Historically, alternative assets have largely only been tapped by institutional investors, given their ability to take a longer-term view and lock up capital much more readily than their wholesale counterparts, who have struggled to gain access due to issues such as scale and liquidity.
Recently, however, investors across the board have shown more appetite to explore alternative assets, partly due to returns in public markets becoming less certain. Equities are expensive on almost any measure and credit spreads are at record tights on central bank buying.
With a clear abundance of capital, coupled with the pressure on investment managers to ensure portfolios are diversified, investing in private markets seems like an obvious strategy. There are various ways investors can access this growing segment of the market.
Wrapping illiquid assets in closed-end funds, where managers do not have to deal with inflows and outflows, is one solution. The risks associated with share price volatility exceeding that of the underlying net asset value (NAV) due to short-term and medium-term supply and demand dynamics can be mitigated. A lot can happen in the economy and markets between quarterly NAV announcements, therefore a share price adjustment is logical and healthy. Additionally, whilst these price moves might overshoot the actual impact on the underlying NAV, this presents ample opportunity for active managers to add value.
Private equity, whilst not offering much by way of diversification from traditional equity markets, does offer the potential to make higher returns than those from listed equivalents. This is in part due to the benefits associated with investing during the most explosive growth phase of a company and the entrepreneurial drive of company’s founders combined with the nous of more experienced corporate veterans. There is greater flexibility to rapidly finance the building of platforms around existing successful firms, the absence of onerous quarterly public results reporting schedules, and the ability to act quickly and decisively at key junctures than in listed companies that have more bureaucracy to contend with.
Specialist credit investments will behave in a similar manner to traditional credit markets in terms of doing well when company earnings are sound and default risk is lessening. The key difference is that assets such as loans and asset-backed securities tend to have floating rate coupons, meaning that when interest rates
rise, there is much less of a negative impact than fixed rate bonds. They also tend to be physically backed by company assets or property and therefore recovery rates in the event of default are much higher than unsecured bonds. Often, these investments are not liquid enough to feature in open-end structures, so returns can be higher than other similarly rated credit due to their illiquidity premium.
Infrastructure and renewable energy investments have much in common, particularly in terms of their very long-term, often inflation-linked revenues, which are generated by assets that are vital to the functioning of modern economies and the move to de-carbonise. These assets usually generate a high level of cash flow and pay most of that out to investors via dividends. These companies tend to be non-cyclical in nature and more defensive than many sectors during economic slowdowns. Some areas of the property market have characteristics more in common with infrastructure than mainstream commercial property assets, especially for long lease assets with very high-grade tenants. Alternatively, there are opportunities in more specialist areas of the market, which large property funds have low exposure to due to smaller lot sizes. This specialist focus can often bring higher yields and more room for yield compression, and therefore lead to price appreciation, especially where assets can be managed and lease terms improved.
UCITS hedge or uncorrelated funds encompass a large range of assets and strategies; some are riskier than traditional funds, employing either notional or financial gearing, while some explicitly seek to generate returns with a lower level of risk than mainstream markets. Managers have an array of tools at their disposal, most obviously the ability to short assets or to invest in less liquid securities. It is important to have an extremely thorough understanding of how returns are generated and what the key risks are in order to ensure hedge fund exposure holds up well in both mild and unruly markets. The benefit to accessing these different asset classes, with their varied risk and return drivers, means that asset managers are able to construct robust, highly diversified portfolios across the alternatives spectrum. With the added layer of active asset allocation, it is possible to tilt these portfolios towards more attractive areas, depending on the backdrop and outlook, allowing investors to look beyond the global equity, bond and credit markets, both for returns and for diversification.
This article was featured in Pensions Aspects magazine September edition.
Last update: 15 September 2021