Why Invest in Alternatives?
Alternative investments have become a key component of a mature, well-diversified investment portfolio over the last 20 years. The asset class was initially mostly the realm of sophisticated investors, such as high-net-worth clients, but has developed into products now available to much smaller portfolios with minimum investments starting as low as $10,000. This is an important consideration since it allows a large class of investors access to value-additive products, where tactical considerations are less important, and able to capitalise on the structural trends that have taken place since the end of the financial crisis in early 2009. This, however, requires to choose the right investment vehicle.
Today, the main opportunity lies in liquid private debt, where solid returns can be generated without significant correlation to stocks and bonds- which are both very expensive.
1. CURRENT STATE OF TRADITIONAL ASSETS.
A well-diversified portfolio of financial assets typically combines traditional investments, such as stocks, bonds, and even commodities, as well as alternative assets, such as interests in hedge funds and private equity funds.
Traditional assets are generally more cyclical in that they tend to lose value faster and in larger volumes when a crisis hits; over about 1 year and a half, between September 2007 and March 2009, the stock markets of developed nations lost typically more than half of their value, for example. This makes tactical allocation into stocks and bonds an important aspect of investing: avoiding even one crisis over a long-term investment period would allow investors to outperform the overall market by a substantial margin over the long run.
In the current context, this is important since the present growth phase in stock markets is above the average length of bull phases in the last 100 years, even though some bull markets have lasted longer (see below for US S&P 500 index).
In bonds markets, prices seem even more extended, as interest rates in Europe and in the US are close to a 30-year low and not far from zero, which seems to indicate that they are likely to start rising (when interest rates go up, bonds price go down and vice versa).
2. ALTERNATIVE INVESTMENTS
Alternative investments are less prone to tactical “trading” because they are more difficult to time than traditional assets, and good tactical management generally leads to lower value addition. Not that traditional assets are easy to time – most investor fail at it- but having the correct view would typically lead to outperformance. Alternative assets are different, since they offer a wide range of strategies that offer differentiated performance profile in regards of market conditions: some strategies thrive when equity or bonds markets are difficult, or when volatility of returns increase, for example. For this reason, alternative assets are an excellent portfolio management tool: they allow the astute investor to induce diversification into a portfolio as well as to cushion losses that might be incurred by the traditional assets.
Finding performing alternative investments offering diversification potential as well as attractive expected returns is of course, not easy, notably because a significant proportion of alternative assets are traditional assets disguised as hedge funds: the so-called “long-short equity” funds are correlated to the stock market, whereas “global macro” funds are influenced by the bonds market. Long-short equity and global macro are two of the most common alternative investment strategies.
As a result, going back to first principles helps identify the really interesting opportunities in the Alternative investment space. In current markets, one of the most interesting structural opportunities lies with private debt, one of the newer alternative investment strategies. Private debt investments offer outsized returns in relation to risk because the banking sector has been through profound changes since 2008- regulations have significantly curtailed bank’s ability to lend. The shortage of capital means that borrowers are willing to pay more to access funding.
3. INVESTMENT IN PRIVATE DEBT, THE NEW ELDORADO
Alternative investors have recently begun to expand into providing debt (loans or bonds) to businesses, an area traditionally dominated by banks. The disintermediation process is part of a broader global trend known as shadow banking or shadow lending (see chart below), whereby non-bank actors seek to provide credit to companies. The growth in alternative investment related to shadow lending has been spectacular and the implications for investors, regulators are significant. In particular, so far the returns to investors have been very good in relation to the risk taken.
The trend is driven by three factors. First, the post-crisis financial regulatory reforms have led banks to reduce their lending activities, particularly to small and medium sized businesses. Second, the demand for credit from businesses has not fallen to the same degree, leading to unmet demand. Third, the demand by institutional investors for debt that yields more than government debt remains robust. Overall, the non-bank financial actors including alternative investors, are expected to replace banks in providing a projected $3 trillion of lending by 2018.
Alternative investors have long invested in certain types of debt, but the scope of the market broadened in recent years. Historically, the private debt market consisted of specialized funds that provided mezzanine debt, which sits between equity and secured/ senior debt in the capital structure, or distressed debt, which is owed by companies near bankruptcy. Following the financial crisis, a third type of fund emerged. Known as direct lending funds, these funds extend credit directly to businesses or acquire debt issued by banks with the express purpose of selling it to investors (in the past it would have been held by the bank).
The market for direct lending includes an array of core and noncore alternative investors. Leading alternative investors have all expanded their product offerings to include private debt funds. They are joined by a number of specialized new firms.
The strong demand by institutional investors has enabled these funds to expand their size rapidly. Collectively, some 531 private equity style debt funds have been raised since 2009. Overall, total assets under management have doubled since the financial crisis, from $213 billion in assets under management in 2007 to $465 billion by June 2014, with 25% of that coming from direct lending funds. Hedge funds have also been an important source of debt capital and now manage more than $600 billion of debt focused funds.
The valuation of traditional assets is stretched. Equities have been in a bull run for 9 years, which is long by historical standards, while bonds offer very little yield and a significant risk of capital loss as the odds of seeing higher rates, and the fall in bonds price that comes with this, are high. Alternative investments, when chosen wisely, offer a chance to diversify the risk of a portfolio of traditional assets. In private debt, where returns are currently very attractive in regards to the risk, outsized returns are also possible. This area represents the most compelling investment opportunity in the alternative space.
Laurent Jeanmart, CFA – April 2018