Before, during and after the opening bell, investors across the globe are in continual search for market returns. But with low yielding, highly correlated traditional asset classes, where are the opportunities to improve portfolio performance? This article offers an insight into the value of investing in alternative asset classes and the potential for them to become the ‘Alpha’ solution of the future.
Understanding Alternative Investments
Alternative Investments (AI) are often misunderstood. This derives from a number of factors, one key influence is the relatively new oncoming of these asset classes. Their popularity with investors has predominantly grown in the recent decades, this along with volatile markets has meant the comprisal of AI has tended to frequently evolve. As such defining AI can be somewhat difficult, but it is commonly expressed that; AI, include those asset classes not considered by the traditional three investments (stocks, bonds and cash). Investors may then look to asset classes, both in developed and emerging markets, below is a non-exhaustive list of these. AI can be further understood through comparing their trading behaviour and looking at characteristics such as liquidity, correlation and efficiency, which directly effect risk-return, diversification and overall portfolio performance.
- Real Estate: Land/ Residential/ Commercial
- Funds: Hedge, Venture Capital, Private Equity
- Commodities: Agriculture, Energy, Precious Metals
- Collectables: Wine, Artwork, Automobiles
- Others: Intellectual Property, Patents, Intangible Assets
Funds
When considering AI, most commonly thought of is private equity (or P.E funds). Private equity investors such as hedge funds and venture capital firms, can be thought of as ‘privately organised investment vehicles’ that use their hedging and leveraging techniques to generate absolute market returns. They may do this by engaging in leveraged buyouts (LBOs), investing in distressed debt and pre- IPO equity. These investors will commonly look to invest in new start-ups and under-performing companies but this will depend on the route taken by the P.E fund. For example, venture capital firms will invest in the early stages of private firms, looking to make high returns once the firm becomes publicly traded. LBOs involve acquiring companies that can be ‘streamlined’ to flip for a profit. The effects of LBOs can be controversial, this may involve the selling of non-essential assets and can result in job losses. Alternatively, improvements may be made, which actually moves the companies market position.
Most private equity funding comes from institutional investors (pension funds et al) and the owners of the P.E fund (usually investment banks), but also HNWI (though to a lesser extent). An attractive aspect of private equity investment is the diversification it offers. Uncorrelated sources of return among AI like private equity are essential in the creation of risk-adjusted returns that do not offset expected return. This is a key driving factor that differentiates AI from traditional asset classes which are comparatively more highly correlated. Private equity investment also boost above average market returns, outperforming public equites. Apollo Global Management, a large alternative firm (US$159 billion AuM), generated 26% net return on all their capital in private equity, during the same time, the S&P 500 was up only 9%. In an interview with the Milken Institute, co founder and harvard MBA, Josh Harris expressed how private equity offers an attractive investment in finding ‘pockets of arbitrage, even in todays overvalued world’.
Emerging Markets
With significant growth and development opportunities in the Asian contient, its no surprise emerging markets offer real investor value. In-fact the GDP growth of India and China in 2014, was nearly three times that of mature economies like the UK. Investing in real assets such as infrastructure investment allows private investors to generate returns through the ‘privatisation of existing infrastructure or by the private creation of new infrastructure’. This is beneficial for both the local development of regions and for private investors looking for alternative sources of return. Estimates from OECD suggest infrastructure investment requirements will reach US$50 trillion by 2030. Traditionally, banks and governments have funded infrastructure projects but with the rapid expansion of emerging economies, private sector investment is becoming increasingly prevalent. Investing in emerging markets carries a unique level of risk, generally due to less stable economic characteristics of developing economies, including changing interest rates and regulation. However, emerging markets remain a core alternative area to invest in and can be hugely rewarding in generating absolute returns.
Caveats of Alternatives
Asset liquidity is a key factor to consider in portfolio management. Due to the nature of AI, they tend to be highly illiquid. Their low trading volume can make them difficult to value and invest in. AI can also suffer from the ‘survivorship bias’. Volatile market conditions mean past performance is not always the best indicator of future performance, so caution should be taken when considering asset allocation. Moreover, in comparison to the more liquid traditional assets, AI tend to lack historical data, unlike stock and bond index’s. Alternative investors should be prepared to take long holding positions, being forced to sell of assets or reducing private equity in the short to medium term may result in low returns or may not be possible at all. Therefore investors wanting to change their portfolios risk profile are likely to encounter difficulties. To generate superior risk-adjusted returns, portfolios should include a balance of both liquid and illiquid asset classes.
Looking to the Future
It would seem alternatives are rapidly becoming mainstream. Research from PwC expresses the macro conditions that are likely to drive this growth in the alternative asset market, to a potential $15.3 trillion by 2020. This would include ‘high performing capital markets, accommodative monetary policy and stable GDP growth’. Whilst ‘rising interest rates, along with normal correlation in capital markets’ would support a more conservative value of $13.6 trillion. Overall, the wide ranging asset classes under the alternative umbrella offer very desirable qualities for investors looking to enhance portfolio performance, improve downside protection and increase diversification. Even so, as an investor it’s always important to consider your investment goals, which directly influences investment strategy and asset allocation, whether that be traditional and/or alternatives.
Source - themarketmogul
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