Investors are increasingly turning to alternatives to meet their objectives as they hunt for alpha in a low rate environment. We see an expanding allocation to alternatives in the coming years by institutions, advisers and individuals. While each investor has distinct investment needs and constraints, they all face the same challenge: how to allocate capital to achieve their desired outcome.
Lower interest rates over the past decade have prompted an avid search for income. The ability of bonds to provide portfolio protection by rallying in a market downturn has been diminished as policy rates are at, or close to, zero in many developed markets, creating a need for new sources of diversification and portfolio protection. Meanwhile, long-term expectations for public market equity returns are below historic averages. And, should inflation risks tick up then the need for assets that can serve as an inflation cushion could increase.
WHAT MAKES THEM ‘ALTERNATIVE’?
‘Alternatives’ is an oft-used, catch-all phrase for all types of non-traditional assets (private equity, alternative credit, real assets including real estate and infrastructure, etc.) and investment strategies – hedging, short-selling, leverage and others. But that does not mean alternatives are just a hodgepodge of assets. They are all alternative sources of one or more outcomes that investors seek from traditional stocks and bonds – alpha, income and diversification – and can, with trade-offs, potentially help investors achieve their outcomes.
Alternatives also share characteristics that distinguish them from traditional stocks and bonds. They are all, to different degrees, less liquid, have longer investment horizons and operate in less efficient (private, less regulated) markets. They have less transparency and information that isn’t always equally available to all market participants. For all these reasons, alternative investments generally exhibit low correlations with traditional assets – which can make them good diversifiers of traditional portfolios. They can also deliver returns that are driven by both income and alpha – making them potentially good return enhancers and stabilisers.
Finally, alternative managers’ returns exhibit significantly higher dispersion than those of traditional managers. This underscores the importance of manager selection: skillful managers are able to exploit market inefficiencies, bring about operational improvements and deliver enhanced returns.
COMING TO THE AID OF PORTFOLIOS
Three categories of alternatives can be used to support the main criteria of portfolio allocation across assets and strategies: those which are return enhancers (alpha); yield generators or safe havens (income); and diversifiers (diversification). In this sense, alternatives can AID in delivering on today’s investment challenges and portfolio objectives:
Alpha is commonly defined as the return from skilful active management or value creation that lifts portfolio returns. Traditional active stock selection, cycle-aware asset allocation as well as private equity, opportunistic alternative credit and higher risk real assets can all be attractive alpha sources.
Income generation is a primary objective for many investors. Income provides a source of liquidity and stability. High quality government and corporate bonds often fill this role but if there is a need for an asset that can provide a stable income stream in downturns, then core alternative credit and real assets including core real estate and infrastructure may offer some appealing safe haven characteristics, with potentially higher yield, albeit at the cost of some liquidity.
Diversification is a critical risk management tool. Holding assets, both traditional and non-traditional, with low or uncorrelated sources of return, can reduce volatility. Hedge fund betas are often used as effective risk diversifiers, although they do come with lock-ups, leverage and relatively large left tail risks.
As alternatives increasingly become a mainstay in supporting these functions, the boundaries between what is traditional and what is alternative will become blurred further.
The industry-defined labels of hedge funds, private equity, alternative credit and real assets will become less meaningful as investors and asset allocators start to think in terms of fixed-income-like, equity-like and hybrid style assets. We predict a trend towards focusing on outcomes, rather than labels when it comes to assets.
TRADE-OFFS
An allocation to alternative assets can increase the risk-adjusted return that a well-managed portfolio may be expected to return, but careful consideration needs to be given to the full set of risks and trade-offs inherent in alternative investing. Alternative investing comes with additional challenges not faced to the same degree in traditional investing, namely: illiquidity, manager return dispersion, tail risk and a lack of transparency.
Consider the trade-offs in two alternative asset classes, private equity and core real estate. Private equity is a highly illiquid investment that involves a long-term commitment to a strategy, and importantly to a particular manager, often through an entire economic or market cycle. The returns, which stem largely from capital appreciation, have the potential to be large, but are highly correlated to public equity market returns and will vary significantly across managers. At the other end of the spectrum is core real assets, which have the potential to provide returns driven by stable cashflows. Return in core real assets are typically lower than those of private equity, but come with greater liquidity, lower dispersion of manager returns and can offer strong diversification to public market equities.
While liquidity and dispersion of return may dominate investors’ decision-making processes, other challenges, such as tail risk, lack of transparency and fee structures, should also be considered in a holistic assessment of alternative investing. While these factors may play a role in portfolios today, they are likely to be a lower hurdle in the future.
The chance an alternative investment generates a larger than expected loss, known as a left tail risk, is a valid concern in private markets, but a scan through the financial history books highlights the many company collapses in public markets that have inflicted equally painful losses on investors. Certainly it’s true that a lack of transparency can shield a true understanding of potential downside, and also that illiquidity reduces investors’ optionality when it comes to getting out. However, these are not new concerns and have not been restricted to private markets.
The rise of emerging markets in the 1990s offered higher returns than could be found in industrialised countries, but many public exchanges were in their infancy, liquidity was limited and information sharing in the market and between investors and companies was far less efficient that it is today. However, over time emerging market equities have become deeper and more liquid, transparency has increased and fees for international investors declined.
Could alternatives follow a similar path?
BROADER ACCESS, INCREASED FLOWS
As investors turn more to the alternative world in search of alpha, income and diversification that is becoming harder to find in public markets, accessibility for small to midsized institutions and retail investors is likely to improve. The increase in flows could mean deeper, more liquid markets and more pressure from investors for greater transparency. Mature and core-like categories of alternatives (such as real assets) are generally more scalable and have the ability to absorb increased flows. Increasing allocations will impact each segment of the alternative asset class differently when it comes to the potential impact on fees, transparency and alpha, given each has unique characteristics and may only eventuate over the medium to long-term.
However, the premium over public markets for both income and capital appreciation is currently greater than it has been for a number of years; the near-term potential for alternatives to deliver on alpha, income and diversification appears unchanged.
SUMMARY
Smartphones, online streaming, and indoor plumbing were once things that were limited to small groups or considered as wants rather than needs.
For decades, institutional investors have enjoyed the option of adding alternative investments to their portfolios. Their ever-growing allocations, despite higher fees, liquidity constraints and manager performance dispersion, hinted that they were getting something in alternatives that wasn’t readily available in the public markets. Whether in search of alpha, income or diversification, these investors now find themselves facing ever fewer opportunities for these pursuits in the traditional asset classes.
Stretched valuations in traditional markets, limited correlation benefits between fixed income and equities, and the likelihood of persistently low bond yields create an increasing urgency to add alternatives. Consequently, we expect rising alternative allocations over the next decade for investors of all stripes. Larger institutional investors will need to make way for mid- to small size institutions and a fresh crop of retail investors as the new alternative asset management industry invents new means for smaller sized entities and more individuals to access the benefits of these asset classes.
The challenge for investors then is to ensure they are getting what they ‘pay’ for when spending their precious fee, liquidity and risk budgets, and not paying for what can be had elsewhere with less sacrifice. The operational intensity and complexity of many of these asset classes is substantially higher than for traditional investments. Manager skill, experience and track records, and use of an alternatives asset allocation framework are rarer commodities, but also vital for success. In spite of the challenges, the alpha available from higher risk real assets and private equity, the income from core real assets or alternative credit and the diversification from less macroeconomic-sensitive asset classes such as hedge funds have convinced investors resoundingly that the trade-offs inherent in alternative investing are worth it, particularly when the investment universe offers few compelling alternatives.
Kerry Craig is global market strategist at J.P. Morgan Asset Management.
