A Regime Shift
More institutional investors are adopting alternatives, and at an accelerated pace, aiming to diversify and offset the effects of inflation, interest rates and the volatile economy. They are turning to diversified alternative strategies — private equity and venture capital, private credit, hedge funds, real estate, commodities and infrastructure — that may involve more risk but can help meet their long-term total-return objectives.
“Public markets overall have been a great place to be invested for the last decade,” said Wylie Tollette, CFA, head of client investment solutions at Franklin Templeton Investment Solutions. “But our capital market expectations anticipate that public market returns will normalize over the next 10 years, while cash yields on fixed income, in particular, will remain low. The search for inflation protection is rapidly driving investor interest in private real estate and other real assets.” A recent Prequin survey showed institutional investors plan to increase their allocation across alternatives (see chart).
“Investors are increasingly using alternatives to achieve specific portfolio objectives such as to enhance returns, generate income or diversify core holdings” said Rupert Watts, CFA, CAIA, senior director of strategy indices at S&P Dow Jones Indices. “Obviously inflation has recently become a big concern. These high inflation rates are driving a lot of interest in infrastructure and other real assets indices.
“We’re seeing some very sizable regime shifts going on in the market,” said Russell Korgaonkar, chief investment officer of Man AHL, one of the systematic investment management businesses of Man Group. “People’s expectations for a 60/40 [stock/bond] portfolio are lower than they were 12 or 18 months ago. Investors are rightly questioning what the impact of inflation will be on their traditional assets and traditional portfolios. That theme has been building over the last six to 12 months.” He added that significant market volatility has increased the potential for downside risk. “We’re in a period of a great deal of uncertainty for markets [with] lots of forces pulling markets in different directions.”
While large pension plans in the U.S. and other countries have been availing of the attractive return streams offered by alternatives for some time, Korgaonkar said he expected the pace and scale of interest to grow going forward. “The outlook will continue to be one of closer engagements and probably an increase in sophistication on the pension fund side, with an acceptance of alternative return streams in the context of a more challenging investment environment.
Managing Inflation Risk
Alternatives can provide investors with inflation protection and higher yields than fixed income, particularly in the current environment of rising inflation.
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“We’re seeing inflation prints every month at the highest readings in decades,” said Jim Wiederhold, associate director of commodities and real assets at S&P DJI. “The cost of everything is going up, which means that central banks are trying to combat these high prices by hiking rates this year. Historically, during the first year of a rate-hiking cycle, returns of core investments tend to still be positive but much lower than their prior performance. So there’s a search for yield [that’s] higher than the rate of inflation, which is driving investors to go further out on the risk curve. And alternatives offer the opportunity for higher returns.”
“The reason many alternative asset classes are helpful in times of inflation is they often have inflation riders built into their income, rental or lease contracts,” said Tollette at Franklin Templeton. “If you’ve got an inflation rider built into your office lease or your warehouse lease that increases the regular income that you get off the building as inflation ramps up, that’s a kind of built-in component to help offset the impact of inflation. [It] presents reasonable alternative to fixed income in terms of managing inflation.”
The increase in inflation, which some market participants had hoped would settle down in recent months, has only accelerated, Korgaonkar said. “The outcome of the last couple of years of COVID has been this inflationary scenario that’s become a bit more entrenched than people first thought it would be. Geopolitical uncertainty only adds to that,” he noted. “So you’ve got this scenario in which yields are becoming challenged from that aspect, and investors are asking, What are my alternatives to equities and what are my alternatives to fixed income in my search for yield? And the answer, from our perspective, is either different strategies — that is, trading strategies that are more active and can navigate these scenarios or managed exposure to different asset classes like alternatives.” Man Solutions’ research shows the trend strategies of traditional and alternative assets across different inflationary regimes (see chart).
Read: The Best Strategies for Inflationary Times
Degrees of Liquidity
While lack of liquidity continues to be a concern for asset owners who are drawn to alternatives, asset managers say the degree of illiquidity differs widely based on asset type.
“Liquidity risk is an important consideration across all types of investments, including public market investments,” Tollette pointed out. “You have to really think about liquidity risk across all [parts] of your portfolio, but particularly when you’re investing in private markets and private market alternatives.”
