Alternative asset retail fund investors are becoming a more interesting market for the growing universe of managers active in this field.
Family offices have traditionally dominated the market; seeking the less volatile investment returns that portfolio diversification can deliver.
We investigate whether this still small but growing number of retail investors approaches the market in a similar manner.
We ask whether direct retail fund investors are genuinely looking for lower portfolio volatility through exposure to investments with low correlation to major asset classes. Or are they trying to pick winners when they invest in alternative assets?
“If you have trouble imagining a 20% loss in the stock market, you shouldn’t be in stocks.” – John Bogle
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The attraction of alternative investments
Alternative asset is a term that is interpreted widely depending upon context.
A general familiarity with the subject is assumed. However readers with less experience may well find Investopedia’s1 broad overview of the asset class and explanation of correlation helpful.
It describes the importance of alternative investing thus:
“The advantage gained by owning alternative assets (that are relatively uncorrelated with both stocks and bonds) is the reduction in exposure to systematic market risk factors. Investment strategies seeking a low correlation to systematic risk are known as absolute return strategies, and their key objective is to attain relative independence from the performance of underlying equity or fixed-income market benchmarks.”
Common examples of alternative investments include:
- Private equity (including venture capital)
- Hedge funds (including long-short strategies)
- Micro equity
- Commercial real estate
- Illiquid credit
- Distressed debt
- Catastrophe insurance bonds
- Aircraft leasing
- Precious metals
The growth of alternative investments in Australia
High Net Worth Investors (HNWIs) and family offices have traditionally been the main investors in alternative funds.
This is in part due to frictional barriers preventing retail investors from easily accessing alternative funds, such as:
- Platforms which struggle to process performance fees
- Alternative investments have often been held in closed-end vehicles
- Infrequent pricing and dealing
- Regulatory constraints
However as alternative investing becomes better understood, funds under management have grown significantly. This is largely being driven by superannuation funds and retail investing.
According to a recent Towers Watson2 survey, the world’s largest 100 alternative asset managers oversaw some US$3.5tn of assets in 2014. The top 25 Australian managers are responsible for some US$250bn.
Dania Zinurova, senior investment consultant at Towers Watson is quoted in the report highlighting that: “Australian investors remain very active in alternative asset classes. Superannuation funds, in particular continue to have strong interest in asset classes like real estate, infrastructure, liquid alternatives (for example, hedge funds) both in Australia and overseas.”
The emergence of alternative asset retail fund investors in Australia
However there are signs that alternative investing is beginning to extend from family offices into the retail market. This comes when investors’ interest in their superannuation fund tends to increase as their portfolio grows in value. There are two aspects to this.
Firstly the incremental value delivered by management fees (i.e. post-fee returns) becomes more important than nominal fees to investors’ who are actively engaged in the management of their funds.
Hence investors tend to become more open-minded towards the alternative investing opportunity.
Secondly the more engaged investor is becoming increasingly aware that returns on their investments are seeing increasingly cyclical volatility. Investments may well be diversified across conventional asset classes, however the correlation of returns from assets such as domestic and global equity markets and corporate debt is high and increasing.
This becomes an issue when government bonds and cash (which do offer lower correlations) offer unattractive long and short-term yields. Thus exposure to such investments becomes lower in practice.
Therefore retail investors focussing on long-term growth assets find themselves with portfolios that are more cyclical and less diversified than they would wish. This has long-term return implications for those considering their options as alternative asset retail fund investors.
Why diversification is attractive
In order to understand the role of alternatives it is important to understand the impact of volatility on longer-term returns.
Darcmatter3 explains the link between volatility, returns and diversification:
“A volatile ride, even with huge gains, is still not as attractive as a smoother ride featuring more modest gains. The reason for this is that investments are compounded. A 6% gain every year for 3 years is a cumulative return of 19.1%. A 6% average gain for three years, with a 30% gain the first year, 20% loss the second year, and an 8% gain the third year creates a cumulative gain of 12.3% over three years. Smoother rides are beneficial for long term gains and this is gained through diversification; constructing a portfolio of assets that will behave differently through different economic cycles can help stabilize returns.”
