Alternative assets encompass a broad range of investments which offer a different risk and return profile from traditional asset classes.
The investment universe of alternatives is now large and growing. Property, private equity, commodities and hedge funds are examples of alternative asset investments that have existed over the longer term. More recently, renewable energy, infrastructure, loans and reinsurance have all emerged as alternative asset classes. It is likely that the universe will continue to expand, for example, peer-to-peer lending funds have recently emerged as an additional sub-sector.
One of the key benefits of alternative assets is the diversification that they can bring to a portfolio. During 2015 many developed equity markets touched all-time highs while fixed income market yields remained near historic lows. As both equity and fixed income markets have climbed over recent years, partly as a result of accommodative monetary policy from central banks, the correlation between their returns has increased. While investors have enjoyed a sustained period of good returns, the diversification benefit from holding equities and bonds in a balanced portfolio has arguably decreased. If this is the case, assets with low correlations to equity and fixed income markets are now even more important for investors in order to maintain an acceptably diversified portfolio.
There are many reasons why it is difficult for most investors to invest in alternatives either directly or through the investment vehicles that have been used to invest in alternatives in the past. Investment in alternatives often requires long-term investment horizons and it can be costly for investors to seek liquidity in the short term. For example, it is unlikely that individual investors would be able to invest directly into private equity as an asset class. Instead, investors have traditionally obtained exposure via limited partnership structures where a general partner (the manager) invests on their behalf.
Typically limited partnerships would invest over a period of around five years and then take a further five years or so to realise investments and return capital to investors. Investors looking to exit the partnership before the end of the vehicle’s life may have to sell their investment at a significant discount to carrying value in order to obtain liquidity. As the alternatives universe has expanded limited partnership structures have been used by other asset classes such as infrastructure and renewable energy managers. Similarly, direct property investments tend to be long-term in nature due to the significant transaction costs involved. These costs are far in excess of those suffered by investors in traditional asset classes.
A second hurdle hampering the individual investor’s ability to access alternatives is the size of the capital commitment required. Limited partnership structures often have minimum commitment levels and in some cases the manager will charge a higher fee to investors that commit capital below a certain threshold. This is akin to how many hedge funds operate. Hedge funds will often have minimum investment levels and charge different fees to investors who commit different amounts of capital. Investing directly in property requires significant capital due to the nature of the underlying assets and the fact that they cannot be sub-divided.
Complexity provides an additional barrier to investing directly in alternatives. Alternative assets are diverse by nature and, in some instances, are at a relatively early stage of market acceptance. As a result, they are less well researched academically, less well covered by the investment community and are often more difficult to assess than traditional asset classes. In recent years a number of new alternative asset classes have emerged that highlight the complexity that can be involved in investing in alternatives. For example, reinsurance funds invest in contracts that pay premiums for cover against catastrophic events. It is outside of nearly all traditional investors capabilities to model these catastrophic events and requires specialist investment expertise.
Open-ended funds are an alternative way for investors to access some alternatives. A number of direct property open-ended funds exist. The problem with holding property assets and some other illiquid assets in an open-ended fund structure is clear. If an open-ended fund has significant redemptions the fund management team may be unable to liquidate assets to meet these redemptions which can lead to the situation where redemptions are suspended. Thus, a supposedly liquid access to alternatives becomes illiquid, although rare a number of investors in direct open-ended property funds did experience this during 2008 and 2009.
Investment trusts and companies provide an answer to many of the problems of investing in alternatives either directly or via open-ended funds. Investment trusts are closed-ended in structure, the number of shares in issue is static unless the trust decides to undertake a share issuance or buy back.
Investor demand for closed-ended vehicles does vary over time as asset classes and particular funds go in and out of favour. As a result the price of a closed-ended vehicle will usually be different from the net asset value (NAV) of the underlying assets depending on investor perception of their quality, growth potential and yield amongst other things. Some asset classes, such as infrastructure currently trade on average at a significant premium to NAV. Others, such as private equity, commodities and hedge funds, currently trade on average at a discount.
In recent years the number of alternative asset-focused investment trusts has increased significantly. The benefits of the closed-ended structure and increased correlation of traditional asset classes are supporting this growth in the alternative asset universe.
Ian Barrass is a fund manager and Peter Webster is assistant fund manager of Henderson Alternative Strategies Trust
Key points
* The investment universe of alternatives is now large and growing.
* Investment trusts and companies provide an answer to many of the problems of investing in alternatives.
* In recent years the number of alternative asset-focused investment trusts has increased significantly.
