The rise of alternative investments

The search for yield has sent investors putting more money than ever into alternative assets as the returns from conventional sources of equity and bonds show lack of income and limited diversification opportunities. With several bonds yielding negative returns and loose monetary policy in several regions driving key indices to record highs, alternative assets are accounting for a bigger piece of the pie in investor portfolios within a maturing business cycle.

As reported by Preqin, an alternative assets data intelligence firm, total global alternative assets under management, which were valued at $8.8 trillion back in 2017, are estimated to reach $14 trillion by 2023, in terms of a conservative forecast according to the study. In 2018 alone, investments in high-yield bonds and publicly listed markets reduced by 12.3% and 8.3% respectively, whilst global assets under management in alternative investments conversely grew more than 11%, representing a momentum shift in investor capital allocation.

Alternative investments can be seen as investments in assets that don’t fall under the traditional asset classes of stocks and bonds. Through these, investors are able to gain exposure to opportunities that are generally not made available through equity and fixed income markets. Examples of these can include financial assets such as private equity and hedge funds, or real assets such as infrastructure, real estate and even art and jewellery. Compared to traditional investments, alternative investments are classified as having relatively higher levels of illiquidity, minimal correlation to market performance, higher fees, limited availability of historical risk and return data and flexible regulation standards. Additionally, they commonly have complicated legal and tax considerations as well.

One of the primary reasons for the growth in demand for alternative investments is due to their minimal correlation to market performance and conventional asset classes. This allows investors further diversify their portfolios, as investments in alternative assets such as real estate and commodities, for instance, can serve as a reliable hedge against inflation and mitigate market volatility. Furthermore, alternative investments also have higher rate of returns potential with regards to the use of higher levels of leverage compared to conventional investments. However, as low interest rates prompt institutional investors such as insurance companies, pension funds and asset managers to pump more money into alternative investments to diversify into portfolios with increasing revenue streams, they gain further exposure to a key risk factor, reflected by the higher levels of illiquidity associated with these assets.

Pension funds in particular have raised concerns through allocating more capital than ever into private equity and real estate. According to a Global Financial Stability Report by the International Monetary Fund, these investments in alternative assets made by pension funds can put pressure on their traditional stabilising mechanism in financial markets due to their relative illiquidity.

As global markets enter the latter stages of the economic cycle, companies are seeking to extend their credentials and venture out further into the alternative investment sector. For instance, J.P. Morgan recently launched its Global Core Real Assets investment trust (JARA) which deals in infrastructure, real estate and transportation assets. Vanguard, the world’s second largest asset manager, recently unveiled plans to offer a private equity fund in partnership with HarbourVest, in order to address rising demand for the asset class and diversify their product portfolio from low-cost index funds. Furthermore, whilst alternative investments have previously only been available to institutional and accredited high net worth individuals, innovations in product structures have made these assets much more accessible to individual retail investors.

As appetite for alternative investment avenues builds up, acquisition prices in the sector are being driven up which in turn compresses the expected returns. ‘Dry powder’ in private capital, which is the surplus amount of money that has been raised and is readily available to be deployed by fund managers, has reached record levels. According to a Preqin study, global dry power surpassed $2.10 trillion as of June 2018, signifying unprecedented competition for alternative assets of which the majority is concentrated towards private equity. Consequently, the upwards pressure on valuations through demand may risk suppressing the desired rates of return that investors seek in alternative markets.

Ultimately, alternative investments offer opportunities for a more diversified portfolio and higher rates of return in the current environment of static low interest rates, negative yielding bonds and expensive equity markets. Being characterised by low levels of market correlation allow alternative assets to withstand downturns and periods of economic recession, making them attractive to institutional investors. As investors continuously look to incorporate alternative asset management into their strategies, it will only be a matter of time till these become mainstream investments.