April 23, 2019

Why Alts Are Burgeoning: Naked Fear

Amid the aftershocks of the ’08 crisis, investors are drawn to the perceived safety of their diversification, and to pretty good returns.

Reported by Larry Light

Art by Alex Eben Meyer

Welcome to the age of the alts, as more and more institutional investors are turning to them. Why? Fear. Investors, still traumatized by the seismic shock of the 2008 financial crisis, are drawn to alts’ relatively steady, long-term nature.

Alternative assets benefit from wide-ranging diversification—a quality that gives a sense of comfort, even safety. It helps that alts in general deliver decent returns, and occasionally superior ones. And they do so with less volatility than stocks and sometimes bonds.

Alts have almost tripled in size since the 2008 financial crisis, growing to $8.8 trillion as of 2017, research firm Preqin says. What’s more, Preqin predicts that alts will reach $14 trillion by 2023, as emerging markets like India turn to them. Even retail investors are getting in on the act.

Alternative investments, of course, lie outside the three standard asset classes—stocks, bonds, and cash. The main raison d’etre of alts is that they are not correlated to traditional investment choices. In fact, as a multi-asset strategy, alts are a disparate bunch that don’t correlate much with each other.

Alts span physical assets, such as real estate, infrastructure, and commodities, as well as financial entities, like hedge funds, private equity funds, and shadow banking (a.k.a., private credit). As a result, their payoffs may take a long time to emerge. Private equity funds, for instance, make most of their money by selling businesses they have taken over and, years later, transformed.

Overall, returns have been good enough to justify investing in alts. This century, they have outperformed stocks and bonds. On an inflation-adjusted, total return basis, they averaged 6.05% annually from January 2000 through December 2018, by the reckoning of 361 Capital, which specializes in alts. That’s compared to 4.86% for the S&P 500 and 4.84% for the Bloomberg Barclays US Aggregate, which tracks the bond market.

While they got hurt in 2008, along with pretty much everything except Treasury bonds, alts generally lost less: down 5.3%, compared to the S&P 500’s 37% loss, according to 361. “Institutions are very concerned about drawdowns” of their assets, said Eric Kuby, chief investment officer (CIO) of North Star Investment Management.

To be sure, alts did fall short since the end of the bear market in March 2009, returning 6.3% to the S&P 500’s 17% due to an epic run for stocks. (The Agg was up 3.5%).

Storm clouds are further heightening the appeal of alts nowadays. Predictions are rife about the end of the bull market for stocks due to an anticipated recession in a year or two. Some also expect ebbing bond prices amid a possible continuation of rising interest rates. “Where else will I find returns?” asked Josh Vail, president of 361, referring to alts. “Stocks and bonds look bleak.”

Among institutions, applause for alts is widespread. Institutions “have a long time horizon,” noted Daryl Deke, chief executive officer (CEO) of New Market Wealth Management. The University of California’s fund in recent months more than halved its cash, and redirected almost all of it into alts—mostly into real estate and other real assets, and the rest into hedge funds.

In particular, public pension plans, many of them underfunded, find alts a good place to entrust money, with private equity and real estate the most popular, an analysis by the Boston Federal Reserve Bank says. The Boston Fed study says public pensions’ investment in PE and real estate doubled in the 10 years since the crisis, and as of 2017, comprised 20% of their assets. The Washington State Investment Board has one of the biggest commitments to private markets among US pension plans, at 27%, with growing holdings in PE, real estate, and other tangible assets.

Investment performance has earned alts’ keep in pension portfolios. Credit alts for giving New Mexico’s education pension fund a positive showing (up 0.6%) last year, when the S&P 500 lost 4.4%. “We are looking for investments that will contribute to our return goals and that are not highly correlated to public markets, particularly equities,” said Bob Jacksha, CIO of the $12.9 billion New Mexico Educational Retirement Board (ERB) fund.

For college endowments and foundations, a survey by investment firm NEPC reveals, the expectation is that hedge funds should be the best performer should market volatility return. Even though hedge funds haven’t done well recently, volatile markets are where they historically have shone.

Looking ahead three to five years, the NEPC survey indicates the highest returns endowments and foundations expect are for private equity (59% of respondents agreeing), followed by hedge funds (15%), commodities, and real estate and real assets (each 9%).

The appeal of alts is also strong among rich individuals. Family offices are taking to alts in a big way. Some 46% of the average family office portfolio is in alts, a UBS/Campden Wealth study finds (equities are in second place, with 28% and then come bonds at 16%).

The hoopla over alts is mirrored on the retail level. No longer are alt strategies reserved for institutions and the very wealthy. Now a regular investor can buy “liquid alt” vehicles, mainly mutual funds and exchange-traded funds (ETFs). The number of such retail funds has grown to 370 ($146 billion assets under management) in 2018 from 59 ($44 billion) in 2007, right before the financial crisis, according to a compilation of Morningstar data by 361 Capital.

