Alternative Investments: Finding The Right Tool For The Job

This article was contributed to us by Wylie Tollette, Chief Investment Officer, Franklin Templeton Investment Solutions and Gene Podkaminer, Head of Research, Franklin Templeton Investment Solutions

After an extended period of low inflation and solid growth, investors now confront a stormier economic scenario marked by rising rates and potential stagflation. The wrenching pullbacks in stock and bond markets this year vividly illustrate the limitations of the traditional 60/40 stock/bond portfolio and the potential value of diversifying with a dedicated allocation to alternatives.

But how big should that allocation be? And what to hold within it? Alternatives include a huge number of potential investments—basically anything that isn’t a stock or bond. Alternatives do tend to share some general risks (i.e., liquidity, complexity, and some use of leverage)—but can potentially accomplish many different goals in a portfolio, depending on the specific attributes (i.e. improve return, reduce risk, improve diversification, enhance income).

That’s why we feel that alternative allocations need to match investor needs, the forward-looking macro-economic environment, and the specific strengths and weaknesses that each type of alternative (i.e., private equity, private credit, real assets and hedged/ alternative strategies) can bring to an existing portfolio. As with anything, you want the right tool for the job.

Alternative Investments—Different Functions, Different Risks

In our experience, the various types of alternatives are best suited to accomplish one “job” in a portfolio, and sometimes can accomplish a second “job” reasonably well but almost never check all the boxes.

Consider real estate. Private real estate directly ties a portfolio to what is happening in the real economy, and helps hedge against inflation, given lease agreements frequently have inflation clauses. This can be helpful in diversifying stock and bond exposures as a primary “job”, and can provide some income as a secondary “job”. As a result, they are often they are the first type of alternative that individuals consider when looking beyond equity and fixed income. However, over the long run stocks are likely to generate more capital growth than core real estate—so high growth is not generally the primary “job” of private real estate.

The hedged/alternative category, which encompasses a wide range of alpha-oriented approaches, can be particularly useful in seeking diversification and risk management. While some of these strategies may swing for the fences, the great majority seek to limit risk and deliver specific return goals by hedging positions in equities, fixed income, currencies and/or commodities. As a result, they’re not typically where you go to seek the kind of high-octane returns expected from private equity—which of course comes with high-octane equity risk.

Funding An Alternative Allocation

Funding an alternatives allocation from existing positions in a stock/bond portfolio means making prudent tradeoffs. For private equity investments, which have equity factors, it may make sense to draw assets from the existing stock allocation. Similarly, existing credit holdings are a natural place to fund private credit.

Real estate has both growth, interest rate and inflation characteristics—so funding for it usually comes from both equities and fixed income, not one or the other.

Of course, there are nuances within each type. Private equity includes venture capital, growth and buyouts. Private credit incorporates senior direct lending and mezzanine capital. And real assets represent more than core real estate—e.g., timberland, farmland, infrastructure, and commodities.

The relative illiquidity of private credit and private equity can easily lead to a misperception that these assets demand ongoing funding support from other parts of a diversified portfolio over time.

It’s true that thanks to capital calls, private portfolios typically do require additional liquidity during a “build phase”, but in most market environments, mature portfolios tend to give back more cash than they demand. Experienced managers of these strategies generally employ pacing models to estimate what can be realistically deployed and accessed each year, subject to a defined margin for error.

Practical Considerations

Alternatives have delivered attractive risk-adjusted returns over the last 20 years, as shown in the chart below. However, index-level data have limitations that inhibit its value in guiding allocation decisions.

Exhibit: Historical Performance vs. Risk

It’s essential to recognize that many alternative indexes are comprised of actual managers, not market-cap-weighted holdings. The dispersion of returns among these managers tends to be much wider than stocks or bonds. The reality is that manager selection is hugely important in alternatives, far more than in traditional asset classes, and the return of the index may be far off from the return of any specific manager.

In addition, the data used to build indexes for private equity and private credit have issues that make it less representative and limit its utility. These indexes are generally comprised of manager peer groups with data quality concerns; common biases that result in these indices include selection bias, survivorship bias and appraisal bias.

It’s usually preferable to compare alternative managers to a traditional mix of public assets that represents the opportunity cost to investing in private markets (e.g., the return one otherwise could have had at a similar risk level), such as public market equivalents (PMEs) and reference portfolios.

The Reality of Expanded Choice

Many advisors and their clients continue to assume that private markets require large ticket sizes with complex agreements and fees.

The reality, however, is that an ongoing “democratization” of private assets is now underway, through non-traditional market vehicles that feature greater liquidity (via quarterly redemptions) and also open the segment to generally accredited investors—individuals generally with a net worth between US$1 million and US$5 million who don’t fall into the qualified purchaser category for private funds. Examples include publicly offered closed-end funds that are not exchange-traded, REITs and business development companies (BDCs).

We expect that this asset class will continue to expand as these options proliferate and more investors recognize the value that alternatives can confer on a portfolio.

Exhibit: The Rise of “Non-traded” Vehicles

This article was contributed by Franklin Templeton Investment Solutions.

This publication is for information only and does not constitute investment advice or a recommendation and was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. Please refer to the website for Important Information.

Copyright© 2022 Franklin Templeton. All rights reserved. Issued by Templeton Asset Management Ltd, Registration Number (UEN) 199205211E, and Legg Mason Asset Management Singapore Pte. Limited, Registration Number (UEN) 200007942R. Legg Mason Asset Management Singapore Pte. Limited is an indirect wholly owned subsidiary of Franklin Resources, Inc.

The post Alternative Investments: Finding The Right Tool For The Job appeared first on DollarsAndSense.sg.