Many investors recognize the challenges of investing in the less liquid strategies, but they need the associated extra diversification, yield and return often found with them, particularly in an environment of low expected yield and return with a shrinking pool of publicly-traded opportunities, said Mike Foley, head of U.S. institutional services at Franklin Templeton.
“We’ve been seeing significantly more demand for private, less liquid strategies, especially in the institutional market,” he said. “There are a couple of other factors that underpin this demand. When you look at the public markets, as an example, the number of U.S. public stocks is estimated to have declined by 50% over the past 20 years or so. There are also now approximately 23 times more private companies than public companies in the U.S. The investment options in the private markets have been expanding at a pretty rapid pace and present an increasing array of attractive investment opportunities,” Foley said.
“Investors are now more focused on downside risk,” said Korgaonkar at Man AHL. When building an investment portfolio, investors need to think about how it can cope across different market environments over the next 25 years, he said, noting that his team’s approach is focused on managing downside risk. “When we’re thinking about alternative strategies, we think about tail risk events in which markets can sell off dramatically, or when many assets sell off at the same time, or assets that previously seemed uncorrelated suddenly sell off at the same time. These are all problems for [investment] portfolios, and we’ve spent a long time looking at those kinds of environments, which allows us to navigate [through] them.”
Serving a Diversified Menu
Alternatives present a range of diversified strategies to reach for improved returns over traditional assets. Investors can use both active and passive approaches, with exposure across markets or in specific sectors.
Public and liquid alternatives offer a complementary aspect to existing portfolios by providing improved overall diversification and risk management, said Russell Korgaonkar, chief investment officer of Man AHL, one of the systematic investment management businesses of Man Group. Korgaonkar oversees a range of quantitative multi-asset strategies across hedge fund and long-only formats.
Given the current macro environment, investors seem to be most concerned with addressing large and unexpected risks, Korgaonkar said. “We’ve seen a big uptick in conversations over the last six to 12 months with institutional investors looking at ways to improve the tail behavior of portfolios,” he said. “Given the concern over inflation, investors are thinking about diversifying parts of their portfolio and about controlling the tail [risk]. It’s a conversation around trading capability and risk management from that perspective.”
S&P Dow Jones Indices’ liquid alternatives indexes give investors access to the benefits of alternative investing, including portfolio diversification, while also offering improved short-term liquidity, said Phillip Brzenk, CFA, head of multi-asset indices at the firm.
“We expect to see increased adoption of index alternatives, as asset owners are realizing that [these solutions] can be an effective way to gain access to certain alternative exposures,” Brzenk said. “Particularly within liquid alts, there’s a realization that certain hedge fund styles can be replicated using systematic index-based strategies.” (See the graph on S&P’s risk parity index returns versus returns of the HFR index, which is an active manager composite.)
“[Also,] some so-called alpha strategies are actually better labeled as alternative beta and can be replicated in a rules-based fashion. Over the last several years, we’ve seen advances in financial engineering and more tools available to build these types of indices,” said Rupert Watts, CFA, CAIA, senior director of strategy indexes at S&P DJI. “It’s an exciting time for us on the passive side to be building and launching new alternative indices.”
A longer investment time frame is an important consideration when investing in alternatives. “Most alternatives are not designed to be tactical short-term strategies, but we definitely are seeing interest in strategies that act as a hedge over the medium- and longer-term, such as infrastructure, real estate and other types of real assets, in case inflation stays above trend,” said Wylie Tollette, CFA, head of client investment solutions at Franklin Templeton Investment Solutions. “Many investors are looking to enhance return, particularly [if] they can tolerate the additional illiquidity and other risks that come with the private markets.”
Read: Indexing Liquid Alternatives
Focus on Real Assets
Asset owners are looking at allocations in real assets overall, and particularly in commodities and infrastructure, in light of positive market performance, increased underlying economic demand and supportive legislation.
“Commodities should continue to see increases in allocations because positioning is not really a headwind yet. Market participants had been delaying allocations because of last year’s entrenched transitory inflation narrative,” said Jim Wiederhold, associate director of commodities and real assets at S&P DJI. “But that is starting to change now [as inflation pressures continue]. Real assets in general should continue to see inflows as they have very strong inflation-protection aspects and some of them can be considered safe havens.” While investors may have stayed away due to the negative yields of long commodity exposure over the past decade, that cycle has changed with a positive carry environment for commodities, he noted.
