An 'aerial' view of major Alternative Asset Classes
A simple case for Alternative Investments to enhance portfolio returns
Alternative investments, including both private markets and hedge funds, have become increasingly popular among institutional investors and high net worth individuals as a means of diversifying their portfolios and enhancing returns. According to industry projections, total assets under management (AUM) in these investments have surpassed $13 trillion in 2022. The North American region has been a major contributor to this growth, accounting for 60% of global private markets AUM*.
How best to visualize the current Alternatives universe? Our team at Klarphos is a fan of utilizing simple but effective charts whenever possible to convey large sets of information. The depiction below, for example, offers an efficient lens for quickly assessing the broad swathes of major Alts verticals and simultaneously for gleaning information regarding their respective returns. An insight that becomes obvious upon first glance is that these two pieces of information (AUM and performance) are of course correlated, owing both to compounding returns as well as performance-chasing flows.
More specifically, within private markets, private equity holds the largest share of AUM, accounting for over half of the total private markets AUM and driving the majority of growth in the sector. Buyout funds, in particular, make up a significant portion of private equity assets, with about one third of the total private markets AUM. Both real estate and private debt have also seen substantial growth in AUM in recent years, with private debt experiencing an annual growth rate of 20% over the past five years and now accounting for about one fifth of private markets AUM*.
According to a study conducted by Klarphos, out of 16,000 private market funds launched after 1990, the historical average internal rate of return (IRR) varies significantly for different types of alternative investment funds. The study found that private equity funds had approximate historical average an IRR between 15% and 24%, real estate funds produced an approximate historical average IRR of 11% to 18%, venture capital funds enjoyed an approximate historical average IRR of 12% to 26%, private debt funds had an approximate historical average IRR of 10% to 14%, and infrastructure funds had an approximate historical average IRR of 10% to 15%. It is worth noting that the study is based on a specific dataset, time horizon, and periodicity, so IRRs may vary depending on the source and time period considered.
Breakdown of $13trn Alternative Assets (excl. Hedge Funds)
Source: Klarphos, Preqin; Data as of December 2022; IRR colors are based on average net IRR observed from a universe of 8,941 funds with vintage years between 2010 – 2022
Higher Returns in Private Markets: A Comparison of Traditional and Alternative Investments
To gain insight into the risk and return characteristics of private market funds compared to traditional assets, as well as their correlations, we present the annual returns and ranges of worst-to-best returns between 2010 and 2021. During this period, most core traditional assets such as equities and bonds in major markets had average annual returns of between 3% and 8%. Specifically, US equities had the highest average annual returns in the lower double-digit range.
By comparison, private markets have produced much higher average returns over the last decade. Out of the 21 strategies we studied, 17 generated double-digit returns and with narrower return ranges than most traditional assets. Furthermore, only five of these private market strategies recorded full year losses at any point.
Traditional Assets: Average Annual Returns and Dispersion Ranges
Source: Preqin, Bloomberg; Period 2000- 2021; Data as of December 2022
Alternative Investments: Average Annual Return & Dispersion Ranges
Source: Preqin, Bloomberg. Period 2000- 2021; Data as of December 2022
The superior risk-adjusted performance of Alternative Investments can be attributed to a variety of factors, not only the commonly-cited illiquidity premium. Some of the contributing factors may include:
• The ability to identify investment opportunities that will outperform public markets, known as Alpha.
• More predictable returns, often privately contracted, leading to higher certainty in execution and pricing compared to public markets.
• A greater focus on specific sectors and industries, such as venture capital and growth capital that target technological and demographic trends.
• Involvement in operations, providing expertise in lending upon first notice of early warning signs, or implementing turnaround strategies in private equity.
It is important to note that while these factors can lead to Alpha generation, they are not consistently present in all Alternative Investment strategies. On a risk-adjusted basis, private equity funds and private debt have been particularly impressive, boasting Sharpe ratios of close to 2, while also maintaining a maximum drawdown of less than 10% over the course of a decade. These characteristics make private market funds a compelling investment option for those seeking higher returns with relatively low volatility.
Risk/Return Summary of major assets from 2011 - 2022
Source: Klarphos, Bloomberg, Preqin; Data as of December 2022
Correlations and Portfolio Benefits of including Alternative Assets
In addition to the superior, standalone risk-adjusted returns that Alternatives have generated over the past several decades (refer to first chart), their low correlations to traditional asset classes also imply that they may act as excellent diversifier to a liquid investment portfolio. To answer the question of how an existing portfolio may be impacted by inclusion of alternative assets, we constructed a mean-variance optimized model portfolio consisting of major traditional assets, and showed the marginal benefits in a scatter plot from the centroid (MVO portfolio).
Each marker at the end of a dotted line represents a new portfolio volatility and return profile given the change of adding 5% into the existing MVO portfolio while reducing all other assets proportionally.
This spider chart thus helps to answer the question of ‘Given the current allocation, which asset class can provide the best marginal risk-reward benefit?
