International firm Invesco talks to this publication about the ever-changing world of alternative investing.
How useful do you consider it to think of “alternative
assets” as being at the less liquid end of the spectrum (with
venture capital and special situation hedge funds, private
equity, etc, at one end, and listed equities at the
While it can be tempting to conflate the concept of “alternative” and “illiquid” assets, it is important to take a more nuanced view and note recent developments in this space, and carefully bifurcate the different types of alternatives into distinct groups. In our view, there are two broad categories – the first being diversifying alternatives, which contain ample liquidity and maintain low correlations to equities and bonds. Some strategies that would fit into this categorisation would be market neutral, global macro, and alternative risk premia mandates.
Often, there is daily or weekly liquidity, which provides investors with the ability to access capital in a short timeframe and position a portfolio to serve as “hedge fund replacement” vehicles. The return profile for these strategies is often cash plus 4-6 per cent, with a volatility profile of 1-1.5 times core fixed income. One potential drawback of the daily liquidity approach is the reduced ability for the manager to fully execute the strategy, due to leverage constraints, but we’re seeing that investors are very willing to accept this tradeoff.
The second category of alternative investments are private markets – such as real estate, infrastructure, private credit, and private equity. This is a set of asset classes that has traditionally been associated with long lock-ups and very limited liquidity. It is this framework that helped drive the notion of an “illiquidity” premium, which implies that the tradeoff of locking up capital should come with a return enhancement. While there is historical evidence to prove this, we see investors looking to access these investments with more generous liquidity parameters, often monthly or quarterly, but sometimes daily.
While the increased liquidity could come with more “paper volatility”, we think that it is important for investors to consider de-smoothing return profiles, which can tease out some of the biases that can artificially deflate volatility for strategies with very limited liquidity. Given this, we still think that private market investments can be used to enhance returns and reduce risk in a portfolio, given lower correlation to the general macroeconomic backdrop than traditional investments, and greater exposure to idiosyncratic risks to drive returns.
In the alternative asset class space which you track,
what are the main trends you see (in hedge funds, private equity,
VC, real estate, infrastructure, commodities, other)? For
example: increased/decreased wealth management interest in
certain areas (please give examples); use of specific types of
vehicles (listed alternatives, offshore structures),
redemption/liquidity requirements, etc?
There are three distinct trends which we see occurring in the wealth management space. The first being the implementation of lower-cost, systematic diversifying alternative strategies which can serve as replacements for traditional hedge funds and usually have daily liquidity. Often, we are seeing traditional style factors used in a rules-based, long/short framework to serve as a diversifier to a portfolio of stocks and bonds. However, we have seen other approaches that have garnered success in the marketplace. We think the key here is a hedge fund-like return profile at more attractive pricing.
The second trend is the usage of traditional private market investments – real estate, infrastructure, private credit, and private equity with improved liquidity terms and often bundled together to meet a specific investment outcome such as growth or income. Another critical component of this exercise is to strategically allocate to these asset classes, based on long-term capital market assumptions, which has been a big focus of ours over the past year. This allows investors to “bolt on” these strategies to meet a specific gap in a portfolio.
The final trend would be specific to real assets, and the implementation of real asset strategies which incorporate multiple types of asset classes under one umbrella. The challenge with this has traditionally been that these strategies are often managed by distinct investment teams – examples being real estate, infrastructure, and commodities. What we have been able to do is strategically and dynamically harness these distinct disciplines into a single real asset mandate, which has drawn interest from both wealth management and institutional investors.
A big challenge is for accurate reporting on the
valuations and performance of alternatives (calculating net asset
values, etc). How, in your view, is the wealth management
industry served today in getting such data? There are a few firms
out there developing technology, such as FundCount, Private
Client Resources, etc. Is there still work to do?
Given the demand we see for strategies with more generous liquidity parameters, there could be potential scepticism from investors as to the perceived quality of valuation and performance data based on past experience. We do think that improved liquidity could lead to better data, as the ability to access capital in a shorter timeframe would ideally drive improvements in data calculation and more frequent fund/asset valuations. It is important to understand why poor and/or stale data matters – it can create a perception that certain strategies contain superior returns and/or lower risk, which can impact portfolio allocation decisions, so it’s essential to leverage research and technology that can de-smooth returns for illiquid asset classes in order to inform portfolio management decisions. This, coupled with more frequent valuations, should provide investors with better clarity over what they are actually buying.