Hence diversification across further asset classes offers a real benefit to alternative asset retail fund investors.
Diversification delivers lower correlation
Ask most people working within the alternatives industry why these funds are growing and they will normally respond that investors are looking for diversification across asset classes.
It is certainly true that wealthier investors have an appetite for increasing their exposure to assets that generate returns with lower correlations to equity and fixed income markets.
David Griffith4 at Blackrock argued in a recent article that it is a myth that alternative assets are their own unique asset class: “Alternatives represent different approaches to investing across a variety of markets and asset classes.”
In other words these quite distinct investment types have unique characteristics. Their unifying feature is merely that most provide greater diversification to a portfolio. Returns through the business cycle should offer a low correlation to the major asset classes – equities and fixed income.
However the systematic risk diversification benefit should not be assumed merely by the presence of the alternative investment label on the packet.
Equity-based hedge funds in particular often focus on alpha generation and/or the use of gearing to deliver a higher beta. Such strategies in practice often provide alternative asset retail fund investors with returns that vary largely in line with the main equity indices.
Picking winners with alternative investments
The previous section may well represent the “textbook answer” to the question of what drives growth in the allocation to alternative assets.
However there is plenty of evidence to suggest that growth is in practice driven more by tactical positioning than strategic diversification.
The growth of retail funds into alternative products can appear to be driven by investors hoping to ‘pick winners’ rather than by a desire to invest in funds with a lower correlation to the major asset classes.”
There is evidence to support the belief that the business (and thus investing) cycle is shortening. This coincides with investors using alternatives as part of an asset allocation strategy.
A Director at one leading provider of alternative funds suggested that: “The low yielding environment is perhaps driving the trend; when bank stocks are yielding 8% it is much harder to make the case for alternative investments.”
In this low-yield investment environment, more direct retail investors are examining opportunities in alternative assets.
Some are attracted by the diversification benefit of reduced systematic portfolio risk.
However very often retail investors are intrigued by the potential of certain alternatives to outperform the conventional asset classes of equities and fixed income.
Unfortunately investment success based on identifying out-performing asset classes in advance is unlikely to be sustained by many investors throughout the economic cycle.
Therefore managers of alternative investment funds might do well to demonstrate how their expertise in innovative products can contribute to investors’ overall diversification, and thus long-term returns.
In next week’s blog post we look at how managers might position their value proposition and engage with prospective clients in order to connect with direct alternative asset retail fund investors.
Do you think alternative asset retail fund investors are looking for reduced volatility through diversification or are trying to pick winners?
We have created a concise twenty-step guide to how an investment manager can establish a profitable and sustainable direct retail funds business through an engaged customer strategy; please click here to download.
‘Hand Holding Wind Turbine And Us Dollars Banknote’ image courtesy of satit_srihin at FreeDigitalPhotos.net
‘Business Man Growing Up Single Money Sprout’ image courtesy of Pixomar at FreeDigitalPhotos.net
‘Time To Diversify Indicates At The Moment And Currently’ image courtesy of Stuart Miles at FreeDigitalPhotos.net
1 Investopedia, accessed 25 April 2016, http://www.investopedia.com/articles/financial-theory/08/alternative-assets.asp
2 Towers Watson, 2015, “Alternative assets no longer considered alternative”, https://www.towerswatson.com/en-AU/Press/2015/07/Alternative-assets-no-longer-considered-alternative
3 DarcMatter, 2015, “4 Things to Know About Alternative Investments”, https://www.darcmatter.com/blog/4-things-to-know-about-alternative-investments/
4 Griffith, D, 2015, “Myth busting alternative investments”, Money Management, 11 June 2015, http://www.moneymanagement.com.au/expert-analysis/tools-guides/myth-busting-alternative-investments
alternative asset retail fund investors