Asset managers and financial advisors can address concerns about low returns from traditional asset classes by diversifying into alternative investments.
Alternative investments could deliver better returns at lower risk by introducing greater choice to their client portfolios. Investing in alternative asset classes is not easy – it will take a great deal of work both on your part and that of asset managers to make appropriate solutions widely available – but it is worth pursuing.
Historical review of returns
The last decade has been good for global equities, with Japan, the worst performing part of the world, delivering 8.4% per annum since 2009. Over the same period equities in the US (13.5% per annum), Eurozone (9.5%), UK (8.8%) and emerging markets (9.9%) rewarded investors with substantial inflation-beating returns. This equity return bonanza is unlikely to be repeated over the next decade.
In every case, except perhaps for emerging markets, we expect annual returns from equity to be between 4% and 7% lower per annum. A similar situation exhibits in the global market for government bonds. Schroders expects the prevailing government bonds in each of these regions to deliver poorer returns over the next 10 years than those achieved in the preceding decade.
There are many factors to consider when diversifying client portfolios away from traditional assets towards alternative assets, including regulation (South Africa’s retirement fund industry must comply with Regulation 28, which sets strict caps for exposure to certain asset classes), appetite for risk and achieving the appropriate blend of alternative assets. There are different ways in which you can blend alternative assets and different benefits to be derived from them.
The alternative investment landscape
There are three broad categories in the alternative investment landscape, namely equity (private equity, venture capital, infrastructure and real estate), debt and absolute return.
Local financial advisors and their clients are turning to private equity opportunities because this is often the only way to access certain industries or companies. Another compelling reason to consider the private equity route is the dearth of quality opportunities on our country’s stock exchange. Since 1994 the number of domestic listed companies on the JSE has halved from 600 to 300 – which means there are fewer opportunities to invest in attractive growth industries than there used to be.
The private equity investment trend has accelerated due to the myriad start-ups – often tech disruptors – that cannot source capital from traditional equity markets. And we now see innovators such as ride-sharing firm Uber being brought to traditional markets much later than previously. The only way for asset managers and investors to benefit from these exponential growth opportunities is through rounds of venture capital and/or private equity funding. To illustrate, Ant Financial, an affiliate of the Chinese Alibaba Group, raised US$18 billion in its private form, something that would have been inconceivable a decade ago.
Private equity has the clearest positive return pattern of any of the alternative asset classes, outperforming the S&P 500 Index by 2-3% over long periods of time.
Private equity investors know a lot more about what is going on inside a firm than they would when buying through a stock exchange. Investors can influence what management does and create management incentives that are geared towards long-term value maximisation. The executive teams at private equity firms are also ‘freed up’ to focus on multi-year business plans rather than obsessing over the next quarterly performance numbers.
Asset managers need their wits about them in the riskier world of venture capital. Part of the risk is due to investments being made much earlier in a company’s life cycle. But there are many other reasons to proceed cautiously. The return variation between the top quartile and bottom quartile venture capital fund is in the order of 15% per annum, so the choice of who is running your fund is of extreme importance. As many as six in 10 firms that source funding from the venture capital market fail, so investors must aggressively diversify these portfolios. As soon as you have 10 or more companies in your portfolio you will benefit from a reduction in risk – and an overall risk profile that is not far off that of the listed stock market.
How can financial advisors steer their clients into alternative investments?
Both advisors and asset managers have a responsibility to advise and educate clients on how these new asset classes work within the regulatory environment. The best minds in the asset management industry are developing new investment vehicles that address problems like complexity, investment size, liquidity, valuation and fees. To date, the preferred solution is through listed vehicles that offer exposure to underlying alternative investments.
Gavin Ralston is head of official institutions and thought leadership at Schroders.