Correlation matrix of major assets between 2011 – 2022
Source: Klarphos, Bloomberg, Preqin; Data as of December 2022
Marginal benefits of including alternative assets in a model portfolio
Source: Klarphos, Bloomberg, Preqin; Data as of December 2022
A few observations are readily apparent:
• Real estate and equity hedge funds, including event-driven and fund-of-hedge-fund, lie on the diagonal. The incremental expected return is accompanied by a nearly linear increase in volatilities.
• Private equity and venture capital, by contrast (which are often under-weighted within European portfolios), extend the efficiency of portfolio the most. Macro HF, Infrastructure, and parts of Private Debt also significantly de-risk overall portfolio volatility while enhancing returns slightly.
Understanding Historical Average IRRs and Factors for Selecting Top Alternative Funds (top vs. 2nd quartile)
Although it seems obvious that investors can benefit from adding alternative assets into their portfolio, there are several major difficulties and pitfalls for investors looking to invest in alternative funds, including:
• Complexity: Alternative funds can be complex to understand and invest in and may require a higher level of financial expertise than traditional investments. Private equity funds and hedge funds often have complex investment strategies and may not disclose all of their holdings.
• Lack of transparency: Many alternative funds have limited transparency, which can make it difficult for investors to understand the underlying investments and the fund's performance. This can make it difficult for investors to assess the risks and potential returns of the investment. This opacity may also pose major issues for highly regulated allocators.
• High fees: Alternative funds often have higher fees than traditional investments, which can eat into returns. Most funds often charge both management fees and Incentive fees, which can significantly reduce returns for investors.
• Limited liquidity: Many alternative funds have limited liquidity, meaning that it can be difficult to sell the investment when desired. Private equity funds often have a lock-up period of several years before investors can redeem their shares.
• Regulatory restrictions: Some alternative funds may be subject to regulatory restrictions, which can make it difficult for certain investors to participate. Hedge funds often have restrictions on who can invest, such as a minimum net worth requirement.
• Lack of diversification: Investing in alternative funds may not provide the diversification benefits that some investors expect, as alternative funds often have a higher correlation with each other than with traditional asset classes. Note this is highly dependent on the type of strategy employed as well.
• Market timing: Alternative investment strategies can be highly dependent on market conditions, and their performance can vary significantly. They may perform well during economic expansions but may struggle during downturns, or perform well during market volatility but may underperform during stable markets. Investors must be mindful of market timing when investing in alternative funds and should be prepared for the potential of significant performance fluctuations.
Given the above, it should come as no surprise that the returns of alternative assets often deviate from standard normal distributions, and returns from alternative funds pursuing the same strategy can vary widely. Even though there is no guarantee for outperformance, seasoned investors and managers can still rely on some factors to select top alternative funds, such as:
1. Due diligence: Experienced investors conduct thorough due diligence on the alternative funds in which they invest, which helps them identify the best GPs and avoid potential risks.
2. Track record and historical returns: Experienced investors carefully evaluate the track record and historical returns of alternative funds, which helps them identify the best performing funds and note potential pitfalls such as style drift.
3. Manager expertise and risk management: Experienced investors understand the importance of fund manager expertise and invest in funds managed by experienced and skilled managers, however they also understand the importance of risk management and invest in funds that have a well-defined risk management strategy.
4. Network and access to top managers: Experienced investors have a strong network and access to top managers, which gives them an advantage in investing in the best alternative funds. The chart below, which displays the difference in average annual returns for first vs. second quartile managers by strategy, highlights the importance of selecting – ex ante – top performing GPs.
2nd Quartile to top quartile – how much return improvement (Net IRR) an investor can expect from the winners
Source: Klarphos, Preqin. Funds vintages between 2000 – 2022; Figures reference the vintage years between 2010 – 2022 and data extracted as of December 31, 2022;
Increasing Shift towards Private Markets: A survey and Forecast Study
On net, we find it straightforward to believe that the trend of more money flowing into alternative space will continue. Based on a survey and forecast study made by Preqin, private markets are gaining share at an increasing pace from traditional asset classes across both equity and credit verticals.
A significant growth has been observed in global AUM across all alternative asset classes. Preqin expects to have a CAGR of 9.8%, outpacing traditional assets with a CAGR of 5%*.
Particularly strong growth is expected in private equity and private debt markets. Private markets fundraising in 2021 realized a new record, reaching almost $1.2trn globally. North America led the boom with an annual growth rate of 21.6%, followed by Europe’s 16.9% and Asia’s 13.1%*.
Endowments, foundations, and US pensions were early movers. European Pension managers are now increasing their allocation to alternative investments at a faster-than-before speed, but they remain shy of their investment targets. Taking Germany as an example, less than 5% of occupational pension assets are invested in in Alternatives, and less than 10% in real estate. Both figures are expected to grow between 3 to 5 percentage-points in the next 2 to 4 years*.
Alternative AuM Growth
Source: Klarphos, Preqin; Data as of December 2022
* Preqin data – as of December 31, 2022