In 1999, just before the ‘dot com’ crash alternative investments made up roughly 6% of an institutional portfolio
In 2020 we see this figure at 25% – and all sophisticated investors are looking to increase their weighting over the next decade.
This year stocks have crashed, but nevertheless continue to trade at historically very high valuations. For how long?
Bonds remain in their 40-year bull market, and are offering little hope relating to future poor performance in equity markets, and providing even less by way of returns and income .
There has been no real rise in interest rates since the global financial crisis back in 2008. Many of the ‘developed’ world’s economies have interest rates at or around 0%, or indeed, even negative rates if measured in real rates of return.
Worldwide, large pension funds have been dramatically increasing their weightings to so called ‘alternative’ investments like Real Estate, Private Equity, Corporate Bonds and Hedge funds in search of the risk adjusted returns and stable income revenue they need to function at optimum effeciency.
This increase in allocation led to the situation today where we see far more sophistication and security in the ways to invest in alternatives, and it has created a far more accessible market for individual, sophisticated investors and globally minded high earners and HNW individuals. Previously, these were only available for large institutional investors.
What constitutes an ‘Alternative Investment’? and what is the motivation for rapidly increasing exposure to them?
Alternative Asset Classes usually consist of:
- Real Estate
- Precious Metals
- Private Equity
- Hedge Funds (Macro, Long Short, Volatility etc)
- Structured Products
- Asset Backed Lending
Property and Real Estate has long been considered a solid investment, and for very good reasons. Before the great crash in 2008, historical housing data made it seem like prices could continue to rise forever…
The most significant downturn in the real estate market history, before the COVID-19 pandemic, was the ‘Great Recession’ of 2007-2009. Prices fell up to 30% . Prices however, recovered rapidly. This was due to the ongoing limited supply and every increasing population/demand.
This indicates that while the results of the coronavirus crisis on Real Estate market have yet to be seen, the potential for mispricing of assets and the opportunity that can come from a reset in prices are quite simply huge.
More Advantages Of Real Estate Investing
Property can add to a portfolio’s diversification and protection. It has a low and sometimes negative correlation with other major asset classes. Increased volatility in stocks, as we are witnessing now, can cause an increase in real estate assets while increasing risk adjusted returns and decreasing portfolio volatility. It can be a win-win.
As central banks launch MASSIVE quantitive easing programmes at the Covid crisis many analysts are thinking this may cause inflationary problems in the future.
Real estate and property investment can mitigate some of the risks of inflation – either through capital appreciation and/or income and rental increases.
The more direct the investment in real estate the lower the correlation to other assets and potentially higher protection for your portfolio.
Infrastructure consists of investments in pipelines, roads, bridges, railways, cabling etc. It is worth noting today that monetary policy is, it seems, showing less and less influence on true economic recoveries. Countries are forced to implement and increase fiscal spending to raise GDP and provide much needed employment. This is true in many countries around the world.
Like Real Estate, Infrastructure is a good hedge against inflation and demonstrate low correlation to other major asset classes. However, as you may have realised, it can still be difficult to gain access to infrastructure investments without huge capital investment, and be inaccessable for an individual HNW investor.
Commodities and precious metals are a direct investment in raw materials such as crude oil, natural gas, foodstuffs, and precious metals like platinum, gold, and silver.
Most investors are unable, or unwilling to invest in these directly as it would not be cost effective. Instead they use funds that have direct exposure, or ETFs that try to mirror price moves in the relevant futures market.
Commodities are typically cyclical and can offer excellent returns – just so long as you time the economic cycle right! Otherwise they can add high volatility within an individuals portfolio. Generally speaking, it is fair to say that commodities offer a good hedge against inflation.
It should be noted that as technology moves forward some of these commodities – oil for example – can experience long term demand depreciation. This is due to electric vehicles, less travel for face to face meetings, the development of renewables and greener energy production, and other well known and pressing factors.
Private Equity is where you take an equity stake or ownership in an entity that is usually not publicly listed. Private equity can take the form of three major categories.
- Venture capital is the funding of start-up businesses with good potential and forecast to be set for continued growth.
- Leveraged Buyout to allow firms to take significant stakes in companies, using mostly borrowed money, to meet the capital requirement for the acquisition.
- Distressed securities refers to the practice of purchasing equities close to bankruptcy or possibly bonds that are fast approaching default. The motivation for such purchases is to benefit from a turnaround in the company’s situation or it is judged that will be substantially more money left after liquidation to profit from.
Initially hedge funds got their name from the practice of reducing portfolio risk by ‘hedging’ investments by using offsetting positions or derivatives for example. They are used by investment professionals to generate returns using nontraditional investment strategies. These can be across both traditional and non-traditional assets.
Hedge funds utilise a variety of strategies to create higher risk adjusted returns relative to investing in bonds and equities. Such strategies are usually categorized under four main headings.
- Market Neutral Strategies like absolute return.
- Directional/Special situations like long short or managed futures.
- Multistrategy employing a variety of the above.
Hedge funds are often still only open to HNW individuals or institutional investors and don’t always offer the desired stability of returns, or income. This can be due to high fees. Another issue to note is that fund managers can be quite secretive in how they go about their preferred strategies.
Structured products are a pre-packaged investment put together by a group of trustees and asset managers allowing individual clients access to derivatives – usually around a very defined portfolio.
This can come with benefits such as a principal capital guarantee, or non traditional payoffs if the product achieves certain levels of performance. While these products can offer attractive returns, they can often be highly complex and narrow in their very specific performance targets.
Asset Backed Securities
Asset backed securities are financial securities backed by non-mortgage related items pooled into an investible asset created by securitization of the assets.
The underlying assets can be as varied as credit card receivables, home equity loans, auto loans and equipment leases, to name just a few. These securities provide higher income than a government issued security and can also be credit enhanced. This means that they contain measures to allow their credit quality to be higher than those of it’s underlying assets. This can be achieved by excess spread, overcollateralization and Senior/subordinate structures.