The intellectual underpinnings for alternative investing were crafted in 1952 by economist Harry Markowitz, with his invention of Modern Portfolio Theory. MPT, for which he won a Nobel Prize in 1990, demonstrates how to offset risk in a portfolio by using multiple assets.

A pioneer of implementing MPT in the investing world was Yale CIO Edward Swensen. Since taking control of the university’s endowment in 1985, he has enjoyed enormous success with a multi-asset approach based on alts, known as “the Yale Model.” Over the past 10 years, Yale has logged average annual returns of 7.4%, outdistancing institutional fund indexes. Yale, for example, has 10.3% in real estate, while the educational institutional average is 3.2%, Cambridge Associates research finds.

Not everyone can replicate Swensen’s superb showing, certainly. A look at several of its asset classes gives a picture of investments that have their own set of pros and cons. What remains is that alts seldom have much are synched up with conventional assets:

Hedge Funds. These have been trying times for hedge operators. But last year, for the first time since 2008, hedge funds outperformed the S&P 500 on an annual basis, Hedge Fund Research data say.

To be sure, hedge funds and their investors often say beating the market is not what they are all about. Instead, they aim to offer diversification and be a buffer against market slumps. A 60-40 stock-bond portfolio in horrific 2008 was down about 30%, while hedge funds were off just 19%.

If greater price dispersion (where a stock’s price shows broad differences among sellers) and higher volatility are coming, then long/short equity funds should find good opportunities, suggests JP Morgan Asset Management in its quarterly Market Insights publication.

Private Equity. PE has been booming in recent years, with lots of new money raised, a plethora of capital waiting to be committed (a.k.a., dry powder), and multiples at the high end. Last year had the most PE buyouts ever. Although exits via initial public offerings of stock were down, sales to other PE forms or corporate acquirers were healthy.

This has caused some to worry that the PE market will be overextended. The median enterprise value (equity plus debt minus cash) to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio dipped only slightly last year, to 11.6 from 11.9, Pitchbook reports—yet was a good bit higher than 2009’s 7.0.

Regardless of PE’s immediate course, the enterprise of buying and selling companies remains a long-term proposition. A PE fund typically lasts 10 years. “It’s like buying 100 shares of Lyft and saying I’ll check in 10 years from now to see how they are doing,” said Norm Conley, CIO of JAG Capital Management.

Real Estate. As a long-run proposition, property ownership has a venerable track record. True, there have been periodic excesses, such as in the late 1980s, where overbuilding has damaged the commercial market, or in the previous decade, where it damaged the residential sector.

That said, buying and holding a good property, especially in a hot area like industrial (translation: warehouses for Amazon and its online delivery ilk), should fare well. Little overbuilding is occurring now. “Private real estate funds are more stable than REITs,” noted JAG’s Conby. Real estate investment trusts are traded daily like stocks. “Not enough buildings are being sold to scare people,” he said.

Infrastructure. Government funding to repair and construct roads, tunnels, and so forth is strained. “That’s why more privatization going on,” noted Rob Balkema, senior portfolio manager for multi-asset solutions at Russell Investments. The Trump Administration started out talking about shoring up the nation’s sagging infrastructure, although that impetus seems to have sagged. Nonetheless, the need is apparent.

Private ports and railroads are increasingly tapping private money. Carlyle Group is investing in the upgrade and expansion of a terminal at JFK Airport in New York, for example. Overseas, private infrastructure investing is more advanced.

Private Credit. These so-called shadow banks have exploded since the financial crisis, as commercial banks have tightened their lending standards, thus excluding many smaller businesses. “Banks are still averse to financial risk,” observed Joe Brusuelas, RSM’s chief economist.

As of 2018, by Bloomberg’s count, private credit providers have raised almost $500 billion. Outfits such as Owl Rock Capital Partners are lending to the likes of Cold Spring Brewing, a craft beer maker in Minnesota, to help it expand.

The attraction is interest rates up to 7%, although greater interest in these private debt funds has eroded their premiums versus public capital markets of late, from 3 percentage points in 2009 to 0.5 point last year, a Willis Towers Watson study concludes.

Commodities. Here is the most volatile of the alts. China has a large effect on commodity prices, which ebb and flow in tune with the huge nation’s economy. A Chinese slowdown had been buffeting them, but a shot of government stimulus seems to have reversed that.

And although inflation is quiet now, if and when it reemerges, this is one asset class to be in. “This gives you some inflation hedge in your portfolio,” said Frank Rybinski, chief macro strategist at Aegon Asset Management.

The intricate mosaic of alts is designed to blunt the risk of the stock market, and yes, the bond market. In his novel Pudd’nhead Wilson, Mark Twain facetiously suggests: “Put all your eggs in one basket and –WATCH THAT BASKET.” Alts give you many baskets, and odds are the eggs will be safer.