Alternatives: From optional to essential
- Alternatives are evolving from an optional to an essential portfolio component, with expanding allocations expected across all types of institutional and individual investors.
- A framework that focuses on what these assets do rather than what they’re called will be essential in achieving investors’ objectives.
- While alternative investing presents distinct challenges, growing investor interest suggests the trade-offs are worth it.
From optional to essential – that’s how we see the role of alternatives evolving over the next 10 to 15 years. Traditional markets alone, we believe, are unlikely to deliver the alpha, income and diversification investors need. The significant rise in alternative allocations among larger institutions as well as high and ultrahigh net worth individuals suggests these investors agree.
Three basic views underlie our expectations:
- Interest rates will stay “lower for longer.”
- Opportunities for alpha, income and diversification are shrinking.
- Access to alternatives is improving across the full spectrum of investors, and regulations are becoming less restrictive.
An objectives-based framework for alternative investing
A comprehensive framework for allocating to alternatives will be critical as allocations rise and alternatives are recognized as vital to achieving investors’ desired outcomes. We provide a framework that starts with investors’ objectives. It focuses not on what alternatives are called (alternative credit, private equity, hedge funds or real assets) but rather on what they do for portfolios. It considers the characteristics alternatives share with traditional asset classes (be they fixed income-like, equity-like or a hybrid) and concentrates on their position within a portfolio (as core foundation components, core complements or return enhancers). Whether newly investing or expanding and restructuring existing allocations, alternative investors are likely to find that a framework for aligning allocations with specific investment objectives is as essential as alternatives themselves.
How different investors use alternatives: Current snapshot and anticipated trends
Our research examines how different investor segments are using alternatives today and suggests where growth in allocations is likely to occur. We anticipate expanding alternative allocations across all investor types. We see relatively strong growth among insurance companies and corporate pensions – asset liability-aware investors with alternative allocations generally below those of their asset-only peers. In a persistent low rate environment, these investors are exploring alternatives for stable income, diversification and/or enhanced return. At the same time, endowments and foundations, sovereign wealth funds and public pensions will continue to reshape and enhance alternative allocations to improve portfolio outcomes. Small to midsize institutions, with generally smaller allocations, are also likely to start integrating alternatives or to expand existing allocations. Finally, we see the average individual investor taking advantage of improving access to alternatives.
The incremental risks of alternatives
Alternative investing, however, has distinct challenges. Illiquidity, dispersion of returns, tail risk, lack of transparency and complex fee structures are, to varying degrees, intrinsic to alternatives. Constructing portfolios that skillfully incorporate the full range of what alternatives can do and diligently selecting managers to ensure those capabilities are realized will be critical. But not all investors have the resources to build and manage alternative allocations at scale. Industry innovation and the development of multi-alternative asset solutions and access vehicles should help diminish some of these challenges for smaller institutions and individuals. Of course, increasing flows into alternatives may be a double-edged sword – compressing alpha and, as a result, fees over time.
A worthwhile trade-off
In spite of the challenges, investors appear convinced that the trade-offs inherent in alternative investing are worth it, particularly when traditional markets alone are unlikely to meet their objectives for alpha, income and diversification.