Alternatives: What Are the Advantages Now?
Alternative assets represent a diverse landscape of asset types, including private equity, fixed income, real estate, hard assets, infrastructure, farmland, timber and hedge funds.
This group of strategies is wide-ranging in their possible roles in portfolios, in how they perform, and how they should be implemented and monitored.
Alternatives: Popular and Growing
At a time when expected returns from public equity and fixed income are expected by many to be lower, alternatives can either offer return enhancement, a way to reduce portfolio risk, or both of these things.
The return enhancement opportunity is generally associated with private equity (PE) strategies, which have offered more potential outperformance from manager skill than any other asset class.
A top quartile private equity manager can be expected to outperform the private equity category median by several percentage points, versus a narrower spread for most traditional strategies, especially after fees are considered.
Manager due diligence is critical here, and if, and when, the current economic expansion runs out of steam, private equities may suffer. We believe that, over time, well-managed private equity strategies will offer strong returns and some diversification away from PE.
Another advantage of alternatives is that the wide array of strategies allow investors to create increasingly customized portfolios that are able to satisfy varied risk and return objectives.
Investors are accessing alternative assets in many ways, ranging from Fund of Funds to single strategy partnerships to – increasingly – secondary markets, which allow for potentially attractive entry points into established portfolios, providing relatively quick diversification and “dollars in the ground.”
Alternative assets can help plans meet some of their ESG (Environmental, Social & Corporate Governance) goals and objectives.
Water management, public transit, renewable energy and improved health care delivery are increasingly being financed by private capital, leading to job creation, affordable housing and improved health outcomes.
Private capital is also used to help portfolio companies adopt best practices when it comes to governance—investment managers can make good corporate governance a condition of funding a business.
Risks in Alternatives Investing
While alternative strategies come with several potential advantages, plans must implement sound risk-management frameworks, including plan governance, analysis, monitoring and reporting.
More than other asset classes, alternatives have the potential to create additional work for clients’ back office/legal resources.
These strategies often introduce new market, operational and liquidity risks for a plan to monitor. Therefore, they require an enhanced risk management framework that includes documented investment policy provisions, assessments (e.g. liquidity tier analysis), measures and reporting tailored to alternatives exposures.
The additional complexity of analyzing alternatives adds to the need for enhanced risk management for plans.
Alternatives’ popularity among investors poses another risk: at this stage in the market cycle, there is a historically large amount of capital (i.e. “dry powder”) waiting to be invested in private market strategies.
With so much investor money going to funds, and with more managers searching for opportunities to put money to work, managers are having trouble finding investment ideas that meet their standards.
That said, we believe there are still compelling investment opportunities in alternatives, and Segal Marco has a robust pipeline of what our analysis indicates are best-of-breed managers and funds approved for investment by our clients.
Strong Performance, but Challenges Remain
As noted above, recent performance of most private market strategies (like private equity) has been higher than historical averages as well as above Segal Marco’s current capital market assumptions.
Real estate has also enjoyed a sustained period of outsized returns since 2009. However, with both private markets and real estate, there is growing concern that these strategies may be in the late stages of an economic or market cycle, and that returns going forward will not be as strong.
With this in mind, it is more likely that private market strategy returns will be more muted, and prudence around leverage is appropriate for private market and real estate investors, especially given rising borrowing costs.
Infrastructure continues to attract significant institutional interest and capital, in part due to the continuing need for public infrastructure improvements in the US and globally.
There are several attractive infrastructure funds identified by Segal Marco Advisors that have potential for strong returns, as well as compelling diversification characteristics, especially in the higher return/higher volatility Greenfield sector. We still believe that it can act as a strong diversifier, while also providing compelling return potential within the Value Added and Opportunistic sectors.
Hedge funds have continued to act more as risk diversifiers than return enhancing strategies, especially relative to the very strong returns seen for long-only public equity strategies since the depths of the Great Financial Crisis back in 2009.
Hedge funds have historically preserved capital in down markets, while lagging in up markets.
Monitoring is Essential
Alternative investment strategies can offer strong return potential, diversification benefits, customizable options and ESG-related options.
For all these reasons, they are popular with investors lately. However, their complicated structures as well as growing levels of dry powder in private markets mean that these strategies pose some unique risks for investors.
It’s important to choose alternatives managers with solid long-term track records and sound risk-management capabilities, and for investors to monitor these strategies closely.