The Rise of Alternative Investing: A New Frontier for Portfolio Diversification
Since the early 2000's a seismic shift has been quietly reshaping portfolios across the globe. The rise of alternative investments has emerged as one of the most significant trends in modern finance, challenging traditional asset allocation models and offering new avenues for returns and diversification.
The increasingly wide variety of Alternative investment options available is reshaping how investors approach portfolio construction and asset allocation. This shift is particularly relevant for sophisticated investors in Australia, who are increasingly exploring alternatives to traditional investments like stocks and bonds.
The Dramatic Shift in Institutional Portfolios
Perhaps the most striking evidence of the alternative investment revolution comes from the changing composition of institutional portfolios. Public pensions, in particular, have led the charge.
The below chart illustrates the remarkable increase in the alternative-to-risky share across various institutional investors. U.S. public pensions have seen their allocation to alternatives rise from about 15% in 2000 to nearly 40% by 2020. Even more dramatically, UK corporate pensions have increased their alternative allocations from about 10% to over 50% in the same period.
The Alpha Hypothesis
One of the primary drivers behind this shift appears to be a changing perception of the risk-adjusted returns (alpha) offered by alternative investments:
The below graph shows a steady increase in the median alpha reported by investment consultants for alternative investments relative to public equities. From around 1.5% in 2000, the perceived alpha has risen to over 2% by 2020. This change in belief about the potential outperformance of alternatives has been a significant factor in driving allocations. (source
Source / Rise of Alternatives- Juliane Begenau January 2024
The Diversification Benefit
Alternatives are often praised for their potential to provide returns that are uncorrelated with traditional asset classes. This diversification benefit has become increasingly attractive as correlations between stocks and bonds have become less stable in recent years.
An Historically Low Interest Rate Environment
With interest rates at historical lows for much of the past decade (until more recently), investors have been forced to look beyond traditional fixed income for yield. Alternative investments, particularly private credit and real assets, have been seen as potential substitutes for the income traditionally provided by bonds.
The Illiquidity Premium
Many alternative investments, such as private equity and real estate, are inherently illiquid. Investors are increasingly willing to accept this illiquidity in exchange for the potential of higher returns – the so-called "illiquidity premium."
The Role of Investment Consultants
The research suggests that investment consultants play a crucial role in shaping institutional portfolios.
This scatter plot demonstrates a strong positive relationship between a consultant's reported alpha for alternatives and their clients' allocation to alternative investments. This underscores the influence that consultants have on institutional portfolio decisions.
Peer Effects and Herding Behavior
Interestingly, recent research into investor behaviour also points to significant peer effects in alternative investment adoption. Institutions tend to follow the lead of their geographical peers, suggesting a potential herding behavior in the industry.
The Supply Side of Alternatives
As demand for alternatives has grown, so too has the supply.
This chart shows the global share of risky assets in alternatives rising from about 2% in 2000 to over 8% by 2020. This expansion of the alternative investment universe has made it easier for institutions to access these strategies at scale.
The Challenge of Performance Measurement
One of the ongoing challenges with alternative investments is the difficulty in accurately measuring performance. Unlike public markets with daily pricing, many alternatives rely on infrequent valuations and complex methodologies to assess returns.
Navigating the Alternative Future
The rise of alternative investments represents both an opportunity and a challenge for investors. While the potential for enhanced returns and diversification is alluring, the complexity and opacity of many alternative strategies demand careful consideration and due diligence.
For Australian investors, this global trend has significant implications. As our superannuation funds and other institutional investors increase their allocations to alternatives, individual investors may find themselves indirectly exposed to these strategies. Moreover, the growing availability of alternative investment vehicles accessible to retail investors – such as listed investment companies (LICs) focused on private equity or real assets – means that direct participation in this trend is becoming increasingly feasible.
However, it's crucial to approach alternatives with a clear understanding of their role in a portfolio. They are not a panacea for all investment challenges, and their benefits must be weighed against their risks, including illiquidity, complexity, and potentially higher fees.
As we move forward, the key to successful investing may lie in striking the right balance between traditional and alternative investments. This requires a nuanced understanding of each alternative strategy, a clear assessment of one's risk tolerance and liquidity needs, and a long-term perspective that can weather the unique challenges posed by these investments.
The rise of alternatives is not just a passing trend – it represents a fundamental reshaping of the investment landscape. For astute investors willing to do their homework, this new frontier may offer compelling opportunities to enhance and protect wealth.
Royce Advisory Pty Ltd (ABN 43 622 402 706) is a Corporate Authorised Representative (CAR) of MB Capital Partners Pty Ltd (AFSL 536053). This article, commentary and discussion is general information only and is not intended to provide you with financial advice as it does not consider your investment objectives, financial situation or particular needs. You should consider whether the information is suitable for your circumstances and where uncertain seek further professional advice.
This communication is based on information from sources believed to be reliable at the time of its preparation (August 2024). However, despite our best efforts, no guarantee can be given that all information is accurate, reliable and complete. Any opinions expressed in this email are subject to change without notice and neither Royce Advisory or MB Capital Partners is not under any obligation to notify you with changes or updates to these opinions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.
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