Over the course of the last two decades, alternative investments, or more specifically, alternatives to the traditional asset classes of public stocks and bonds, has become an increasingly common way to allocate capital. While these alternatives are far more mainstream than before, the term is a bit of a catch-all—the phrase “alternative investing” is used to describe an ever-increasing landscape of investments. There are numerous types of alternative investments, too many to enumerate here, but it might be a worthwhile exercise to discuss this growing category.
First, one should recognize that even in the world of alternative investing, by far the most common financial assets for investment are stocks and bonds—but with an important distinction: in many cases, unlike public stocks and bonds traded on exchanges or between broker-dealers, these are investments in private instruments. There is no readily visible market or exchange for transacting in these assets. Investments in private stocks, commonly known as “private equity,” or private bonds, also known as “private credit” in industry parlance, constitute a large part of alternative investing.
This lack of a liquid market creates lots of extra work for investors in alternatives—investment managers must work harder to find, price, and buy or sell investments. There’s an added element of risk created by the lack of liquidity in the private markets. The good news is this illiquidity risk is a driver of returns that is not present in the public markets. Investors earn a premium for giving up public market liquidity.
Normally, investments in private equity and private credit require an investment horizon of at least ten years. This is another element of illiquidity for which investors can demand a premium over public-market returns.
Besides the illiquidity premium that investors can earn in private investing is another premium—an information premium. While prices and information in public markets are readily available, prices and information about private companies are more difficult to ascertain. While private investments have seen oceans of capital flow into the alternatives universe over the years, the private markets are always going to be less efficient than public markets. Hence, the same lack of transparency that creates a risk premium for private investments is also an additional dimension for investment returns.
The private markets are larger than the public markets, so while information is less available, theoretically the opportunity set is larger. In part, this has been driven by the private market’s own success; there are fewer public companies in the US than there were two decades ago. In the late 1990s, there were more than 8,000 publicly trade companies in the United States. As of last August, there were only 6,300, which is actually an increase from a decade ago, when the number of public companies dipped below 5,000. Also, the private sector skews toward growth companies, which often require owners willing to wait years before profits, if any, emerge. This skew toward growth has also been attractive to investors willing to take on a certain amount of risk.
Besides private equity and private credit, another large category within alternatives is the hedge fund universe. Hedge funds commonly invest in publicly traded securities but engage in a multitude of investments and trading strategies such as equity long/short, global macro, and convertible arbitrage. There are many others. Generally speaking, hedge funds require that investors commit capital for various pre-determined periods of time.
While certain hedge fund returns can be eye-popping (both positively and negatively, often due to leverage), perhaps the largest benefit to many investors is the role that hedge funds can play in managing portfolio volatility.
Lastly, the other extremely large category with the alternative investment universe is real assets—investments in precious metals, commodities, infrastructure, real estate, and other land and natural resources. Investment in real assets can also be illiquid and may utilize leverage, but are often seen as a hedge against inflation.
Each of these three subcategories of alternative investments has its own risk and return characteristics, and within each category are myriad strategies and risks. The upshot, however, is that by allocating a portion of total assets to alternative investments, a qualified investor might be able to achieve a more broadly diversified portfolio and boost overall returns while lowering volatility. This is what has been driving demand for alternative investments.
In summary, qualified investors with long-term investment horizons could theoretically benefit from an allocation to alternatives. Private equity, private credit, venture capital, hedge funds and real assets each represent a different risk/return profile that can be used in conjunction with traditional stocks and bonds to create suitable, well-diversified portfolios.
This communication is for informational purposes only and should not be used for any other purpose, as it does not constitute a recommendation or solicitation of the purchase or sale of any security or of any investment services. Some information referenced in this memo is generated by independent, third parties that are believed but not guaranteed to be reliable. Opinions expressed herein are subject to change without notice. These materials are not intended to be tax or legal advice, and readers are encouraged to consult with their own legal, tax, and investment advisors before implementing any financial strategy.