INSIGHTS FROM ADAM GORLYN
Adam Gorlyn is an investment management professional hired by Fountainhead to consult on its alternatives investing approach as we continue to enhance our OCIO services and offerings.
Alternative investments provide a myriad of potentially valuable benefits for investors, balanced with a cost of complexity and illiquidity. In a series of articles, we will explore the increasing popularity of alternative investing. We focus on how investors can analyze and utilize alts as part of their overall strategic asset allocation in order to increase the likelihood of achieving desired outcomes.
Today’s investment world has come a long way from the days of simply buying and holding stocks, bonds, and mutual funds. Financial product innovation and technology has furthered the democratization of markets, providing investors access to more choices than ever before. For example, the rise of index-based strategies via exchange traded funds (ETFs) have made investing in specific sectors and foreign countries as easy as clicking a mouse, while technology platforms have provided access to more complex managed products available in a variety of vehicles. Unfortunately, with greater access comes increased complexity. It’s simply more difficult to properly understand underlying market exposures, investment strategy approach, risks, differing liquidity characteristics, and therefore to accomplish the task of properly selecting and then sizing these potentially advantageous alternatives into an investor portfolio.
Much like the evolution of the broader markets, alternative investments have also benefited from product innovation and technology advancements. Alternative investments were initially created as a way to diversify assets in strategies beyond traditional long-only stocks and bond portfolios. Investors sought these products to deliver differentiated sources of return, serve as an inflation hedge, or generate current income from sources other than publicly traded fixed income. The potential benefits of alternative investments, however, are countered somewhat by product complexity, frequently high fees, and often a requirement that investors commit capital to a fund for an extended period of time. Today, as the alternative marketplace has matured, new fund structures have become commonplace, giving investors the ability to obtain exposure to select strategies that may provide more transparency and a greater degree of liquidity than vehicles available in the past. Of course, understanding and screening these strategies and structures is time consuming and requires a high degree of expertise.
Today, alternatives cover a broad swath of investment strategies across asset classes such as private equity, private credit, hedge funds, real estate, commodities, and crypto. To best understand the current alternative investments landscape, it is helpful to look at some historical use cases of alternatives in enhancing a portfolio.
ULTRA-LOW RATES IN THE 2010S DRIVE ALTERNATIVE USE FOR INCOME AND PORTFOLIO BALLAST
The ultra-low interest rate environment following the 2008 financial crisis was a significant driver in generating interest in alternative investments. Following the significant drawdown of asset values in public markets, investors were faced with a zero-interest rate environment. They were forced to seek reasonable yields—and the related degree of portfolio stability those products could provide—from sources other than traditional fixed income. The low-rate environment also caused investors to deploy capital into strategies they may have previously rejected due to the inherent complexity and length of time required to remain invested. Select private real estate strategies gained in popularity as they typically offered higher yields than traditional fixed income, in addition to potentially providing upside return. They also had some similarities to fixed income, including a relatively predictable yield component and some portfolio risk diversification where a more “conservative” exposure[1] could be constructed. Private credit, specifically direct lending and infrastructure investments, are additional examples of strategies which began to play a greater role in building a strategic asset allocation due to their attractive yields and presumably predictable rate of return.
Technology has played a significant role in facilitating the distribution of alternatives, particularly to accredited investors. Electronic platforms have made it easier for investors to access strategies while providers leverage technology to ease the application process, potentially cutting down the time and need for extensive paperwork and other certifications. This has lowered the cost of bringing alternative strategies to market, making it feasible for managers to make their strategies available to a broader array of investors with lower minimums.
DIVERSIFYING THROUGH PRIVATE MARKETS EXPOSURE
Traditional private equity strategies, encompassing venture capital, growth equity[2] and buyout strategies, continue to play a larger role in building the optimal growth allocation of a client portfolio. Historically, the most disruptive technologies incubate and remain as private companies for a period of time prior to going public and becoming available as an investment opportunity to the masses. This time frame has increased dramatically over the last 20 years with fewer companies going public after longer periods. This has resulted both in fewer public companies and those that have gone public taking roughly 12 years as compared to 4.5 years 20 years ago[3]. Venture capital has provided some of the best long-term gains in exchange for a lock up of investor capital that historically lasts 5 – 7 years at a minimum[4]. With companies staying private for longer, the number of opportunities and market size of private equity is simply too large to ignore. Additionally, with the rate of innovation seeming to increase at an ever-quicker pace, investing in artificial intelligence, biotechnology, and other sectors rife with innovation is both exciting and potentially rewarding.
