Market mythology

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What really lies beyond the alternative investment horizon?

In the wake of the global financial crisis, returns in traditional asset classes have slowed to a glacial trickle, triggering a migration of capital as investors set out in search of portfolio diversification. But investors haven’t moved as a monolithic bloc. Some have embraced these opportunities more readily than others, whose appetite for alternatives has been spoiled by stories that have built up around this seemingly primitive financial landscape.

Pension funds, with their chunky compliance departments and R&D budgets, were the first to navigate this terrain. Other investors – particularly in the retail space – lag the trend, and may have been missing out on strategies that could help them realise their investment goals.

This hesitance is understandable. We are often told that alternatives complement traditional investments in terms of “return enhancement”, “portfolio diversification” and “inflation protection[1].”But what gives these mysterious investments such attractive properties?

Some say that alternatives’ outperformance is simply down to their illiquidity premium; others that they tend to underperform in a downturn. But to feel comfortable investing in the alternatives space, we must know the truth about these assets and how they should be handled.

Liquidity: All alternatives are not created equal: they vary greatly from the relatively illiquid, such as unlisted infrastructure, to the highly liquid, including most hedge funds and commodities. Financial theory reckons that investors are paid a premium for holding illiquid assets. If you hold a blue-chip listed equity – for example, Apple – it’s easy to trade, so you get the market price. But if you hold something that’s harder to sell, like a direct investment in an unlisted wind farm, you can’t simply trade this on a stock exchange. It takes time and effort to source a direct buyer at a mutually acceptable price. As there is no publicly listed price for the asset, even determining what that is can be troublesome. Investors are therefore believed to be able to command a premium for sacrificing their liquidity.

Assessing liquidity risks

Source: BlackRock, The core role of private markets in modern portfolios, March, 2019

Source: BlackRock, The core role of private markets in modern portfolios BlackRock, March 2019

However, research suggests this premium may be due to other factors, such as complexity or higher governance costs. As a result, underinvestment in such assets because of liquidity concerns may mean Swiss investors are not optimising their portfolios’ risk/return potential (see chart). 

Pump and dump: Before the Global Financial Crisis, much outperformance of alternatives – particularly private equity – was due to leverage. This is unflatteringly known as ‘pump and dump’. As excessive leverage is seen as one of the causes of the crisis, investors are understandably sceptical about its use (and leverage in certain parts of the market and among some investment managers may be concerning). However, a robust due diligence process can identify managers who add value through strong origination, knowledge of how businesses taken private are transformed and prudent use of leverage.

Downturns: The belief that alternatives underperform in a downturn has grown from an understanding that the leverage that increases returns in markets going up, also amplifies losses when markets turn sour. It’s also not necessarily true, especially when taking into account the broad offering of alternative assets.

The structure of private market funds actually can provide a buffer against the liquidity issues caused by investors fleeing for the exits, both because higher cash reserves – dry powder – can be a source of finance for portfolio assets and, because the illiquidity of some private market assets is already understood, ‘rushes for the exit’ don’t materialise in the same way.

A wealth of opportunity

Through the fog of market mythology alternatives exhibit clear and distinguishing characteristics. Not only are they powerful portfolio diversifiers but also allow investors to hone in on specific objectives.

ESG: Direct ownership can make it easier to influence corporate policy and achieve environmental, social and governance (ESG) goals than smaller stakes in publicly listed companies. ESG principles are increasingly being integrated into alternatives’ investment processes, for risk management and to generate new opportunities, as well as to address sustainability issues such as climate change, resource constraints and demographic trends.

Diversification: Alternative assets offer a return pattern that differs from equity or fixed income markets, according to SFAMA[2], providing greater portfolio diversification.

Investors who need fixed income-like assets to meet regular liabilities or specific cash-flow goals also could do this through alternatives like private debt or infrastructure. Both of these private assets have relatively low allocations within the market (see chart) and can offer yields greater than their public equivalents.

Switzerland-based investors average current and target allocations to alternatives

Source: Preqin Pro, Preqin Private Capital in Switzerland, October, 2018

So how much is enough? BlackRock has calculated that the appropriate private markets allocation can range from 10% to 40% of portfolios, depending on individual objectives, conviction in manager selection, risk tolerance and cash flow needs. Many investors could make relatively large allocations to private markets before liquidity constraints start to bite, as demonstrated above. Only those with high spending needs – 8% of the portfolio or more each year – should have allocations below 20%.

In the demanding environment investors face, it’s important to be able to distinguish between justifiable caution and reticence based on myth. Overcoming the misperceptions about alternatives can lead to a wealth of opportunity.

1: SFAMA, Alternative Investments in Switzerland, April, 2019
2: SFAMA, Alternative Investments in Switzerland, April, 2019

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