The hitchhiker’s guide to alternatives
In the cult classic 'The Hitchhiker’s Guide to the Galaxy’, the answer to the question of what is the meaning of life is a rather simple –‘42’. The answer to the question of how to invest in a world of diminishing opportunities for alpha, income and diversification is rather more complicated. Part of the answer lies in alternative assets, which in our view have become essential, not optional, for meeting portfolio objectives. With many investors now convinced of why alternatives are necessary, they are now grappling with how to add alternatives to their portfolios.
This presents unique challenges for outcome-oriented investors, whether they are experienced institutions or first-time alternatives investors. Barriers such as a lack of familiarity, limited information and transparency, liquidity concerns, fees, minimum investment requirements, and intra- and inter-asset class correlations are just some of the factors that need to be considered.
Investors may have already dipped their toes in the alternatives pool based on one-off opportunities, or by limiting themselves to one particular asset stream such as real assets, private equity, or hedge funds. However, without a ‘how-to’ guide that considers the role of alternatives in a more holistic manner, the result may be an incohesive collection of “great investment ideas” rather than a purpose-driven portfolio.
There is already plenty of interest in why alternatives could be a sensible allocation to a portfolio but the how is the trickier question to answer. The first step is to determine investment objectives.
What is your goal?
The diverse nature of alternatives and variation of this asset class provide a robust investor toolkit. The breadth of what can be called an alternative is one of its advantages, but it requires added levels of scrutiny to uncover the underlying attributes of each alternatives category, as well as any overlapping risks.
While some alternatives have a distinct and easily defined primary function in a portfolio (e.g., private equity as a source of appreciation-driven returns), other categories can be more opaque and play multiple roles. We group alternatives according to three main portfolio functions – diversification, income and alpha. We then consider the extent to which each category can deliver on these goals.
Through this lens, investors can sort the universe of alternatives according to their primary (and secondary) attributes and what is most applicable for their portfolios. Once identified, attention needs to be directed to determining the best way to access them.
Building a bridge
Opportunities to invest in private markets are becoming increasingly accessible to non-institutional investors, as asset managers are constructing bridges to cross from public to private markets. A proliferation of new investment vehicles are allowing smaller investors to build more diversified portfolios incorporating unique potential alpha sources.
Liquidity, fees and transparency are often cited as reasons why investors avoid private markets. However, three key drivers of excess returns are becoming less of a barrier to smaller institutions and individuals: quality of execution, optimal vehicles and fee structures.
Investors that find these hurdles are still too high may look for public market options. Real estate investment trusts (REITs), for example, can provide a substitute for private real estate. High yield bonds can provide a substitute for distressed debt. The inefficiency of small or mid cap equities offers an alpha opportunity similar to core private equity. However, while these options may potentially deliver similar long-term return outcomes, they are typically more highly correlated with public equities, implying their benefits may be less pronounced than those found in private markets.
Increasing accessibility to alternatives for smaller investors is a positive development, but every prudent investor should be mindful that improved access comes with the traditional risks inherent in private market investing. These risks can vary significantly depending on the underlying investment characteristics of the private market asset class.
Core vs non-core, manager vs asset dispersion
There are two measures of return dispersion that investors should consider when allocating to alternatives: manager dispersion and asset class dispersion. Whether investing in core or non-core alternatives, both types matter.
The very wide dispersion of returns across alternative managers is well recognised in today’s investment arena. But asset class dispersion (the difference in returns between the best and worst performing sub-asset classes within a given time period) can also be wide and may be lesser known, and the distribution of returns tends to have fat tails (implying a higher than “normal” probability that extreme high or low returns will occur).
In our view, investors should be laser-focused on manager selection when allocating to non-core alternatives, where manager dispersion is relatively high. Within core alternatives, the primary focus should be on actively managing an allocation across core categories. While manager dispersion within core asset classes is low, there is a high level of return dispersion across core asset classes, which may offer opportunities for diversification and potential return enhancement.
The far greater manager dispersion within non-core versus core alternatives likely reflects the tremendous importance of manager skill in creating value within, for example, private equity, venture capital or non-core real estate. Poor manager selection can seriously jeopardise the capital appreciation outcomes for these investments – the primary objective driving investors’ non-core allocations.
One explanation for this high asset class dispersion is that the underlying drivers of return vary across core assets and are impacted by different economic factors at different stages of the economic cycle. For example, core infrastructure, with its relatively stable cash flow profile, outperformed within core alternatives in 2020 amid COVID-19-driven macro uncertainty. Conversely, periods of broad macroeconomic strength have benefited core private real estate.
This diversity in return drivers, combined with the potential for dislocations at extremes within the economic cycle, may add another potential source of enhanced portfolio returns for investors who actively manage a broad core alternatives allocation. That may round out the two primary objectives for allocating to core alternatives: diversifying portfolio equity risk and generating income-driven returns.
Made to measure
It’s no secret that finding quality data on all alternative asset types can be difficult and makes the application of traditional quantitative methods to evaluate risk and return tricky. An awareness of the pitfalls and what measures are most appropriate for different types of alternatives is essential to an objective assessment.
Data on alternative investments, especially those in the private markets, is limited in terms of historical returns, quality and transparency. Data sets have grown in recent years, enhancing investors’ ability to analyse these asset classes, but as the breadth and depth of data increase, taking its quality into account becomes even more important.
Then there is the issue of the best way to compare return profiles. For example some strategies may be more suited to a time weighted return to calculate investment performance. Others may be best measured using the internal rate of return. The difficult calculation methods means that these two measures cannot be directly compared, and often produce different results, especially when applied to a short investment horizon. Another option may be to use multiples of invested capital to make an apples-to-apples comparison. This method states an investment’s current value as a multiple of the initial investment regardless of the length of the investment period.
Measuring volatility is also challenging. Private investments have an inherent ‘smoothing effect’ as returns are often derived from appraisal-based valuations on a time lag. Applying a de-smoothing approach to mitigate the impact of any prior valuations on current valuations is likely to provide a closer representation of these investments’ ‘true’ volatility.
From why to how
Anyone that’s ever found themselves lingering too long over a dessert table or holding up the line at an ice cream parlor will be familiar with the behavioural trait of ‘overchoice’. This term describes how decisions become increasingly difficult when there is an abundance of options, many potential outcomes and the risks that may result from the wrong choice.
Though investors may be convinced they need the diversification, income and alpha that alternatives can potentially deliver, even the most intrepid investors can be easily overpowered by the array of options. Keep in mind a few simple steps and remember successful alternatives investing starts with a well-defined investment objective, that should always remain the true north of the portfolio:
- Screen the universe of alternative investments by function within a portfolio to match investment choices with your desired investment outcomes;
- Determine the investment vehicles or structures most appropriate for executing on your investment objectives;
- Improve portfolio outcomes by emphasising inclusion of the full opportunity set within core alternatives, and focus on manager selection for non-core alternatives;
- Pay attention to the quality of the data being used to make decisions; and
- Take into account the nuances of how volatility is calculated and important differences among the various measures of return.
We wish the buyer’s guide to alternatives were as simple an answer as ‘42’ but knowing why to invest in alternatives is far more obvious than knowing how to invest in them. Once understood though, there are a diverse range of opportunities for investors as they construct portfolios to meet their objectives.
David Lebovitz is global market strategist, Jason DeSena is head of analytics, alternatives investment strategy and solutions and Pulkit Sharma is head of alternatives investment strategy and solutions business at J.P. Morgan Asset Management.
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