Improving access for high net worth investors.
What do farmland, timberland and office buildings have in common with traditional financial markets? Not much, hopefully. These are known in the financial world as alternative assets. Traditionally used by big pension funds to diversify their overall portfolios, private alternative assets – and the income generated from their daily operations – can play an important role because they tend to offset losses from traditional asset classes and provide additional yield.
Today’s low-yield debt environment may inspire accredited investors to consider alternative assets as a sustainable source of income. In the past, alternative strategies have required a large initial investment with long lock-up periods, which made it more difficult and more expensive for high net worth investors to participate. But times are changing, and it’s becoming easier for accredited investors to get involved.
With the ongoing democratization of finance, strategies are available that can give high net worth individuals and smaller institutions exposure to the benefits of alternative assets previously available only to the very largest players in the space.
Breaking down barriers
Diversifying into alternative assets may have been challenging due to the capital required. A high net worth investor considering assets in the alternative space might have achieved only narrow exposure. With limited capital, the barriers to investing in several asset classes could be too high to overcome, forcing the investor to pick only one when a combination would be beneficial for the portfolio.
For example, commonly, investors hold some U.S. equity in their portfolio. As the chart above shows, if they were to add exposure to public U.S. real estate, these holdings had a positive correlation of 0.68 to U.S. equity, which is not ideal. If the same investor were able to gain exposure to all five alternatives in the chart, however, and allocated 5 per cent of their portfolio to each of private U.S. real estate, farmland, timberland, infrastructure and private equity, the efficient frontier of the portfolio would be greatly improved. This means a better potential return for the same amount of risk, or reduced risk for the same level of expected returns. Shown below is an illustration of the efficient frontier with and without alternatives.
Up until recently, this illustration would have been purely academic for high net worth investors because capital requirements and liquidity concerns limited access to private alternatives. But some products are changing the alternative landscape.
Smaller investors deserve diversification
Open-ended products have come to market that allow high net worth and smaller fund managers access to the alternative space. But traditionally, these mandates have to hold the physical assets in order to benefit from the potential returns. So, what does this mean when it comes to lock-ups and minimum investments?
Historically, private alternative asset funds have been structured as closed-end funds. In a closed-end fund, an investor’s capital is locked up until the fund terminates or liquidates, and new investors are not able to participate after the initial offering. Managing the funds this way was considered necessary because of the “J-curve” effect.
The J-curve, shown below, is a graphical representation of the time required for a young portfolio of companies to become profitable in the alternative investment space, particularly in private equity. Young portfolio companies may not be profitable for several years, meaning unrealized returns to end investors are lower (and even negative) early on, before they ramp up. Fees on capital committed but not yet deployed also contribute to the J-curve effect by reducing returns in the early years.
With an open-ended fund, early redemptions can make it difficult to deploy capital effectively. But both of these factors – young investments and fees – can be managed within an open-ended fund structure and, therefore, the J-curve effect can be diminished.
One solution is for an open-ended fund to mix brownfield assets (profitable and generating income, but with less capital appreciation potential) and greenfield assets (not yet profitable or income generating, but with significant potential for capital appreciation). New entrants into the fund could benefit from the stable portfolio of investments in private companies, farms, bridges or office buildings, while freshly committed capital could be used to invest in new assets.
A portfolio can be constructed with roughly 70 per cent committed to private assets – such as farmland, timber and infrastructure – and 30 per cent allocated to publicly traded investments – such as listed REITs, energy and commodity stocks. The fund could provide the long-term capital appreciation found in the private alternative space, while maintaining the transparency and liquidity Canadian high net worth investors require.
Moreover, alternative assets may not be profitable for several years, and high net worth investors may have shorter-term obligations to meet with their capital. An open-ended fund of funds with a mixture of public and private assets could help meet the liquidity concerns of accredited investors.
The quest for yield
With bond yields across the world near record lows, it’s all the more important for small institutional managers and high net worth individuals to have access to alternatives to traditional fixed income investments.
Larger pension funds have extensive lines of credit and significant assets that enable them to navigate the long-term capital lock-ups and high initial investment required to enter the alternative space. In 2020, only 20 per cent of Canadian pension plans with assets valued under $500 million had exposure to the alternative space. Meanwhile, more than 35 per cent of plans above $500 million included alternative assets in their portfolios.
Without alternatives, smaller managers may have to assume more risk in the portfolio to generate the same returns as fund managers with access. The ongoing democratization of finance seems to be answering the demands of these investors with new fund structures that can provide access to a variety of alternative assets.
New structures, new solutions
The existence of alternative investments is undoubtedly a good thing for the financial community at large, but until recently, their benefits have been available only to the largest investors. Going forward, accredited investors and smaller institutions could seriously consider new structures that don’t require large investment minimums but can provide the same diversification and returns benefits that larger investors enjoy. For more information and insights on alternative asset solutions, visit Manulife.ca/mraif.