Infrastructure is another sector that is seeing strong investor interest, particularly with the passage of the $1.2 trillion infrastructure bill in 2021. “Infrastructure is one of the biggest topics under discussion with asset owners right now,” said Watts. “It’s not surprising given the macroeconomic environment, as well as the need to fund major global infrastructure projects.”
Active and Passive Paths
There’s room for both passive and active strategies in alternatives, given the advantages of each approach.
Franklin Templeton sees strong investor need from asset owners for an asset manager who can be a strategic partner and deliver broad capability across alternatives, said Mike Foley, head of U.S. institutional services at Franklin Templeton. The firm is moving further into actively managed alternative investments with its purchase of Lexington Partners this year, he said.
“With the recent close of our acquisition of Lexington Partners, our firm is managing just over $200 billion in alternative assets, primarily for institutional investors,” said Foley. “We offer private equity and venture capital, hedge funds, private credit, real estate and infrastructure capabilities. And this is by design. We’re exploring private equity solutions right now in innovative, important areas going forward, like blockchain and climate solutions. We’ve been very deliberate in developing and acquiring alternative capabilities in all these areas to better serve our clients’ needs.”
“We believe there’s a place for both active and passive in alternatives” said Phillip Brzenk, CFA, head of multi-asset Indices at S&P Dow Jones Indices. “Liquid alternatives historically have been implemented by active managers, given [the managers’] potential flexibility and also the [possibility that their] expertise could lead to potential enhanced performance. But, more recently, pension plans and other [asset owners] have faced significant fee pressures. There’s also been underperformance in the active world. We have seen increased demand for low-cost, transparent solutions with similar long-term return potential in the form of indices. Index providers such as S&P DJI have really focused on developing a wide range of alternative indices to meet that increased demand.”
Passive products and indexes can offer alternative exposure that has more liquidity and can help facilitate portfolio rebalancing, said Watts at S&P DJI. “With a passive vehicle, you may get more diversification through country sectors and holdings. With infrastructure, [for instance,] you may be able to access assets not offered by the public market. But not all alternatives may be well-suited to passive implementation.”
“There’s quite a difference between publishing an alternatives index and that index actually being investable,” said Franklin Templeton’s Tollette. “The private markets are defined by unique characteristics and what I would call supply-constrained managers. Even if you can track the price of a potential private market investment, that doesn’t necessarily mean you can go out and buy it.” Franklin Templeton is focused on an active approach to alternatives investing, which enables the firm to seek out opportunities across all the private markets, he noted.
Man AHL’s Korgaonkar said he sees room for both active and passive approaches, depending on the investor’s portfolio objectives. He also emphasized that active management needs to prove its value to investors. “Active needs to have an edge or needs to be able to do better than the passive approach, or at least complement it, such that the sum total of passive plus active is better than either one.”
Renewed Focus on ESG
Similar to the traditional asset sectors, the assessment of environmental, social and governance factors in alternatives has moved from an ancillary area to a main consideration for investors, said Anne Simpson, global head of sustainability at Franklin Templeton. One reason is because overall prudent risk management is expected to include how climate change and other ESG risk exposures may impact investments.
“Whether we’re in the asset owner or the asset manager arena, it’s the sustainability of returns that we’re looking for,” said Simpson. “That means taking a holistic investment approach to consider financial, physical and human capital management, where we have seen the impact of the pandemic and recognition of diversity, equity and inclusion as drivers of change, alongside rising environmental issues, [in] which climate change is a [major concern that] impacts water risk and biodiversity. What we’re seeing is a shift from viewing these considerations as some side order on the menu to [seeing them come] into the mainstream. All of this is providing a confluence of factors that make the investment case for sustainability to be factored into our understanding of risk and opportunity.”
“There is no logical reason to exclude private markets. Due to the governance structure of private vehicles, change can move more rapidly,” Simpson said. Companies like Novata and initiatives like the ESG Data Convergence Project are working on ESG metrics for private markets, she noted.
At Franklin Templeton, sustainability-related activities, policies and memberships are spread across the firm’s alternatives strategies. The firm is a signatory of the U.N.’s Principles for Responsible Investment; it follows the GRESB global standards for portfolio-level ESG reporting (formerly known as the Global Real Estate Sustainability Benchmark), which include real estate and infrastructure; and it consults with third-party advisors, such as Malk Partners, on private-market ESG issues.
