Myths Of Alternative Investments | Seeking Alpha

Transcript

Devin Ekberg, Senior Consultant, Advisor Education: My name is Devin Ekberg from the PIMCO Advisor Education Team. I’m here to talk about a very important topic of alternative investments. Now there’s a lot of interest, and innovation, and opportunities for advisors to add significant value to their client’s portfolio in this investment space. There are also a lot of misperceptions about alternatives. And I’m here to address two in particular.

The first misperception is that alternative investments are only for institutions or only the top 1 percent. We’re also going to address whether or not alternatives are just too risky.

So let’s talk about institutions.

Devin Ekberg: Now it’s actually true that institutions have been investing in alternative investments for the last several decades. Institutions like endowments, and foundations, and pension funds.

The most famous example is the Yale endowment model. Now Yale has allocated almost 70 percent of their portfolios to some form of alternative investments over the years.

And when you ask them why, they give you a lot of reasons. One of the biggest reasons is that their expectations for future returns in the traditional markets like stocks and bonds are a little bit less optimistic.

They think that the opportunities maybe lie in some of the alternative investments like private equity, private credit, and real assets. And they’ve certainly allocated to those investments over the year in anticipation of potentially higher returns.

Also what they’ve noticed is that the correlations between traditional asset classes like stocks and bonds have largely started to become more positive. Now that for diversification purposes is a little bit challenging when you’re seeing correlations rise amongst traditional asset classes.

In this particular chart, you can see 10-year rolling correlations increasing over the last several decades, and might continue to increase as well. I also want to point out that in the periods during the ’60s and ’70s when we were experiencing high inflation, those correlations tended to be highly positive as well between stocks and bonds. And that may be a situation that we may be headed for in the future, at least to some degree institutions are predicting.

Devin Ekberg: Now there is a case for continued outperformance in some of these areas like private equity, private credit, and real assets.

One is that asset managers actually have an opportunity to add what I would call active alpha at a security level. In other words, they have an opportunity to construct an investment with the issuers to give it the best chance of success, aligning their objectives with the asset managers, and maybe providing some expertise and knowledge in some of those areas to produce the best result.

Secondly, there is an information asymmetry involved in some of these private markets and alternatives. Some of that information can actually be helpful to make the case for outperformance. And then thirdly, the opportunity set for alternative investments is typically broader and deeper. You simply have access to other types of investments that are not available in the traditional markets and traditional public markets.

Now individual investors are starting to see some of the benefits of this type of investing.

And they’re indicating that they intend to allocate more to these types of investments. So in areas again of private equity, private credit, real estate, and others, these individual investors, high net worth and other affluent investors, are indicating their interest in this area.

Also, some of the barriers and friction that individual investors have experienced in these areas are starting to be removed.

Traditionally in alternative investments and especially private markets, you had to deal with things like capital calls, dealing with situations of cash drag and illiquidity. There may have been complicated tax forms like K-1s that they had to deal with.

Often times they weren’t eligible to be inside their IRA or other ERISA covered accounts. And really, regulatorily speaking, they really didn’t have as many investor protections for these types of investments. Now, this led to a lot of practical problems for individual investors to involve. But as the market has evolved, we’ve seen these practical problems being removed. And we’ve seen the adoption of other technology and products, things like advisor platforms and next-generation structures with liquidity.

We’re seeing 1099 tax treatment, which is a little bit more favorable. And we’re ultimately seeing some of the minimums come down to a smaller degree. All of those things are increasing the interestof these high net worth investors to alternative investments in their portfolio.

Which leads me to the second misperception, which is alternatives are just simply too risky.

Now it’s true that some alternatives may have a higher risk profile than some of the traditional investments. And it’s also true that the manager dispersion of returns is much wider in the alternative space compared to traditional investments.

So it’s that much more important to find a top-quartile manager, or an effective manager. If you find a bottom-quartile manager, you’re simply going to have a worse experience. So it’s important to do your due diligence and align yourself with a good manager, much more so than it is in traditional markets.

But it’s always important to analyze risk, not just at an individual security level but in the context of an entire portfolio.

And some of the historical data has suggested that an allocation to alternative investments, along with other traditional investments in a portfolio, can cause the portfolio to achieve potentially higher returns at a lower potential risk. That causes an upward left shift in the efficient frontier, which is what a lot of portfolio managers are looking for. So it’s always important to analyze the risk of a security or an investment in the context of an overall portfolio.

Now it’s also true that alternative investments may come with additional risks on top of traditional investments, things like regulatory risk. These markets are simply not as regulated and don’t offer as many investor protections as some of the traditional markets. There may be significant liquidity risk. There may be, as we mentioned, information risk, which can be an opportunity but can also certainly be a risk as well.

We may end up with additional operational risks if an asset manager is not set up properly to deal with some of the operational issues in investing in these types of securities. And also manager risks among others as well.

Devin Ekberg: Now we hope we’ve cleared up some of the misperceptions about these types of investments. And we hope that it’s clear that we can potentially add value by meeting other multiple investment needs within the portfolio.

We hope that we can achieve more income potential through things like private credit and real assets.

We also hope to overcome maybe some of the higher correlations in the traditional markets by adding a lower-correlated asset as a diversifying benefit to the portfolio. We hope that we can manage some of the downside risk associated with some of these securities and the portfolio in general. We hope to take advantage of an expanded opportunity set just beyond the traditional public markets. And we hope that we can create better liquidity matching to different time horizons within an investor’s portfolio.

Disclosure

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

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