Effective diversification. Alternative investments open up opportunities.
Are there any alternatives to equities for ultra-high net worth investors in the low interest rate environment? The answer is: yes – alternative investments. Yet many are still hesitant, since alternative forms of investment are fraught with numerous myths. Find out why high net worth investors can benefit from this asset class and optimize the diversification of their portfolio.
Alternative investments are fraught with myths
Well-diversified asset allocation is the key to long-term investment success. In the current low interest rate environment, however, many ultra-high net worth investors are questioning what they should invest in, if not in equities? As such, both institutional and private investors are increasingly turning to alternative investments – such as hedge funds and private equity, real estate, and commodities. Despite the growing popularity, there are persistent myths that surround alternative investments.
Myth 1: Alternative investments are only suitable for institutional investors
Institutional investors are increasingly investing in alternative investments. They contribute to the attainment of the desired return objectives as well as risk diversification in portfolios. The benefits of alternative investments have not been lost on private investors, but in the past, it was difficult for them to access this asset class. However, in recent years the entry barriers have been lowered significantly, and a number of funds of funds now offer private investors the opportunity to gain exposure to this asset class with even a small investment sum.
Myth 2: The illiquidity of alternative investments has a disadvantageous impact
When it comes to investments such as private equity or hedge funds, it is true that investors are bound longer than they would be for traditional investments. But the illiquidity of certain alternative investments also gives investors potential added value. That's because they are likely to receive additional yields in the form of a liquidity premium in return for assuming the illiquidity risk. This liquidity premium can actually be measured, and for private equity and direct real estate investments is estimated to work out at around 3 percent p.a. as a long-term average.1 But alternative investments that do not offer short-term liquidity can also be advantageous on strategic grounds. The "forced" long-term investment horizon protects investors from poor decision-making based on emotions – such as the panic-selling phenomenon that can accompany a temporary market correction.
Myth 3: Alternative forms of investment are risky
Viewed separately, alternative strategies often have a higher risk profile than traditional investments. But, in the case of alternative investments as well, there are more stable strategies and more risky strategies. Carefully selected alternative investments therefore make perfect logical sense in an overall portfolio. On the one hand, they enable investors to tap into new sources of return, while on the other they facilitate the wider diversification and reduction of risks in the overall portfolio. Alternative investments typically have little correlation with equities and bonds, thus improving the risk/reward ratio of the portfolio.
Myth 4: Alternative investments are overpriced
The cost of alternative investments typically exceed those of conventional investments. But these high costs can be justified by complex investment processes. The Cambridge Associates Buyout & Growth Equity Index has outperformed both the S&P 500 and the MSCI World over various time horizons. That's why it's key to choose fund managers that justify their costs over the long term with above-average net returns.
Myth 5: The universe of alternative investments is opaque and inaccessible
It is often very difficult for private investors to gain a clear picture of the diversity of alternative investments single-handedly. A critical, comprehensive, and ongoing review of fund managers is a crucial success factor when selecting best-in-class solutions in the area of alternative investments. This selection is time-consuming, and successful due diligence requires in-depth expert knowledge and resources, which is why it is all the more important to seek the support of specialists with many years of experience behind them.
Enhance your portfolio with alternative investments
In the current prevailing market situation, alternative investments can make a valuable contribution to a robust portfolio. The five alternative forms of investment below act as drivers of returns and diversification in the portfolio.
The private equity sector is gaining ground. Assets under management are expected to increase to USD 5.8 trillion by the end of 2025. This compares to just USD 4.5 trillion invested in private equity at the end of 2019.2 Ultra-high net worth investors have a choice between direct investments, single-manager funds, and funds of funds.
- Direct investments in unlisted companies offer benefits such as a frequently shorter holding period than single-manager funds, as well as potentially lower fees. Due to the high minimum investment sums involved, however, concentration risks can quickly arise. Accordingly, direct investments are typically only appropriate for very large, broadly diversified.
- Single-manager funds typically have a term of ten years and invest in a dozen or more portfolio companies over a period of two to five years. They offer a certain degree of diversification and are particularly suitable for investors who want to make theme-based strategic investments.
- Funds of funds are pooled investment vehicles that invest in a number of different single-manager funds. Thanks to long-standing relationships with private equity houses, funds of funds receive preferred access to otherwise inaccessible fund managers and can negotiate favorable terms. They are therefore suitable for investors who want to be very broadly diversified and thereby expose themselves to lower risks in the private equity segment.
Yield alternatives seek to make new sources of promising return accessible in the fixed income area, while at the same time contributing to the diversification of a portfolio. These strategies typically exhibit a low correlation with the traditional markets of equities and bonds, which makes them an important diversification element for a portfolio.
Hedge funds are typically characterized by very active portfolio management and the use of a wide range of different strategies, which allow these funds to participate in both rising and falling markets. Particularly in falling markets, an investment in hedge funds can have an advantageous impact on the portfolio return.
Prices for commodities such as oil or metals often have different price drivers to equities, and often perform better than traditional investments in periods of increased inflation. Accordingly, commodities can act as a portfolio hedge against a rise in inflation.
Real estate continues to offer an attractive yield premium over government bonds. However, Swiss real estate funds with a residential investment focus have now climbed to particularly giddy price levels. The equities of real estate companies are now also trading at significantly above-average premiums. The risks that arise from inflated valuations of this kind should be carefully considered before any investment, and a strong case could be made for Swiss investors opting for diversification in the form of international real estate.
1Source: Robert S. Harris, Tim Jenkinson und Steven N. Kaplan: «Private Equity Performance: What Do We Know?», SSRN, April 2013.)
2Source: Deloitte, The growing private equity market. Date: November 2020.