Why Alternatives

Alternative investments  have become a significant growth area within the financial services industry for one very good reason – the number of publicly traded companies has declined by 40% since 2006 as companies are staying private longer. Thus, investors opportunity sets have been vastly diminished if they limit themselves solely to the public markets.

 

At the same time, in terms of total corporate revenues, private companies dwarf the contribution from public companies – and now  represent almost 2/3 of the global economy. Thus, investors have come to understand that utilizing alternative investments can substantially increase the size of their opportunity set.

Given this substantial private market opportunity, investors are able to further diversify their portfolios by seeking out investments that are distinct from those listed on the publicly traded markets.

As a result, private market investing opportunities – including equity, credit, real estate and infrastructure investments, and others – continue to expand meaningfully and expose investors to risk and return profiles of companies and asset classes that can complement more traditional asset classes.

Perhaps the biggest allure of private market investing is the opportunity for outperformance when compared to public market assets. Over the past twenty years, a private market growth portfolio has outperformed that of a comparable public asset growth portfolio.

While recent private market performance has been more measured, most investors still expect private returns to exceed public returns over the medium and longer term.

One very important added benefit of alternatives when compared with a traditional 60% equity and 40% fixed income portfolio, is that a private market portfolio can take advantage of uncorrelated returns which positively impact both portfolio returns and volatility.

In this example, adding alternative investments has resulted in an almost 100 basis point improvement in return and yield metrics, while annualized volatility has declined substantially.

One very important added benefit of alternatives when compared with a traditional 60% equity and 40% fixed income portfolio, is that a private market portfolio can take advantage of uncorrelated returns which positively impact both portfolio returns and volatility.

In this example, adding alternative investments has resulted in an almost 100 basis point improvement in return and yield metrics, while annualized volatility has declined substantially.

This is because, when managed correctly, adding uncorrelated assets to a portfolio can improve the efficient frontier which is a set of optimal portfolios offering the highest expected return for a defined level of risk.

As can be seen to the left, for any given level of risk, returns can be enhanced by adding uncorrelated alternative investments to the portfolio.  As a result, even a nominal addition of alternative investments added to the portfolio can result in a more optimal portfolio.

Interestingly, a big source of negative correlation between public equities and fixed income has been the occurrence of a multi-decade bond bull market which saw yields decline substantially.  With this secular trend now in the rear-view mirror, correlations between public equity and fixed income have been increasing and thereby limiting the diversification benefits of a traditional 60/40 portfolio.

Interestingly, a big source of negative correlation between public equities and fixed income has been the occurrence of a multi-decade bond bull market which saw yields decline substantially.  With this secular trend now in the rear-view mirror, correlations between public equity and fixed income have been increasing and thereby limiting the diversification benefits of a traditional 60/40 portfolio.

Private markets can also provide unique investment opportunities by allowing early participation in meaningful secular trends in specific economic sectors like the AI buildout, digital economy or life sciences/biotech. Alternative investments can also provide access to specific property types, infrastructure, or geographic regions that can further differentiate return/risk profiles. In short, alternative come in many different flavors and are as diverse as the private economy.

As with public markets, investors can pursue specific financial objectives using private markets that cover the spectrum from capital appreciation through income generation and tax avoidance.

Bespoke opportunities within private markets can be tailored to individual’s interests and/or values.

As with public markets, investors can pursue specific  inancial objectives using private markets that cover the spectrum from capital appreciation through income generation and tax avoidance.

Bespoke opportunities within private markets can be tailored to individual’s interests and/or values.

The Challenge of Investing in Alternatives

Investing in alternatives is not without its challenges and requires access to a broad universe of opportunities, the insight to select the appropriate vehicles as well as appropriate levels of due diligence on both managers and the investment specifics. And, as with most investments, a good deal of patience can also be required.

Bottom line, without careful due diligence and management, investors may struggle to separate true sources of alpha from strategies that simply add cost or risk.

  • Complexity and opacity: There is a wide dispersion of manager skill and limited transparency.

 

  • Liquidity constraints: Investors need to have longer investment horizons and expect reduced flexibility.

 

  • Higher costs and fees: Managers will charge more for specialized strategies and structures that may or may not be acceptable to the investor.

 

  • Operational demands: Private market investing requires greater due diligence, monitoring, and analysis of integration risk.