Our research has found that an allocation to alternatives would have served to meet conflicting stakeholder demands by simultaneously smoothing and boosting the investment earnings trajectory. We modeled a small allocation to alternatives — 5% for property and casualty insurers and 3% for life insurers, which have larger balance sheets — on top of 10 years of actual investment results for a composite of insurance companies with little or no exposure to alternatives. Of the 40 quarters that began in 2004 and ended with the last quarter of 2013, the hypothetical alternatives allocation would have enhanced results in 83% of them.
Those extra returns demand an extra level of skill. Conventional investment results conform to readily identifiable cycles. They tend to converge on a benchmark mean as investors pile into a successful strategy and arbitrage away the competitive edge. By contrast, idiosyncratic, often proprietary alternative investment results tend to diverge. The tendency has a critical implication. Median returns in alternative investing don't mean much.
A recent study by McKinsey & Co. found that private equity returns in a given vintage year ranged from gains of 50% for the top managers to losses of 30% for those at the bottom. By comparison, top-quartile long-only equity funds outperformed the median manager by 0.7 percentage points to 2.3 percentage points per year over the past decade, according to Morningstar Inc.
Alternatives' dispersion stands to reason: Success in alternative investing feeds on itself. The top managers see the more promising deals. In private equity's earlier days, the majority of top-quartile funds sustained their top-quartile performance. Since 2000, the consistency of manager outperformance has declined, as it has among alternatives managers generally. More competition, better competition and, in private equity, subtler ways of creating value beyond cookie-cutter financial engineering all help explain the trend.
So does the accelerating pace of the global economy. Alpha today depends not only on managers' ability, but also on how their skills coincide with market opportunity and macroeconomic circumstance. Alternative investments don't lend themselves to “set it and forget it” management. They require exhaustive and ongoing due diligence. As essential as it is, a thorough understanding of what portions of manager performance to attribute to luck, to skill and to process is no longer enough. Effective due diligence in the current environment calls for a well-reasoned, exhaustively researched view of how a manager's process will fare in a constantly shifting dynamic of opportunity.
So the compelling potential of alternative investments for the insurance investor comes packaged with a warning label. The potential is compelling only for the top managers, combined with ongoing and rigorous investor oversight.
Once they obtain that oversight capability, insurance companies will have the attributes they need to realize the alpha inherent in alternatives. Insurers already possess the appropriate scale, the right time frame and credibility. They can make investments small enough for their risk budgets to accommodate yet big enough to move the dial on returns. They have a compatible time horizon with alternatives managers — insurers' ability to capitalize on liquidity premiums and invest consistently over time gives them a cash flow that parallels that of alternative investments. Not least important, insurers' reputation as long-term institutional investors can add to an alternatives manager's credibility and leverage in the deal-making universe.
Matt Malloy, managing director, is head of institutional solutions and advisory within J.P. Morgan Asset Management.