Investing in core/core-plus alternatives: Capturing return dispersion alpha while managing risk
- Core/core-plus alternatives (alts)1 exhibit high performance dispersion across categories—core/core-plus real estate, infrastructure, transportation, credit, liquid alternatives—providing opportunities to generate additional alpha through actively managing allocations over time.
- Open-end core/core-plus private alts funds (“open-end”) offer greater liquidity than closed-end private alts funds (“closed-end”), providing greater flexibility to actively re-allocate capital and potentially generate alpha.
- Actively managed, open-end core/core-plus multi-alts funds may deliver comparable net multiples on invested capital (MOICs) to multi-vintage noncore alts funds, with greater transparency and a lower risk profile.
When constructing investment portfolios and managing risk, it’s important to consider and understand performance dispersion—its likely sources and magnitude, and how investors can potentially use it to their advantage.
In alternatives investing, the two main sources of dispersion are:
- By manager: Performance differs historically across alternatives fund managers within single categories of alternatives.
- By category: The year-to-year dispersion in returns is historically quite wide across alternatives categories, both on the core and the noncore ends of the risk spectrum.
The noncore, higher-risk alts alternatives2 has historically higher manger dispersion within each single alts category than core/core-plus segments. This is intuitive: Some of these noncore alternative investments have inherently more uncertain outcomes (e.g., greenfield projects, project development, venture capital). Some have higher relative leverage, greater reliance on capital appreciation for returns, or other factors that can add risk.3 This higher level of uncertainty in outcomes occurs both within single alts categories and across categories at the riskier end of the spectrum.
By contrast, core and core-plus alternatives (i.e., core real estate, infrastructure, transportation, credit, liquid alts) historically exhibit lower manager dispersion within single categories. These are lower-risk investments: e.g., brownfield projects4, developed assets, investments with a relatively lower use of leverage and with returns driven by long-dated contracted income with high quality counterparties.
However, intra-category performance dispersion is significant across core/core-plus alternatives categories (Exhibit 1). This theme is less intuitive but can have powerful implications for portfolio construction—because these different categories historically outperform at different times in the market cycle, creating opportunities for investors to actively tilt their allocations over time, potentially providing opportunities to generate additional alpha.
Core/core-plus alts exhibit significant intra-category dispersion, which has important implications
Exhibit 1: Sources and degree of return dispersion in alternatives, by risk profile
Principles for diversification
Taking these attributes into consideration, we can deduce a few principles for investing in alternatives:
Core/core-plus: Investors should diversify allocations broadly across alts categories with similar investment attributes (e.g., cash flow-driven returns, public equity diversification, low return volatility) for returns that would likely be noncorrelated. This should provide greater diversification and more resilient outcomes over time relative to an allocation concentrated in a single core/core-plus category (even if diversified across multiple managers).
A greater degree of liquidity is available in core/core-plus private alternatives and can often be accessed through open-end perpetual life (evergreen) vehicles. Greater liquidity bodes well for constructing a strategic alternatives allocation, anchored in core/core-plus funds. Greater liquidity also sets up favorably for active management to capture opportunities in intra-category dispersion at different stages of the market cycles—more on this below—and for complementing the portfolio with selective investments in noncore alternatives.
Noncore: Investors should broadly diversify their exposures—by manager, category and vintage year—given high dispersion in the higher-risk categories. Here, manager and asset class selection are both critical.
To be sure, there is a need to be selective and broadly diversify exposures when investing in both core and noncore alternatives.
Manager dispersion across alternatives
As noted, noncore fund managers in similar investment categories (for example, comparing U.S. opportunistic real estate managers with one another, U.S. buyout funds with one another or distressed debt funds with one another) exhibit significantly greater performance dispersion than core/core-plus fund managers. Exhibits 2A and 2B show this difference using U.S. real estate managers’ returns over a 10-year period.
Fund managers within a single category have greater return dispersion in noncore than in core alts
Exhibit 2A: Core real estate funds’ performance dispersion by investment start date and net MOIC
The Wider band of outcomes in closed-end noncore alts highlights manager selection
Exhibit 2B: Noncore real estate funds’ return dispersion
What explains these different levels of performance dispersion?
Closed-end, noncore funds5 rely more on market timing. Their capital needs to be deployed within a set investment period and returned during the fund’s predetermined term. Open-end core/core-plus funds, however, operate as perpetual life vehicles (without a fixed term) giving investors greater flexibility to re-allocate throughout the market cycle.
Open-end core/core-plus funds will also, typically, be more fully invested over the longer term. Closed-end noncore funds gradually deploy capital during a ramp-up period. The difference in time fully invested significantly impacts net multiples, and the compounding opportunity that income-oriented open-end funds provide.