Private credit has grown in lockstep with private equity, providing alternative characteristics to public markets. Some of the differences include higher yields via variable rates which have moved directionally higher with the fed funds rate, as well as typically superior loan terms that are more investor friendly. Direct lending gained even broader popularity over the past 24 months as the strategy provided a hedge against rising rates given its floating-rate structure.
While ETFs have been the headliner for product innovation over the last couple of decades, there has been no limit to financial innovations allowing for access to underlying strategies in a variety of packages. As an example, while structured notes have historically only been available via major bank issuance in the form of a secured note, this type of strategy is now accessible within an ETF, annuity, and Unit Investment Trust structure. Private funds, interval funds, and direct access vehicles are additional examples of methods to package alternative investments, each with their own advantages and disadvantages.
THE BROAD WORLD OF HEDGE FUND INVESTING
Some hedge fund strategies, such as relative value, equity arbitrage and market neutral, are managed to generate returns with a low correlation to public equity markets as well as lower volatility (standard deviation) relative to traditional long-only portfolios. These strategies can assist in balancing a portfolio during periods of market stress and act as a diversifier to conservative equity and certain fixed income exposures. Conversely, other hedge fund strategies seek to provide return enhancement relative to public markets. These strategies can include leveraged long/short strategies, commodity, and currency hedge funds and, more recently, crypto and digital related strategies.
There are myriad hedge fund strategies that cover a vast range of exposures in an active management format with traditionally high base fees in addition to performance-based incentives. When investing in hedge funds it is imperative to fully understand exposures, leverage, investment approach, and personnel given the significantly varied philosophies and objectives of managers, coupled with the typical opaqueness of underlying holdings and potential lock-up periods of capital.
As the size of private markets and investable assets continues to grow, creating a sizeable opportunity set in new and underfollowed corners of the market, there is no question that the alternative investment landscape will continue to evolve and grow. Demand for alternative assets is projected to add more than $8 trillion to assets under management in the next five years, to a total $24.5 trillion, according to Prequin. As alternatives have shown the ability to add value to portfolios by providing diversification and enhanced risk-return tradeoffs relative to public markets, investors have come to better appreciate the potential value that they can add in reaching long term objectives. Ultimately, even investors with moderate sized portfolios cannot afford to ignore this sector of the market and should weigh the significant known risks of alternatives against their appealing investment characteristics.
At Fountainhead, we believe a good approach to managing the trade-offs is to be aware of the significant complexities of alternatives, as well as the necessity of experience in research and due diligence to properly evaluate, select, and size the investments relative to a client’s overall portfolio holdings.
In the ensuing papers of our Alternative Investment series, we dig deeper into Fountainhead’s due diligence and evaluation process of alternatives, highlighting our differentiated approach. We then discuss our approach in positioning alternatives within each client’s strategic asset allocation, appropriately sizing and aligning strategies relative to the investor’s current holdings and risk appetite, and in line with their long-term return objectives.
Disclosure
Alternative investments are not appropriate for all investors. Some alternatives, including private placements, have minimum investor qualifications. Private placements are generally offered only through a private placement memorandum or other offering documents provided by the issuer and may be purchased only by accredited investors. In some cases, in addition to being accredited, investors must also meet the definition of “qualified purchaser” and/or “qualified client.” This paper is not intended as investment advice or the recommendation of any security or class of securities. Fountainhead provides investment advice only to clients, and only after assessing individual client needs, objectives, risk profile, and investment profile. This paper describes general risks and opportunities of investing in alternatives. The actual risks and opportunities of any specific investment must be carefully reviewed before being employed in a client portfolio. Fees associated with alternative investments are separate from and in addition to the advisory fees charged by Fountainhead. No investment can guarantee positive returns or the prevention of all loss.
[1] For example, a senior secured, short-term loan collateralized by the property is relatively conservative. If you diversify this exposure by investing in a portfolio of like securities it becomes more conservative due to the diversification provided. Purchasing and fixing up a single-family house is an example of an investment degrees riskier than the senior secured loan described above.
[2] The defining line between venture capital and growth equity is murky with venture capital typically being earlier stage and therefore focused more on investing in product creation with growth equity later stage and typically focusing on scaling with the belief that the product is viable.
[3] Private Market Investing – Staying Private Longer | Hamilton Lane
[4] Private Market Investing – Staying Private Longer | Hamilton Lane