These actions reflect our investment thesis, said Simpson: “Sustainability is relevant to the duty to provide risk-adjusted returns that are going to be repeatable.”
Read: Beyond ESG: Why the SEC is Right to Make Climate Risk Disclosure Mandatory
Tackling the Issues
For a multi-asset investor, integrating ESG considerations into a portfolio can be more challenging due to lack of data, and it often calls on a different skill set than investing. “I believe that the discipline and the skill of ESG is [different from] the skill of investing. One is trying to pick stocks that outperform, the other is trying to evaluate stocks on criteria. We combine that with our investment expertise to provide products that cater to the client needs,” said Russell Korgaonkar, chief investment officer of Man AHL, one of the systematic investment management businesses of Man Group.
“ESG integration is developing across alternatives in the multi-asset space, where we tend to operate,” he said. “It is probably most straightforward in equity or corporate bonds, where you can create some kind of rating as to whether they are having a positive impact on the environment or social concerns, from a governance angle, and then create an investment process that takes those considerations into account.”
“That becomes more challenging in the multi asset-space. For government bonds, for example, you need to have a country perspective, which is more complicated,” Korgaonkar said, adding that ESG incorporation is a major and ongoing effort at Man Group. Impact investing in alternatives is likely to grow as well, he said.
The ESG lens in alternatives can bring up some interesting complexities for institutional investors. “The place of commodities in ESG-friendly portfolios becomes a thorny question because many see commodities, particularly energy, as harmful to the environment,” said Korgaonkar, and owning them may be counter to the ESG mandates of the broader portfolio. He noted that the decision is further muddled because many alternative energy sources may still require the use of fossil fuels and metals. The inclusion of commodities “is a fuzzy one, and it’s difficult to come up with clean answers,” he said, noting that Man AHL has developed a framework to tackle some of these complex issues for noncorporate assets.
S&P Dow Jones Indices is seeing market participants “hyper-focused” on the ESG elements of their investments, said Jim Wiederhold, associate director of commodities and real assets at the firm. “People care not only about their Scope 1 and Scope 2 emissions, but now they [also] want to understand the impact of Scope 3 emissions,” he said, referring to different levels of greenhouse gas emissions associated with energy purchases and other activities at an organization. “This is all feeding through to the commodity space, which it previously did not,” he added.
Exchange-Traded Funds
The carbon futures market — made up of compliance carbon allowances and voluntary carbon offsets — is a more ESG-friendly commodity investment opportunity, Wiederhold said. Carbon futures-based exchange-traded funds have enjoyed some of the fastest adoption of any ETFs in recent years. “We’re seeing explosive growth recently in the carbon futures markets. These carbon allowances and offsets play a crucial role for governments and corporations to get to net-zero [emissions]. They’re going to be key cogs put in place over the next decade so that everyone’s able to achieve some of these very lofty emissions targets,” he said, referencing the United Nations’ Paris Agreement goal to reach net-zero emissions by 2050.
Another way investors can combine alternatives with ESG is through thematic ETFs, including a basket of metal commodities used to produce electric vehicles, Wiederhold said. “With the shift away from internal combustion engines to electric, metal commodities are going to be a very important component used over the next 10 years because they’re the basic building blocks of electric vehicles — and the battery metals as well. It’s just one example of several new and very exciting ways to take an alternative approach to ESG exposure.”
A Long-Term Growth Story
Although today’s market volatility and rising inflation are driving investors into alternatives, asset managers expect the sector’s broad and diversified appeal will persist into the future.
“Institutional investors are getting more sophisticated, so the pace and scale of adoption of alternatives could be the quickest we’ve seen in decades,” Wiederhold said. “Investors are looking for the new growth story, whatever that might be, and that is now in alternative investments.”
“We don’t see the importance of [allocation to] alternatives fading over the next five years because they are attractive, appropriate and useful to institutional investors” in meeting their portfolio objectives, said Foley at Franklin Templeton. “We’ve seen a lot of institutional investors reducing the number of asset-management relationships or partnerships they have as they search for less complexity. Firms like ours and others that have capabilities across the full spectrum of alternative investments will be well-positioned to meet the increasing demand.”
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