It’s Time to Pay Attention to Alternative Investments
December 1, 2021
4-5 minutes reading time
Stocks, bonds, and cash: the three pillars of a traditional investment portfolio, have looked pretty unsteady at times since the onset of the pandemic, and the current market landscape has its conundrums for these traditional investments as well. Inflation-adjusted yields on cash are negative. Bonds are being squashed by interest-rate fears and didn’t hold up as planned in March of 2020. And to describe equity valuations these days…well, the term “frothy” is often used.
So, where should asset allocators turn to seek diversification from these traditional asset classes?
Lately, there has been a lot of talk about the need for investors to add alternative investments (“Alts”) to their portfolios. Bruce Flatt, the CEO of Brookfield, recently stated that “private credit is replacing fixed income”, further highlighting that Alts should be a core part of a diversified portfolio.
The arguments for Alts are abundant and compelling: whether it’s the demise of the traditional long-only “60/40” stock/bond portfolio, the return enhancing and diversification benefits of Alts, or as we outlined in our recent article, that Alts can provide a much-needed inflation hedge during this crazy time of supply shocks and unprecedented fiscal and monetary expansion.
First, what exactly are alternative investments?
While there’s no official definition of alternative investments, the Chartered Alternative Investment Analyst (CAIA) Association defines them as anything that is not a traditional investment. Traditional investments include publicly traded equities (stocks), fixed income securities (e.g., bonds), and cash.
The five main categories of alternative investments are:
- hedge funds
- private capital (private credit, private equity, venture capital)
- natural resources (agriculture, commodities, land)
- real estate
In recent years, financial engineering innovations have also increased the ease of investing in things such as wine and art (fractional ownership) and has even led to the creation of new classes of investable assets like digital assets (e.g. cryptocurrencies and non-fungible tokens).
Broadly speaking, Alts are active, return-seeking strategies that often have risk characteristics different from those of traditional long-only investments. Alts also often have a low correlation to traditional asset classes, which is a major value add from a diversification perspective.
As long-term proof, consider the renowned $30 billion Yale University endowment fund and its pioneer architect, the late David Swensen.
Swensen became a legend in institutional asset management for introducing what came to be known as “the Yale model”. Decades ago, Swensen’s Yale model diverted their endowment money away from just stocks and bonds into Alts which included hedge funds, real estate, and natural resources. In 2019, the fund had a whopping 75% allocation to Alts.
So, how has this Alt heavy portfolio performed?
Over a 20 year period ending July 2020, the Yale endowment achieved a 10% annualized rate of return, compared to 6.2% for the S&P 500 during the same period. Clearly, the allocation to Alts has benefited this portfolio.
If alternative investments are so great, then why aren’t retail investors all piling in?
The chart below shows that even for mass affluent investors (typically people with between $100,000 and $1 million of investable assets), the average allocation to Alts is only 5%! This pales in comparison with Canadian pension plans who have a 32% allocation on average, and is about 10x less allocated than large endowments and ultra-high-net-worth investors.
How does one explain this drastic under-allocation? We can speculate on a few reasons.
First off, it’s not because they’re entirely inaccessible. In 2018, the Canadian securities regulators permitted the creation of liquid alternative funds (“Liquid Alts”), which are essentially hedge fund strategies made available to retail investors via traditional investment vehicles like mutual funds and ETFs.
Even more exotic investments such as private credit and private equity have become increasingly more accessible to retail investors. Clients of discretionary portfolio managers should be able to access these strategies, though the investment minimums could range from $5,000 to upwards of $25,000. For mass affluent investors though, that’s not usually an unreasonable commitment.
Reason #1: There’s no low-effort “passive” option to invest in Alts
Unlike a broad market index fund, you can’t just dump your money into a broad basket of Alts. Alternative investments are a smorgasbord of asset classes and investment strategies, and they all behave very differently. The frequent use of leverage and short-selling adds further complexity. Just think of the difference between a market-neutral equity strategy and a long/short equity strategy: one strategy has low or zero beta while the other likely has a beta of 1 or more. One might be suitable for a low-risk investor, and the other might not be.
That said, there’s wide variance even within the same strategy. Take a market-neutral equity strategy, for example. The idea is to have a portfolio that has 100% of its Net Asset Value (NAV) in long positions, and 100% of its NAV in short positions, resulting in net-zero market exposure. In theory, a market-neutral strategy should be generating positive absolute returns regardless of equity market direction. Seems simple enough, right?
The chart below shows the performance of several market-neutral equity strategies during the tumultuous year of 2020.
Clearly, there were winners and losers. With a net market exposure of zero, some strategies ended the year positive while others ended the year down nearly 15%! The point is, not all Alts are created equal.
The “passive investing” option doesn’t really exist for Alts, and even if it did, we would strongly recommend against it in light of the example above. Adding the wrong alternative investment to that traditional 60/40 portfolio can actually make it worse.
And this leads us to the second reason:
Reason #2: Alts require an extensive understanding of the investment manager
Everyone is familiar with stock picking and the company-specific analysis it requires. But, when you invest in a hedge fund or private equity fund, you’re actually placing your conviction on a fund's investment manager, who selects the investments that end up in the fund. At the end of the day, it is the investment manager’s skill that drives your investment performance, so how do we assess that?
Obviously, we can’t solely rely on past performance as it’s not a perfect indicator of future success. Instead, the focus should be around the investment manager’s philosophy, process, and team, amongst numerous other factors.
Here at OneVest, we have an extensive due-diligence process to select the best-in-class alternative investment managers. Whereas stock research typically relies on publicly reported company financial statements, details on investment managers are often opaque and require digging.
It’s for this reason that over half of private wealth managers don’t allocate any client money to Alts – they lack the resources and expertise. And the firms that do offer Alts often cater only to high-net-worth investors, with high investment minimums ($1 million+).
Alts can bring a lot of benefits to any investor’s portfolio, but figuring out which funds and strategies to invest in does involve a lot of due diligence and research. Our caution here to investors is: don’t just throw a bunch of Alts in your portfolio for the sake of it. Not only do alternative investment products require extensive vetting, you also need to properly model their risk/return characteristics to determine an optimal allocation.
What’s an investor to do?
Fortunately, OneVest is disrupting the traditional wealth management industry and democratizing access to alternative investments.
Through our discretionary managed account platform, investors can access innovative model portfolios constructed using best-in-class investment products. Some of the Alts we use include market-neutral equity, long/short equity, and event-driven hedge fund strategies as well as digital assets such as cryptocurrencies. Also included are more “classic” alternative asset classes such as commodities, infrastructure, and real estate.
The use of these strategies makes our portfolios look a lot different from your typical traditional balanced fund. And the best part? There are no minimums to get in the door.
Ready to take the next step in your wealth journey? OneVest takes a modern approach to portfolio construction and active management, bringing you a private wealth management experience like never before. Many wealth managers rely solely on low-cost passive ETFs because frankly, it’s less work for them. Navigating financial markets requires skill, time, and a lot of resources. We spend all our time doing investment research so that you don’t have to, and build portfolios that help you reach your goals faster.
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