Are Alternative Assets Still The Place For Smart Money?
Alternative investments—once the exclusive realm of institutional and ultra-high-net-worth investors—have been gaining ground with retail clients. Because they are considered to be uncorrelated with mainstream markets or interest rates, supporters say these unlisted and largely unregulated assets offer improved diversification and outsize long-term returns, along with the allure of exclusivity.
A recent Cerulli survey of advisors working with affluent clients (with net worth exceeding $5 million) found their allocations to alternative assets were expected to rise from 7.7% in 2020 to 9.1% in 2024. Growth opportunities and portfolio diversification were the top reasons, each cited by 50% of advisors responding, for the move.
But lately, some experts have begun to rethink where, when, how, and even if these esoteric investments are appropriate. At last year’s Schwab Impact conference in November, advisor attendees were overwhelmed with the number of sponsors seeking to persuade them to expand their alternative allocations.
Veteran advisors recall seeing this movie before. After the Great Recession laid waste to stocks and bonds in 2008 and 2009, many institutional consultants predicted hedge funds and private equity would provide safe havens for the next decade. Instead, central banks embraced near-zero-interest rate policies that produced one of history’s great bull markets for equities and fixed-income securities, while alternatives struggled.
“There isn’t a lot of evidence to suggest that individual investors have benefited from alts,” says Michael Finke, the Frank M. Engle chair of economic security at the American College of Financial Services in King of Prussia, Pa. Many of these assets “are simply expensive proxies for the overall market, and the ones that offer potential diversification benefits are often too expensive to improve Sharpe ratios,” he adds, referring to measures of comparative performance adjusted for risk.
A Broad Category
Nonetheless, it would be foolish to classify all alternative investments with the same brush. As a category, they comprise a broad variety of assets that aren’t publicly traded. These include private equity; private debt; distressed debt; growth capital; hedge funds; managed futures; certain commodities; derivatives; real estate; tangible assets such as antiques and art; and, yes, cryptocurrencies.
“The alternative investment space is incredibly broad,” says Bob Shea, chief investment strategist at Dynasty Financial Partners, an independent RIA network based in St. Petersburg, Fla.
Many of these investments were until recently only available to institutional investors and those deemed by the SEC as accredited investors, people whose wealth allows them to invest in more sophisticated securities. Thus, many of these vehicles have enjoyed a bit more freedom from governmental oversight.
A ‘Regime Change’ In Financial Markets
It’s hard to tell what the current economic environment will mean for alternatives. A few years ago, the world economy was suffering from deflation, depressing returns for many non-financial assets. But things changed with the return of steep inflation in 2021. Shea argues that we are in the early stages of a “regime change,” when the global central banks will switch from quantitative easing (which results in low interest rates and tight credit spreads) to global quantitative tightening (leading to high interest rates and widening credit spreads).
What that means for alternatives is complex. “I see opportunities in most all of these alternative buckets,” says Shea. “However, we need to be very selective.”
Private Credit Markets
Take private credit markets, which are made up of higher yielding, illiquid corporate bonds and other debt instruments. Shea emphatically dislikes some of those issues, especially those underwritten in the past couple of years and specifically 2021, he says. But he’s enthusiastic about the financing underwritten since then. “I love the opportunity,” he says of this niche.
His reasons are mostly proprietary. “The ability to shape an investment portfolio towards our advisors’ view of the world is something our teams use to differentiate themselves and their practices,” he says.
Nevertheless, Shea allows that the changes in inflation and quantitative tightening “will create more opportunities for the alt space versus traditional asset classes.” Over the past year, the private credit market has expanded dramatically, and big players like Fidelity and JP Morgan have rolled out their own products. With plain-vanilla, fixed-income securities offering competitive yields for the first time in a decade, how the competition between these two markets plays out will be intriguing.
The REIT Quandary
Many alt investors were taken aback in early December 2022 when both New York-based Blackstone Group and Miami Beach, Fla.-based Starwood Capital “gated” redemptions of their private real estate funds after confronting outsize withdrawal requests from investors. These nontraded funds offered limited liquidity of 2% a month and 5% a quarter. That structure was part of the reason they had been considered the gold standard in the real estate space, yet shareholders who wanted to redeem some of their money back suddenly found themselves in a line.
Established in 2017, the Blackstone Real Estate Income Trust (BREIT), a nonlisted real estate investment trust (REIT) that focuses on generating income primarily through investments in residential and commercial real estate and, to a lesser extent, real estate debt instruments, has realized 12.7% net annualized returns since inception, and is currently valued at $68 billion as of November 30, 2022, according to its website.
But when total monthly withdrawals surpassed 2% of its net asset value and 5% for the entire fourth quarter, it had to begin limiting redemptions, according to statements from Blackstone CEO Stephen Schwarzman, reported by Reuters and elsewhere.
Supporters say gating redemptions is a necessary safety mechanism, not a sign of trouble, as it protects investors against forced asset sales. Help arrived for the Blackstone vehicle in early January 2023, when the University of California bought $4 billion worth of common shares in BREIT, pledging to hold its shares for at least six years. It was a shot in the arm for Blackstone, which had lost roughly 13% of its share value since limiting withdrawals—and, indeed, for much of the alt investments category as a whole.
But Blackstone, believed to be the nation’s largest owner of real estate, also is one of the world’s largest manager of alternatives. That the University of California’s pension fund was able to extract favorable concessions says something.
Some are wondering if the Blackstone-Starwood affair was a canary in the coal mine. Blackstone isn’t alone. In January, Bloomberg reported that a group of institutional investors were cutting their exposure and had asked to withdraw some $20 billion from their real estate investments last year, including assets managed by firms like JPMorgan and Morgan Stanley. That is thought to be the highest amount of invested institutional money signaling it wants to dump real estate since the financial crisis.
Expectations of more real estate problems in 2023, particularly in the pandemic-battered commercial office sector, is likely to excite another group of alternative investors. Those focused on distressed debt have been waiting since the Great Recession for a chance to pounce and squeeze original backers, massively diluting investors in earlier rounds and reaping big benefits in the process.
‘Not An Asset-Class-Wide Problem’
Michael Moriarty is the chief investment officer at Wealthspire Advisors in New York City. He affirms that you shouldn’t judge all private REIT funds by the Blackstone-Starwood examples.
“There are many institutional quality private REITs in the market, and those are the only two I am aware of which have suspended [redemptions], so this is not likely an asset-class-wide problem,” Moriarty says, adding that he still likes private real estate. Its underlying assets “should provide positive lift with inflation,” he notes.
Moreover, investors in illiquid, private real estate are likely to enjoy more opportunities to exit these investments. Yoonify, a San Diego-based fintech startup, is building a blockchain-enabled, electronic exchange for private investments, and other software companies are expected to create similar exchanges this year.
However, Moriarty sees problems in other alt categories, specifically private equity. These firms typically rely on debt to fund their acquisitions, and high interest rates increase the cost of that debt.
A giant shadow banking system has sprung up since the 2008 financial crisis, and it has never faced the challenge of a recession, except during the early days of the pandemic when massive government liquidity was abundant. “Existing dollars at work and previously committed may face headwinds in the near term,” he says.
Moriarty says that private credit, on the other hand, “showed its value in 2022” as a less interest-rate-sensitive fixed-income asset. That may change in 2023, though, “given the near-term recession prospects.”
On hedge funds, Moriarty is more circumspect. “The hedge fund strategies we would want to include in client portfolios are increasingly difficult to find,” he concedes. Many of the best managers have closed their funds.
Yet overall, Moriarty insists that alternatives “deserve consideration in most clients’ portfolios.” That’s true, he says, even though the relative value of traditional assets has improved.
“With yields significantly higher than a year ago and equity valuations lower, the bar to add alternative asset classes and the attendant operation considerations … is that much higher,” he says, referring to alts’ specialized tax filing requirements; illiquidity; and potential capital calls or drawdowns, in which investors essentially agree to make additional funds available if the need arises.
Wide Performance Spread
Inevitably, some alt assets will do better than others at different times. Although many advisors favor real estate over other asset classes because it generates income and is easily understood by clients, many proponents of alternatives advocate diversifying into multiple “strategies” to smooth out returns.
Among traditional publicly traded mutual funds, it’s common to find the performance of the majority of, say, large-cap growth funds clustered just below a benchmark like the S&P 500. With alternatives, the performance of funds with similar strategies frequently exhibits far more dispersion.
