Alternative reality

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.

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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.