How might alternatives play a bigger role in investors’ portfolios?

Investors may need sophisticated, though not complex investments in the years ahead, as the longest appreciation in asset prices in history comes to an end. (BlackRock, March 2020)

In this article, our panel of experts discuss the future of alternatives markets, and how you could take advantage of the benefits and avoid the unnecessary risks when adding alternatives to your portfolio.

Our panel:

Jessica Milsom – Senior associate at Stonehage Fleming
Alex Orr – Director within BlackRock’s alternatives specialists team
Shane Balkham – Chief investment officer at Beaufort Investment Management

A growing market

Financial-data analysts have estimated that the alternatives industry will continue to grow and be worth a colossal $14 trillion (£11.5 trillion) by 2023 (Preqin, February 2020). Growth of this nature, however, will ultimately depend on how alternatives perform during the next market downturn.

All amounts given in USD.

Or, as Jessica Milsom, senior associate at Stonehage Fleming, puts it, “Seeing how these strategies perform through a severe test will really dictate how the space evolves in the years to come.”

What trends are driving this growth?

Due in part to a steady decline in the number of listed stocks, industry insiders predict that finding returns in traditional markets will become increasingly difficult. As a result, many are turning to alternatives to add diversification and greater return potential to their traditional 60/40 (equity/bonds) portfolios.

Risk. Diversification and asset allocation may not fully protect you from market risk

Many experts also expect technology to drive more investors towards alternatives. Technology can help develop more sophisticated products, increase transparency and educate investors on the role alternatives can play in their portfolios.

At the same time, Alex Orr, director within BlackRock’s alternatives specialists team, suggests that there may be significant growth in illiquid private markets, as well as more-liquid alternative strategies that invest in listed equities and bonds, such as hedge funds are increasingly seen as sources of income, capital growth and diversification for every kind of investor, from wealth managers to retail customers.

Risk. There can be no guarantee that the investment strategy can be successful, and the value of investments may go down as well as up.

One of the key mechanisms driving this growth is the European Long-Term Investment fund (ELTIF), which makes it easier for a wide range of investors to invest in infrastructure, private businesses and education facilities, among other initiatives. Insiders feel that ELTIFs could have a similar impact on private markets to the impact the Undertakings for the Collective Investment in Transferable Securities’ (UCITS) had on the hedge fund industry, which helped more investors gain access to alternative strategies a decade ago.

“Institutional investors have been allocating to this area for a long time, but what we’ve seen is more and more wealth clients moving into this space,” Orr explains. “Clearly, that’s primarily at the upper end – the ultra-high-net-worth individuals – but there are now structures in place to allow high-net-worth and more retail investors to invest in private markets. The ELTIF is making alternatives more accessible to a wider audience.”

Risk. The Fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund’s may not be able to realise the investment at the latest market price or at a price considered fair.

Do investors understand the risks?

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When we look at the liquid alternatives, people are certainly going to be much more discerning than they ever have been before, and this will be a real test

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Alex Orr, Managing Director, BlackRock Alternatives Specialists team

As the alternatives space rapidly evolves, the risks will also increase, especially in sectors that remain relatively unproven, such as private debt. Some managers have pointed out that one of the drawbacks of the UCITS framework for hedge funds is that it has driven more inexperienced investors into alternatives, investors who remain relatively naive to some of the risks associated with these strategies.

Some investors, for example, may not be aware of overall liquidity profiles when structuring portfolios around liquid alternative strategies, says Kelli Byrnes, a consultant within BlackRock’s portfolio analysis and solutions group. “Funds need to be responsible, and if the liquidity they are offering differs from their underlying investments, that has to be noted and investors need to be aware of it. Although illiquidity is not of itself a bad thing – it’s why private assets like property often offer a risk premium – it needs to be balanced from a portfolio construction point of view.”

Risk premium: The expectation of greater returns in exchange for taking on more risk.

Risk. A fund’s investments may have low liquidity which often causes the value of these investments to be less predictable. In extreme cases, the Fund may not be able to realise the investment at the latest market price or at a price considered fair

“If you get uninformed-investor demand that just goes for the pockets of alternatives that have performed well, then you’re going to reach capacities, breach liquidities and you could end up with a scenario where there’s some really good alternatives out there, but they end up getting crippled because too much capital is being invested in them,” says Shane Balkham, chief investment officer at Beaufort Investment Management.

However, with new technologies and the increasingly volatile and unpredictable political environment pushing greater numbers of investors towards new strategies, alternatives allocations appear likely to increase in the years to come.

“In my opinion, this is undoubtedly going to continue to be a growth area, which means people are going to have to get to understand it a bit better if they’re going to be allocating more money to it,” Dinning says. “Some will use dedicated external managers, and some will invest by themselves, but I think the amount of capital going into this space is just going to increase.”