There is a lot of money going into private capital (private equity, debt, property, infrastructure) and we read comments about the build-up of “dry powder” (uncommitted capital). Is that a cause for concern? Could yields be squeezed? Has the chase after returns caused some excesses?
The supply of and demand for capital will affect return opportunities, but our view is that strong opportunities currently exist in private markets. Ultimately, strategic investors will need to maintain a certain risk profile to achieve desired investment outcomes over the long-term. Thinking about the traditional markets, we are seeing full to elevated equity valuations globally, with very low and often negative yields depending on domicile. This does not paint a great picture for these asset classes, at least in the short term, so if you need growth in your portfolio private markets are still one place where investors can access growing returns without buying into assets that are being completely driven by an increasingly volatile macroeconomic landscape.
Hedge funds have had mixed results in recent years and their traditional 2 and 20 per cent fee models (annual management fee, performance fee) have been squeezed. Do you see further fee compression?
Yes, fee compression is something that we continue to think will be a persistent theme. There will be a confluence of factors which drive this, such as the recent lacklustre performance of hedge funds as an asset class, coupled with increased demand for strategies that provide non-correlated exposure but with a lower cost structure, often using a more systematic approach to execute this.
When accessing hedge funds, do you prefer to go directly to a specific manager of a strategy or still prefer a fund-of-funds/multi-manager approach where the manager/fund selection role is outsourced?
As a solutions provider, we provide customised investment mandates for clients, so we would work with internal and external providers to construct outcome-oriented alternative structures (i.e. “go direct”). However, this is typically in the private market space. With respect to hedge funds, we are deploying more systematic approaches to generate a comparable risk/return profile to hedge funds but at a lower cost to investors. We source distinct internal capabilities to do this, and pair the capabilities in a way that doesn’t over-allocate a portion of our risk budget to a particular capability.
How much has the squeeze on yields for listed equities
and other conventional asset classes encouraged a shift to
Yes, we think reduced yields on equities and bonds has driven a shift to alternatives. Ultimately, our view is that investors typically focus on three key investment outcomes – growth, income, and diversification. These have all become more challenging in this unique late cycle environment, with decelerating global growth and falling yields. Regardless of the macroeconomic backdrop, investors must still maintain a focus on these outcomes, so alternatives have become an area of increased focus to fill the gap created by challenges in traditional assets.
There is a sort of wealth management quest for the “Holy
Grail” of uncorrelated returns, encouraging interest in ideas
such as life settlement funds, liability finance, not to mention
traditional areas such as gold and diamonds. What is your take on
whether such uncorrelated returns are every really
We’ve seen interest in more esoteric investment ideas in the wealth management space, but the actual uptake has been driven by institutional investors. Some examples would be investments in unique assets like aircraft leases, mortgage servicing rights, and life settlement contracts. It would be more complicated to implement liquidity parameters that would be palatable for the wealth management space, so it’s something that we believe will remain more institutional in nature.
Empirical data would show that certain asset classes/investments can demonstrate uncorrelated returns over short, intermediate, and long-term time horizons. It is important to analyse your portfolio through a factor framework and have full visibility and understanding of what your portfolio holds and how it behaves in certain macroeconomic regimes. This will allow investors to understand the tradeoffs of their investment decisions and how certain strategies can complement a portfolio.
Has the 2008 financial crisis and its aftermath radically
changed how you think of alternative assets, or just added to the
data that you need to take into account about these
The GFC impacted the broader approach to portfolio construction and risk management across asset classes, particularly alternatives. We view this event as a primary catalyst for deploying a factor-based approach to risk decomposition, and understanding return profiles within certain market regimes. This is particularly applicable to private market investments, as understanding how the illiquidity premium can drive a portfolio's performance at inflection points should impact its place in the portfolio. We also think that it is vital for investors to understand how portfolios behave in both historical and hypothetical scenarios.
Are there other points you want to make?
Investors should firmly understand the risks in their portfolios, ideally through factors, and align those with their desired investment outcomes. We think that this, coupled with long-term capital market assumptions, will give investors the best means of fitting alternatives into their portfolios. Investors should think about alternatives within their broader portfolio construction, and then begin to assess which specific strategies are optimal for inclusion.