The investment climate has changed dramatically over the last 15 years. The playbook for alpha generation needs to be updated.
Flashback to 2006: the Golden Age of Alternatives
William J. Kelly, President and CEO of the CAIA Association, recently summarized the alpha environment of 2006 in a LinkedIn post:
"Global hedge fund AUM had just breached $1T for the first time, private capital stood at a skinny $1.5T, the S&P 500 was trading at just under 1,300, and the 10 YR treasury was yielding 4.5%. Single-digit (entry) private market deal multiples were commonplace, and accommodative public markets provided for handsome exits, as well as more opportunity for capital formation and access for the retail asset owner. Complexity and illiquidity premiums thrived, and truly defined asset class value above any public market proxy within a sea of asymmetric information advantages and market inefficiencies, which have always been the zip code of true alpha. Achieving return objectives seemed so simple, and even the concept of a glide path for annuitized plans was grounded in some semblance of reality.1"
The 2021 Alpha Environment is Dramatically Different…
Global hedge fund AUM is now around $4 trillion. Total private capital AUM stands at around $7.4 trillion, and “dry powder,” or uninvested capital, is at an all-time high, around 20–30% of AUM. Average buyout entry multiples have risen from the single-digit ranges of 2006 to a hearty 11.4 times EBITDA, not too far from equivalent public market multiples.
Investment technology has improved dramatically, bringing greater transparency and access to alpha generation potential. Tools such as artificial intelligence, factor based investing, alternative data and improved portfolio construction tools have brought scale into the alpha game, redefining betas and alphas, compressing illiquidity premiums in certain private markets and reducing the cost of alpha.
The macro environment in 2021 also is different. Zero interest rates have encouraged risk-taking: with government bonds yielding close to nothing, investors are forced to look elsewhere to earn positive real returns. Combined with quantitative easing, fiscal stimulus and pent-up demand as we emerge from the greatest pandemic in a century, macroeconomic risk is shifting for the first time in decades from a risk of deflation to a risk of reflation.
…Yet, the Needs of Long-Term Investors Remain the Same
Individuals saving for retirement need a higher investment return to increase their likelihood of supporting a healthy lifestyle in retirement. The typical insurance general account needs to maintain its book yield as older investments run off. The underfunded corporate pension fund still needs to earn a premium over its liability discount rate to reduce its funding gap. To meet their liabilities or commitments, the typical public pension fund or endowment still needs to generate annual returns somewhere between 6–8%.
Said differently, there is a need to generate more than 300 basis points (bp) of alpha over a “typical” balanced portfolio — 60% equity, 40% fixed income — while being prudent with the risks taken and fees paid to generate those returns.
Meeting these needs may appear daunting, but doesn’t have to be.
Refreshing the Approach to Alternatives
The current environment, with its richness, complexity and uncertainty, offers investors and advisors an exciting opportunity to hit refresh on their investment playbooks. There are four key themes around which a successful alternative investment portfolio can be designed.
Seek Absolute Return in Specialty Areas
The lower cost of borrowing funds creates an opportunity to earn higher absolute return from strategies where underlying assets can be leveraged while managing principal risk. This makes direct lending, collateralized mortgages and securitized strategies appealing as sources of higher absolute return for investors with longer time horizons.
Short-term risk aversion and market behavior also provide long-term sources of absolute return. A specialized opportunity for such a return can be found in volatility markets, where an investor can earn a premium between higher implied volatility versus realized volatility, provided the manager can manage the downside well. Certain volatility strategies proved resilient in 2020 and may be attractive sources of absolute return.
Diversify and Mitigate Macro Risk
Most return generating assets — public and private equities, credit, real estate or infrastructure — are essentially leveraged bets on a healthy and growing economy. During periods of economic weakness and heightened macro volatility, these assets may stumble in tandem. There is therefore a need for strategies that are either less correlated or negatively correlated to the economic cycle.
Certain hedge fund styles and alternative risk premium approaches are explicitly constructed to generate returns from factors that are distinct from and uncorrelated to traditional markets. Focusing your hedge fund or liquid alternative allocation on these approaches potentially can being much needed diversification benefits. Seek out managers who focus on understanding probabilistic payoffs under various macro regimes; those who are well versed in using quantitative and artificial intelligence (AI) methods as well as option strategies, to manage downside risks or increase participation in upside potential.
Don’t Pay for Beta
A frustrating experience for some alternative investors has been locking up capital for a decade, only to find that the desired returns might have been obtained by investing in lower-cost, market-indexed strategies. In other words, they paid for alpha but received only beta. Fortunately, investment technology has advanced, making it possible to separate alpha and beta sources of return. For example, “portable alpha” strategies overlay market beta exposure over uncorrelated alpha sources, offering investors the potential to pay for alpha while obtaining beta at lower cost than through more conventional investment vehicles.
Another promising development is in the area of replicating private equity investment styles in public markets. With return dispersion between top- and bottom-quartile private equity managers measured in thousands of basis points, this innovation places a valuable tool in the hands of investors and advisors. Diversified private equity portfolios now can be created using a combination of high conviction managers and comparatively lower cost replication strategies.
Make Bold Bets but Size Them as Call Options
The future is exciting — in response to environmental, demographic and social change, innovation in areas of data, AI, technology, healthcare, sustainability, governance, inclusion and infrastructure will have a transformational impact. Invest in these themes of the future, but size them as call options — assume you could lose a significant amount of your invested capital, but the payoff potentially could be several times the premium paid.
So…What Does a Refreshed Alternative Portfolio Look Like?
Based on the above approach, we can categorize strategies into absolute return, skill premium, diversification, low cost and innovation.
Let’s now design a portfolio using these components. We start by defining an investment objective based on an investor’s needs and utility function; for example, maximize return subject to balancing risks across macroeconomic regimes at a reasonable cost. Figure 1 illustrates how one can design an alternatives portfolio to meet such an investment objective.
The need for higher return potential is met through absolute return, equity and credit strategies. The cost of these higher returns can be managed by using low cost beta and replication approaches for growth exposure, complemented by higher cost specialty managers where investors or their advisors have high conviction.
These higher return strategies tend to perform well in macroeconomic regimes that generally reflect a stable growth environment. Conversely, investors may struggle to meet their return objectives should the macroeconomic environment exhibit greater fragility – perhaps due to falling growth, inflation surprises or higher volatility. For such environments, certain types of real assets, and diversified macro and risk premium strategies, potentially provide ballast to the portfolio.
Source: Voya Investment Management
In his book Hit Refresh, Microsoft CEO Satya Nadella writes, “Every person, organization, and even society reaches a point at which they owe it to themselves to hit refresh—to reenergize, renew, reframe, and rethink their purpose.” As we move into the post-pandemic world, it is time to hit refresh on our investment strategies.