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Over the past few decades, institutional and affluent investors have increased their exposure to an asset class labelled as, for lack of a better term, alternative investments. Alternatives are defined not by what they are, but by what they are not: They are not equities, and they are not bonds or money market instruments – at least not the relatively easily tradeable assets found in the typical 60/40 portfolio.
When I was head of fixed income and alternative assets for a mid-sized investment counsel, my mandate was to analyze, recommend and manage any investments that our equity team believed were unworthy of the attention of their colossal intellects.
The alternative investments space contains many different types of products, several of which have nothing to do with each other. They include, but are not limited to, hedge funds, private equity, natural resources, real estate and infrastructure. These categories can contain numerous subcategories.
The best example of alternative investments is hedge funds, which can range from low-risk funds that actually hedge risk, to wildly risky funds that do no hedging but actually do the opposite: Leverage their investments with debt. The latter type of “hedge” fund uses the term to justify their large upfront fees, sometimes taking 10 per cent to 20 per cent of their clients’ returns. They promise to provide investors with attractive opportunities not found in more conventional markets, and some actually deliver on this grandiose promise.
One advantage of alternatives is that they can have low correlations with conventional investments, thereby improving the risk/return profile of a portfolio.
But manager selection is more important in alternative assets, particularly private equity. Large publicly traded stocks will have dozens of analysts following every minutiae of their operations and financials, and hundreds of portfolio managers and thousands of individual investors watching them. They also have accurate stock charts which provide important insight. Their financial information is public.
That’s not the case for many alternative investments, where information is kept very private.
There are a lot fewer private debt specialists out there than equity managers. It does appear that the efficient market hypothesis – the idea that managers cannot outperform the market over the long run – applies less to alternative managers.
Yet, to an extent, part of the incremental value of alternatives is generated by one of their major drawbacks. They are not liquid. An investor may not be able to withdraw their funds quickly. In many cases, there may be a lock-up period for years.
In a relatively efficient market, assets are priced for risk. An important risk is liquidity and therefore alternatives should trade at a discount, or have a higher return relative to liquid assets like stocks and bonds. Since alternatives are not liquid and do not trade on an exchange on a second-by-second basis, managers enjoy a lot of discretion around pricing. To no sophisticated investor’s surprise, many managers will “smooth” out their asset values, meaning they underprice assets during positive periods and overprice them after a negative period. Therefore, some of these investments will appear less risky than they really are.
In general, alternative investments do provide decent returns. But they are too broad a category to assess as a group.
For instance, the HFRI index of hedge funds produced an annualized five-year return of 4.51 per cent over the past five years. That compares with a 9.25 per cent total return for the S&P 500.
According to the CAIA Association, a global investment body, over a 21-year period ending June 30, 2021, private-equity allocations by state pensions produced an 11-per-cent annualized return. That exceeds the 6.9-per-cent annualized return that otherwise would have been earned by investing in public stocks.
Use caution, however, when examining data for alternative asset returns. Their illiquidity and opaqueness can obscure the validity of the returns reported. During bear markets, private-equity and debt investors may be unaware of problems until it is too late. A great example of this in the Long-Term Capital Management debacle of 1998. This highly leveraged hedge fund, arguably the world’s most awe-inspiring alternative asset before its implosion, almost took down the financial system.
Today, an alternative investment using high levels of debt is playing with fire. That’s because those alternatives that are relying on credit to augment returns, or are debt-based to begin with, and are in a radically different world than the one that existed from the beginning of the financial crisis in 2008 to the end of the long-term bond bull market in 2021. The era of artificially low interest rates is over.
This sector will have the same problem with the new era of higher interest rates as commercial real estate: interest rates are no longer below inflation rates.
Up until 2021, we had a prolonged, unsustainable and maladaptive period when interest rates were below inflation and far too low relative to price pressures. This allowed many poor investment ideas to see the light of day. Professional investors happily gobbled up investments and funded the ideas of managers who would have been escorted out of the building before 2007.
When someone responsible for allocating capital to an investment project decides whether a vehicle is acceptable, they look at projected cash flows and assess if the return on capital is above the so-called hurdle rate. The hurdle rate is the minimum return demanded for an investment to receive capital. Loans are used to finance these investments. After all, if rates are 5 per cent and the annualized return of the vehicle is 3 per cent, adding risk would be irrational. However, if rates are artificially low at 0.5 per cent, a once-poor investment can look lucrative using leverage.
We are now in a period where rates will be more appropriate given inflation. This has been the case through much of human history. The 2008 to 2021 years were an anomaly.
Hurdle rates will be higher and alternative managers will have to pay more to borrow in real terms. Alternative investments, depending on the category and methodology of the manager, will remain appropriate investments. But the days of easy money are over, especially for those managers who relied on what is effectively central bank “subsidies” arising from low interest rates.
The good news for investors? In the era now upon us, bonds and dividend-oriented stocks are looking pretty good in comparison to the alternative investment space.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank’s main bond fund.
