Alternative Investments: Growth and Diversification
As the first quarter nears its end the latest research, outlined below, suggests that there are mounting trends in alternative investments that may influence how financial advisors leverage the asset class through the remainder of the year for their clients.
The alternative investments asset class is now bigger than it has ever been, representing a total of $7.7 trillion invested in hedge funds and private capital according to Preqin’s Investor Outlook: Alternative Assets, H1 2017. In the broadest definition, alternative investments generally represent those investable assets that fall outside of the common stocks, bonds, and cash categories. Preqin’s analysis focused on institutional investor activity in six main alternative asset classes: hedge funds, private equity, real estate, infrastructure, private debt and natural resources.
Investments in the alternative asset class experienced growth of $300 billion in 2016, which according to Preqin is largely representative of an increasing diversification of alternative investment portfolios among existing alternatives investors as opposed to an influx of new investors. Preqin’s Investor Outlook study demonstrates that 80% of respondents are invested in at least one alternative asset class and that 34% are exposed to four or more asset classes. This diversification has grown since 2016 when Preqin found that only 25% of investors were invested in four or more alternative asset classes.
Given the increasing trend toward diversification within alternative investments, the same Preqin research offers insight into how investors are allocated among the alternative asset classes, with real estate (61%), private equity (57%) and hedge funds (51%) representing the greatest proportion.
For purposes of comparison, the top 3 alternative asset classes cited by Preqin were also the most popular alternative asset classes cited in the 2016 CAIS Independent Wealth Manager Survey, although in that survey 77% of respondents expressed interest in hedge funds, followed by 66% in private equity. Real estate and private debt were represented as subsets of private equity in the CAIS survey with a corresponding interest of 51% and 47% respectively. The Preqin and CAIS data both suggest that investor attitudes toward private equity, hedge funds and real estate are changing and therefore bear closer examination.
According to Preqin, investor satisfaction with private equity was 84%, the largest proportion among the alternative asset classes. Not surprisingly, 48% of investors intended to increase their private equity allocation over the longer term, and 83% intended to make their next commitment in the first half of 2017. The main concern expressed by 70% of the private equity investors surveyed focused on high valuations and the possible risk that fund managers might overpay for assets that could be difficult to realize if prices fall at a later date.
Mercer Investment Consulting’s position on private equity, according to Mercer’s Economic and Market Outlook 2017 and Beyond, is that private market asset classes can offer a range of attractive opportunities for investors with a tolerance for some illiquidity in their portfolios. While some investors have sought to leverage the asset class to enhance returns, improve income yield and provide better diversification in their portfolios amid an opportunity set that Mercer asserts remains robust, they also caution that investors should diversify risk concentrations such that their private market exposures are not overly concentrated in certain areas of the market that are receiving an inordinate amount of investment.
Private Real Estate
According to Prequin, 93% of real estate investors stated that their real estate investments had met or exceeded their expectations in 2016. Preqin’s 2017 Global Real Estate Report indicates that in the three years leading up to June 2016, private real estate funds have generated an annualized 14.9% return; this is likely why 42% of investors indicated that their expectations had been exceeded over a three-year period, the highest such endorsement among all alternative asset classes.
Much like private equity, Prequin asserts that investors are concerned with asset pricing as one of the challenges of a crowded marketplace. Fundraising saw a modest decline in 2016, from $123B to $108B, and investment activity also slightly declined; 24% of investors surveyed by Preqin indicate that they will reduce their capital allocated to real estate in 2017. However, the opportunity for growth in the real estate asset class remains substantial, with 48% of investors indicating that they are below their target allocation; the average allocation was 8.9% with an average target allocation of 10%. 75% of investors indicated that they preferred to enter the asset class through private real estate funds, although 63% would not invest in first-time funds.
In a year which saw hedge fund assets exceed the $3 trillion milestone for the first time ever, data would suggest that 2016 proved to be a challenging year for hedge funds with a similar set of challenges poised for 2017. According to Preqin, investor satisfaction is low, with 66% indicating that hedge fund investments had not met expectations. Preqin asserts that only 20% of investors intend to increase their exposure to hedge funds in 2017, with performance and fees being the main concerns expressed by 73% and 64% of the respondents respectively.
According to Mercer’s Economic and Market Outlook 2017 and Beyond, the strategic rationale for alternative strategies involving hedge funds remains compelling after 8 years of stellar returns for the bond and equity markets. Mercer expects hedge funds to generate net-of-fee returns well in excess of cash and prefers strategies that exhibit low correlation to traditional asset classes. Mercer states that particular opportunities for macro-oriented strategies should be created given the uncertainty in terms of trade, currency, and central bank policies.
For your reference, CAIS has explored hedge funds in greater depth in other blog articles.
Potential Challenge: Sourcing Investment Opportunities
As investors diversify their alternative asset portfolios, a challenge felt by some investors across almost all alternative asset classes was that it is more difficult to source attractive investment opportunities than it previously has been.
This concern is manifested in different ways in the asset classes explored above, namely in the valuation concerns expressed for private equity, asset pricing concerns expressed for real estate, and performance and fee concerns expressed for hedge funds.
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