher potential returns and greater diversification is on offer, alternatives are not without risk. They will often have higher fees, exhibit more complex structures with less transparency, and often be illiquid relative to traditional asset classes.

Pros

Potential for Higher Returns 

Less efficient markets present opportunities for managers to outperform and take advantage of arbitrage opportunities as they arise

Diversification Benefits

One of the most important tenets of intelligent investing is ‘don’t put all your eggs in one basket.’ Diversification focuses on mitigating risk and enhancing return. During those inevitable periods when some of your investments are performing poorly, you’ll want other investments that are uncorrelated or negatively correlated to these assets to balance off the losses in your portfolio, ultimately creating a more consistent rate of return over time.

Potential Hedge Against Inflation

Some of these investments, typically hard assets such as gold or real estate, can hedge against inflation. Inflation is inevitable in most situations and will function to reduce the purchasing power of your cash over time. Asset classes, such as fixed-rate bonds, are especially exposed to inflation. With this in mind, it is important to invest in areas that are not as vulnerable to inflation, thereby diluting your exposure to future inflation. 

Cons

Illiquid Markets

The private nature of these investments can make them tougher to trade, given the smaller pool of buyers and sellers vs. traditional public markets.

Overall Complexity

Alternative investment assets are generally more complex than conventional investment assets. The complexity of these investments can often lead to a lack of transparency and a lack of available data on the investment.

Higher Fees

Management fees are often higher for many alternative investments, given the specialization required and actively managed nature of the funds.

The Growth of Alternatives

As mentioned earlier, the alternative investments market is expected to grow substantially over the coming years with assets under management of over $14 trillion by 2023, up 59% vs. 2017.

There are a variety of factors fueling the popularity of alternative investments in recent years.

• Alternatives’ track record and enduring ability become more appealing as volatility spreads in financial markets, and uncertainty surrounding the Federal reserve’s interest rate policy persists.
• Investors’ search for yield becomes more difficult given the efficiency of public markets, leading to widespread increases in allocations to alternatives.
• The steady decline in the number of listed stocks, as private capital is increasingly able to fund businesses through more of their lifecycle.
• The growing opportunities in private debt as traditional lenders decline.
• Opportunity in emerging markets. As the world undergoes an economic and political shift globally, the opportunities within emerging markets intensify. By the end of 2020, emerging economies will likely make up over 60% of the world’s GDP. Inefficiencies within these markets continue to represent opportunities for investors, with Asian markets leading the way. Fund managers predict that by 2023, the level of alternative assets capital coming from emerging Asia will have increased by 23%.
• Pension funds’ persistent need to narrow their liability gap. Pension Funds continue to display chronic underfunding problems, with Citibank estimating the total value of unfunded or underfunded government pension liabilities for OECD countries exceeds $78 Trillion. This shortfall will intensify the search for risk-adjusted return over the coming years, with private markets representing one of the few tools available to help close these funding gaps.

The ability to take advantage of private market inefficiencies has seen institutions with longer time horizons leverage their illiquidity premium, creating the potential for greater returns in the process.

Institutional investors have generally allocated 8-12% of their portfolio to real estate alone, with an overall allocation of over 30% across the alternatives space. Individual retail investors are not quite as vested in the space, with the typical individual investor in the U.S. holding less than a 3% exposure to alternatives.

With that said, many retail investors are becoming aware of the limitations of traditional assets. The latest market uncertainty is functioning as a catalyst for further growth within the alternative investment space. Investors with longer investment time horizons and less need for liquidity are now looking to exploit the excess returns and diversifying power on offer that institutions have been availing of for years.