Over the past 20 years, alternative investments have become a key component of a mature and well-diversified investment portfolio. Initially, this asset class was mostly the realm of sophisticated investors, such as “High Net Worth” clients, but has become products now available for much smaller portfolios with minimum investments of $10,000. This is an important consideration as it allows a large class of investors access to value-added products where tactical considerations are less important and can capitalize on the structural trends that have occurred since the end of the financial crisis in early 2009. However, this requires choosing the right investment vehicle.
Currently, the main opportunity lies in liquid private debt, where solid returns can be generated without significant correlation with stocks and bonds, which are 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 more quickly and in larger volumes when a crisis occurs; for about 1.5 years, between September 2007 and March 2009, stock markets in developed nations typically lost more than half their value, for example. This makes tactical allocation in stocks and bonds an important aspect of investment: avoiding just one crisis in an investment period would allow investors to outperform the general market by a substantial margin over the long term.
In the present context, this is important as the current growth phase in stock markets is above the average duration of bull phases over the last 100 years, although some bull markets have lasted longer (see US S&P 500 Index below).
In the bond markets, prices seem even more widespread, as interest rates in Europe and 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 rise, bond prices fall and vice versa).
2. ALTERNATIVE INVESTMENTS
Alternative investments are less prone to tactical trading because they are more difficult to forecast than traditional assets, and good tactical management generally leads to less value addition. Not that traditional assets are easy to forecast, most investors fail at this, but if you have the right vision you would normally generate a superior return. Alternative assets are different, as they offer a wide range of strategies that provide a differentiated performance profile in terms of market conditions: some strategies thrive when equity or bond markets are difficult, or when, for example, the volatility of returns increases. For this reason, alternative assets are an excellent portfolio management tool: they allow the astute investor to induce diversification in a portfolio as well as to cushion losses that traditional assets might incur.
The search for alternative investments that offer diversification potential as well as attractive returns is not easy, especially since a significant proportion of alternative assets are traditional assets disguised as hedge funds: so-called “Equity long/short” funds are correlated with the stock market, while “Global Macro” funds are influenced by the bond market. Equity Long Short and Global Macro are two of the most common alternative investment strategies.
As a result, going back to the initial principles helps to identify the really interesting opportunities in the alternative investment space. In today’s markets, one of the most interesting structural opportunities lies in private debt, one of the newest alternative investment strategies. Investments in private debt offer very attractive returns in relation to risk as the banking sector has undergone profound changes since 2008: regulations have significantly reduced the ability of banks to lend. The shortage of capital means that borrowers are willing to pay more to access funds.
3. INVESTMENT IN PRIVATE DEBT, THE NEW ELDORADO
Alternative funds recently began to expand by providing debt (loans or bonds) to companies; this was an area traditionally dominated by banks. The process of disintermediation is part of a broader global trend known as “shadow banking” (see box below), whereby non-bank players seek to provide credit to businesses. The growth of alternative investments related to shadow banking has been dramatic and the implications for investors and regulators are significant. In particular, investor returns so far have been very good relative to the risk taken.
The trend is driven by three factors. First, post-crisis financial regulatory reforms have led banks to reduce their lending activities, particularly to small and medium enterprises. Second, business demand for credit has not declined to the same extent, leading to unmet demand. Third, demand from institutional investors for debt that outperforms public debt remains strong. Overall, non-bank financial actors, including alternative investors, are expected to replace banks in providing $3 trillion in projected lending by 2018.
Alternative investors have long invested in certain types of debt, but the market’s reach has broadened in recent years. Historically, the private debt market consisted of specialized funds that provided subordinated debt (mezzanine debt), which falls between equity and guaranteed/senior debt in the capital structure, or distressed debt, which is owed by companies nearing bankruptcy. After the financial crisis, a third type of fund emerged. These funds are known as direct loan funds, which extend credit directly to companies or acquire debt issued by banks for the express purpose of selling it to investors (in the past it would have been held by banks).
The direct loan market includes a variety of alternative mainstream and non-core investors. Leading alternative loan investors have expanded their product offerings to include private debt funds. They have been joined by several new specialized companies.
Strong demand from institutional investors has allowed these funds to expand rapidly. Collectively, 531 private equity style debt funds have been raised since 2009. Overall, assets under management have doubled since the financial crisis, from $213 billion in assets under management in 2007 to $465 billion in June 2014, with 25% coming from direct loan funds. Hedge funds have also been an important source of debt capital and now manage over $600 billion in debt-focused funds.
The valuation of traditional assets has been stretched. Stocks have been on the rise for 9 years, which is a lot by historical standards, while bonds offer very little return and a significant risk of capital loss as the odds of seeing higher rates and the drop in bond prices that this entails is great. Alternative investments, when chosen wisely, offer the possibility of diversifying the risk of a traditional asset portfolio. In private debt, where returns are actually very attractive relative to risk, huge returns are also possible. This area represents the most compelling investment opportunity in the alternative space.
Chairman, Katch Investment Group
Para Mayor Información: