As public markets fluctuate wildly from China to Europe to Wall Street, consider the appeal of alternative asset managers, including private equity, venture capital, hedge funds, REITs, commodities, infrastructure and other asset classes. But, before you make an investment, there are several important questions you should ask.
But compared to past decades, alternative managers in the 21st century face steep hurdles to provide alpha -- risk-adjusted relative performance - for investors. When considering alternatives, investors should carefully consider how exactly these asset classes add value, whether they still do, and whether they have potential to do so in the future.
The second half of the 20th century was of great importance in the history of global investment management, as alternative asset classes and independent managers produced sophisticated, innovative products, and attracted a great number of clients, often at significantly higher fees than before. Many firms produced great rewards for investors and managers alike.
However, the long investment history indicates that it is probably not possible to devise a single superior investment technique that works era after era. Like so many important innovations in the history of investment and investment management, competition and changing market conditions moderate high performance rates.
The savviest investors ask themselves a few important questions when it comes to alternative investments. Consider the following:
Are you getting a premium if there is illiquidity?
Alternative investments are often less liquid than a traditional asset class: stocks, bonds and cash. When institutional investors like Yale University's endowment and the Oregon Investment Council began to move into less liquid alternatives in the 1980s, they found that these strategies offered an enormous premium for their relative illiquidity. In exchange for parking their assets in these vehicles, investors could receive sizable incremental returns.
However, this characteristic of alternative investments is no longer guaranteed. The institutionalization of private equity, venture capital and other alternative investments means that illiquidity, in and of itself, no longer necessarily generates stronger returns.
When it comes to liquidity, there is no silver bullet; an investor should not be either liquid or illiquid, as such. A given market participant should instead be aware of how much he or she needs liquidity, how much it costs, and how much it will return in a given investment scenario.
Are the fees worth it?
The standard fee structure for the alternatives market is known commonly as "2-and-20": managers often charge 2% of assets under management as a management fee and 20% of profits generated by their investments as a performance fee. A.W. Jones, the creator of the first hedge fund, charged his clients this based on the fees charged by ancient Phoenician ship captains for profits on successful journeys.
But that was in 1949, and in some ways the 2-and-20 fee structure is a holdover from a different age. Assets under management in hedge funds and other alternative vehicles have grown immensely over the past several decades -- far more than Jones could have imagined in the 1940s when he created what would become the norm. Even in the mid-1960s, total hedge fund assets numbered in the hundreds of millions, a far cry from the $2.5 trillion under management in 2014.
The standard fee structure also means that performance fees are almost always paid on return, not alpha -- the value that a manager has added through investment management talent.
But high fees alone should not concern investors. That a manager receives a hefty fee is not an issue if the manager has produced prodigiously superior returns. But it is exceedingly difficult to achieve vastly superior risk-adjusted returns from one source over long periods. Investors shouldn't expect that their managers would generate alpha every single year, but over time, the manager should be expected to "earn his keep" or be fired.
What kind of alternatives should you be looking for?
The future of alternative assets likely includes the creation of new asset classes. This is particularly true for institutional investors, who have often seized upon exotic asset classes to generate returns. These novel forms of risk tend to bear low correlations with traditional investments, and have included such disparate things as timber, songwriter royalties and catastrophe bonds. Alternatives as we know them today, including private equity, venture capital, hedge funds and other vehicles, were once truly exotic in their own right.
These well-known alternatives are likely to stay in the investment landscape for the foreseeable future. Many managers will generate significant returns for investors, and evidence suggests that the era of vast earnings by top investment managers, while likely to moderate over time, is unlikely to disappear completely.
At the end of the day, the next generation of financial innovations will likely take the spotlight. The next generation may come from niche corners of the market, like algorithmic trading, commodities strategies or real assets - or they may involve a holistic approach like the endowment-style or multi-strategy firm. Only time will tell what financial innovations the future holds.