Fear and demographics can be powerful drivers. Investors who remember the financial crisis fear a repeat performance. Understandably, they want stability. At the same time, demographic changes in developed markets are creating enormous pressure to deliver income on clients' assets.
Given stubbornly low interest rates and anemic global growth, most traditional investment strategies will be challenged going forward.
A diversified income approach that incorporates alternative investment strategies can help meet clients' income goals, if they are willing to take some additional risk in their portfolios.
Few of us are fortunate enough to rely solely on the first two primary colors of investing: capital preservation and income. But what about clients who want — or need — our third primary color: growth?
Making the case for alternatives in this context is less about the absolute returns but their potential over full market cycles to deliver the same or greater outperformance than equity mutual funds — yet with lower volatility, lower correlations and enhanced diversification.
That may be a mouthful, but each element of that sentence has meaning. If an investor wants simple growth products, market-cap-weighted indexing will do nicely — as long as the markets do nothing but keep going up.
(Related read: How to explain alternatives' place in portfolios to your clients)
Anyone making that bet these days?
Rather than all-risk, high-reward, many liquid alternatives are targeted at investors who root for the tortoise in Aesop's fable. The headlines go to the speedy hare, but in a world rife with risk, flashes of occasional brilliance rarely surpass the benefits of solid, steady growth.
Investors can use alternatives to go beyond traditional stock and bond funds, relying upon actively managed products specifically designed to capture growth, even in the most grim and volatile markets. This comprises products previously available only in the high-net-worth space:
private equity,
venture capital, real assets (real estate, infrastructure and REITs) and hedge funds.
Private equity and
venture capital can offer very high returns — when they hit, but they frequently miss too. Both strategies are difficult to deliver in liquid
investment vehicles and are usually only available to accredited investors.
In competitive markets, high-return real estate has become harder to find. It takes acumen, experience and wherewithal to consistently deliver growth across a full market cycle. Still, there are asset managers with demonstrated track records through varied economic cycles that provide liquid products in the
REIT and infrastructure spaces.
As for hedge funds, it is important to understand they are not a separate asset class, nor are most the “black boxes” some fear. While they often pursue similar objectives, well-chosen hedge funds can outperform public equities and fixed income. Many aim for lower volatility and less market correlation, giving them the potential for greater risk mitigation and superior diversification.
(More insight: How to get clients comfortable with alternatives)
The real value proposition of buying alternative products from an asset manager comes in the vetting. Investment strategy and operational due diligence require heavy lifting. Even the savviest, most-resource-rich institutional investors can have a hard time assessing the many available hedge funds. Asset managers go deep with each
hedge fund, taking the time to ferret out their true exposures, along with their strategies and risks. When a
hedge fund's performance pushes against the asset manager's tolerances, steps can be taken to actively address the issues.
All investments carry risk, of course, but investors can sleep better knowing that expert managers are overseeing their investments.
Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.