“It’s important to understand that there is a wider spread in performance between the best and worst alternative strategies than there is for stock and bond strategies,” says Jonathan Henshue, director of complementary strategies at Johnson Financial Group in Milwaukee. With alts, he says, “selecting top-performing strategies is of greater importance and requires a more extensive due diligence process.”
Jeff Nauta, a principal at Henrickson Nauta Wealth Advisors in Grand Rapids, Mich., currently favors alts that have a “risk premium or [that] require operational expertise to execute,” he says, citing managed futures or particular private credit.
He acknowledges, however, that “bonds are now much more attractive compared to alternatives, given their increased yields.”
In A Bad Year For Stocks, Alts Shined
In 2022, amid market turmoil, many of those who favor alternative investments weren’t disappointed. “If I had not used them in the past year, I would not have mitigated the downside of my portfolios,” says Michelle Connell, CEO and CIO of Portia Capital Management in Dallas. “I still lost money, but I just didn’t lose nearly as much as my benchmarks!” She attributes part of her accounts’ outperformance to “not participating fully in the public marketplace and its roller-coaster ride of emotion.”
Other champions of the alts class point out the performance differences between the most illiquid, long-term alternative assets and the newer variety that emphasize a degree of liquidity and are chiefly aimed at individual investors. Implicitly, they are reasoning that traditional investors like pensions and ultra-wealthy families who have been willing to lock up funds for five or 10 years do so because they receive an illiquidity premium for doing so. Newfangled structures that attempt to appeal to the retail mass affluent may be sacrificing return for liquidity.
“We prefer investing in illiquid, closed-end fund structures that often avoid some of the potential drawbacks of more accessible structures,” says Dan Ziznewski, a principal at Homrich Berg, a fee-only RIA in Atlanta. “Many accessible alternatives may have additional and/or higher fees than traditional illiquid funds, such as sales loads or an additional layer of management fees.”
To maintain liquidity, many of these more liquid alternative investments also keep a portion of their portfolios available for redemption requests and occasionally sell off assets to meet those requests, though both of these measures cause a drag on performance, Ziznewski says.
Advisors also are taking steps to ease clients’ comfort with alts. Last October, Morton Wealth, an RIA in Calabasas, Calif., held a one-day meeting that allowed clients to speed-date with sponsors in small groups. According to its CEO, Jeff Sarti, Morton Wealth has been investing in private real estate since the 1980s and other private assets since the 1990s.
Real Estate
A large portion of advisors’ alt dollars is devoted to real estate. Jeffrey Kalapos, the director of investment services at Coastal Bridge Advisors, a firm located in Westport, Conn., calls real estate assets a “solid hedge against inflation.” The depreciation advantages of real estate offer tax advantages, as well, he says, and private real estate increases a portfolio’s diversification.
But others caution that real estate could feel the sting of higher interest rates. “We have adjusted our view on real estate to negative, to be more underweight the sector going into 2023,” says Nick Baron, senior investment specialist at Miami firm Brainvest Wealth Management. “Despite the sector’s attractive inflation sensitivity, interest rate hikes may pressure asset valuations downward.”
Some real estate backers zero in on particular subsectors. For instance, Edward Fernandez, president and CEO of 1031 Crowdfunding, a real estate investment platform in Irvine, Calif., is currently allocating a portion of his accounts to senior and assisted-living housing. “It’s directly tied to the baby boomers, who are aging and need these types of facilities,” he explains.
Infrastructure building also has some investors cautiously optimistic. “While the real estate sector is likely to continue to see volatility, other places, like infrastructure, continue to represent attractive opportunities,” says Steve Brennan, head of private wealth solutions at Hamilton Lane in Conshohocken, Pa.
‘The Hurdle Is Now Higher’
Of course, opinions can be as changeable as markets. Todd Jones, the CIO at Gratus Capital in Atlanta, concedes that changes in market conditions have altered his view of alt investments.
“The hurdle is now higher for increasing our allocation to alternative strategies,” he says. “If we can meet our financial-plan return goals with risk-free Treasurys or high-quality corporate or municipal bonds, then why incur higher costs and risk?”
Higher hurdle rates also mean that investments in traditional industrial projects with faster paybacks than long-duration assets like venture capital now appear more competitive. The next five years will tell us a lot.