Furthermore, early investors in noncore closed-end funds are subject to blind pool risk6 —so prospective clients need to evaluate a manager’s skills and prior track record. These funds’ investments (as noted) tend to be higher in risk because they are earlier in the development lifecycle, can require meaningful operational improvements to lift their value and typically rely on capital appreciation as the primary driver of returns. While this can mean greater upside potential, it also introduces greater uncertainty and the possibility of missteps.
The wider band of outcomes inherent to closed-end noncore alternatives funds makes manager selection a more important factor when making investment decisions.
By contrast, a prospective investor in an open-end fund, can do due diligence before deciding to commit, reviewing the existing portfolios prior to making investment decisions. And since open-end core/core-plus funds typically deploy capital into stabilized (brownfield) assets, and derive most of their returns from long-dated contracted income, outcomes may be less variable.
Active management may improve multi-alts core/core-plus portfolios
Even as manager dispersion is relatively low in core/core-plus alts funds, their year-to-year intra-category dispersion is significant. Annualized performance dispersion among categories was more than 20% over the past 15 years (Exhibit 3). As noted, this can have important implications, providing opportunities to potentially generate additional alpha through actively managing allocations over time.
Core/core-plus alts funds returns show significant dispersion across categories
Exhibit 3: Year-to-year intra-category return dispersion, core/core-plus vs. noncore alts funds
Investors would likely be well-served by diversifying across core/core-plus alternatives with similar attributes, rather than across managers within a single alternatives category. An actively managed portfolio of core/core-plus multi-alternatives can potentially generate incremental alpha vs. a static allocation. Active management decisions should be based on a robust investment framework which takes into consideration a wide range of macroeconomic factors, the relationship between various alternatives in different market conditions, and the investment outlook (both near- and medium-term across alternatives). Furthermore, implementation is key and incorporating the sources and uses of capital over time is a critical step in efficiently implementing investment views. Our analysis suggests that actively tilting the portfolio by 10% each year can potentially generate from 100 to 150 basis points of excess return annually—assuming a 50% capture rate of outperformance each year (the capture rate is a function of the manager’s skill, investment framework, product structuring, and implementation).
The same outperformance capture rate may potentially lift net time-weighted returns (TWR) to 7%–9%, from 6%–7%, which implies a 10-year net multiple on invested capital (MOIC) of 2.0x–2.4x. Furthermore, this can be achieved while also mitigating risk, as illustrated in the lower value-at-risk in the table below. That performance is comparable to multi-vintage programs generating an above-average IRR in the mid-teens (Exhibit 4). This indicates that although core/core-plus funds’ TWRs are lower than the IRRs reported by their noncore, closed-end counterparts, the net MOICs are favorable, particularly in the context of investment risk.
Actively managed core/core-plus multi-alternatives portfolios have the potential to deliver similar net multiples as multi-vintage noncore closed-end strategies
Exhibit 4: Expected 10-year net MOIC and IRR for three types of alternatives strategies
Capturing a category’s relative outperformance
Managers can potentially capture a category’s outperformance. They may use a number of themes and trends that tend to persist at different points in the market cycle to reposition a core/core-plus multi-alts portfolio over time. And since these themes generally persist for multiple quarters, there is likely to be adequate time to capture that category’s relative outperformance. Active re-allocation is also possible because of the liquidity typically available in evergreen funds.
Three examples of consistently recurring themes that offer such an opportunity:
- Public real estate returns have historically led private real estate early and late in the cycle. Actively allocating between these categories may be a source of incremental return.
- Core infrastructure has historically offered safe haven during economic downturns, supplying essential services with typically inelastic demand. Core infrastructure performs best (on a relative basis) during periods of market stress. Increasing a core infrastructure allocation late in the cycle may improve risk-adjusted returns during market downturns.
- Private real estate has historically performed well during periods of economic growth and/or periods of rising inflation. Real estate has an inherently slow supply cycle which benefits the performance of the asset class during periods of strong demand.
Furthermore, the liquidity provisions available through an open-end vehicle let managers effectively implement these re-allocations in a timely manner. Multi-alts fund managers can implement active portfolio tilts using:
- Income distributions: Reallocating income distributions to high-conviction investments.
- Capital inflows/outflows: Repositioning by allocating new capital commitments to high-conviction investments or sourcing capital from low-conviction investments.
- Active rebalancing: Redeeming and redeploying capital into high-conviction investments.
- Capital optimization: Actively managing, over time, the sources and uses of capital (including fund-level credit lines, leverage and/or other liquidity management tools) to more efficiently implement investment views and deliver potentially better outcomes across market cycles.
Understanding and utilizing performance dispersion in alts investing may be a little-known opportunity to potentially generate additional alpha. Active management by open-end multi-alternatives core/core-plus funds that offer liquidity and flexibility may present an investment advantage at different points in the cycle—even allowing such actively managed funds to deliver enhanced returns comparable to noncore funds, but in a more transparent and lower-risk way.