Alternative Investments: A Primer for your Plan

Justin Held, CEBSSeptember 21, 2020September 21, 2020

Finding the right asset allocation for your fund is no easy task. A presentation by Kevin M. Schmid of Gallagher Fiduciary Advisors, LLC, titled Improving Your Asset Allocation, explored the topic and provided some insights on key strategies to improve your fund’s asset allocation and maximize returns. Specifically, the presentation, which was held at the International Foundation virtual conference Investments in Today’s Climate and Beyond, included a primer on alternative investment strategies.

Fund allocations to equity and fixed income have declined consistently over the last two decades, with assets rotating to alternative investment categories. What are some common traits of alternative investments? What are the primary alternative categories? What are some potential benefits and special risk considerations to keep in mind? Here are some key takeaways.

Alternative Investments: A Primer for your Plan

Common Traits of Alternative Investments

Alternative investments share a number of common traits:

For the most part, these investments are accessed via limited partnership structures. Conversely, liquid alternatives are available in mutual, commingled or interval fund structures.
As an asset class, alternative investments are relatively illiquid, either at the fund and/or individual asset level.
Risk/return characteristics differ from traditional equity and fixed income investments.
The underlying investments may include nontraded assets, which are difficult to value and highly subjective.

Alternative Investment Categories

Alternative investments fall into three primary categories:

Liquid Alternatives—Defined as mutual fund structures that cover a wide range of alternative investment strategies. While these assets may offer superior liquidity and lower fees, they may be more highly correlated to public markets.
Hedge Funds—Hedge funds are limited partnership structures with an absolute return focus. The term covers a wide range of potential strategies with more limited liquidity and higher fee structures than traditional assets.
Private Markets—Private markets are limited partnership structures that generally invest in assets that are not publicly traded. Therefore, these strategies offer limited or no liquidity and higher fees relative to public market options.

Below is an overview of these categories, with a comparison to traditional assets for reference.

	Structure	Liquidity	Fees	Leverage	Transparency	Performance Dispersion
Traditional Assets	Separate account/Mutual funds	High	Low	None	High	Low
Liquid Alternatives	Mutual funds	High	Moderate/high	Possible	Moderate	Moderate
Hedge Funds	Limited partnership	Moderate	High	Yes	Low	High
Private Markets	Limited partnership	Low/none	High	Yes	Moderate	High

Potential Benefits of Alternative Investments

There are several potential benefits to including alternative investments in your portfolio. They include:

Enhanced Return Potential—Over the long term, through active management, private markets may achieve 2-5% additional return over public market counterparts. Private market investors take a more active role in sourcing, adding value to and exiting investments. In addition, these investments may access assets that are underrepresented by public markets.
Diversification—Valuation of underlying investments may be driven by factors different from those associated with public investment markets. Hedge funds may have a distinct risk/return profile that is completely different from the general market cycle. In addition, “core” real assets may be less impacted by traditional market shifts.

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Key Risk Considerations of Alternative Investments

Along with potential benefits of alternative investments, there are a number of risk considerations. Here are four key considerations.

Illiquidity

Closed-end private market funds typically have an 8- to 12-year fund life. Limited partners are legally committed to make contributions whenever capital is called for by the manager and usually have no control over capital in/outflow, and the timing of cash flow can be unpredictable. Limited partners may also have difficulty exiting equity/debt funds. Hedge funds and open-end private real estate funds are defined as “semi-liquid.” However, managers generally have the right to lock up funds at inopportune times for investors.

Fees

While hedge fund fees have started to decrease, some private markets still command a “2 and 20” structure (in this example, management fees would include 2% of initial investment, plus 20% of all profits above specified benchmarks). There is a high degree of variability in fee terms across funds, but generally, alternative investment vehicles still receive substantially higher fees than traditional public market managers.

Performance Dispersion

Private market fund performance is highly dependent on the manager’s capability and professional sourcing network, which varies greatly. The performance dispersion between the top-performing managers and the average manager is significantly higher than in public markets. In addition, access to top-performing funds can be difficult, particularly in certain areas like venture capital.

Delivery Vehicle

Alternative investments are made available to retirement funds through a variety of vehicles. Here are some considerations for direct investments and fund-of-funds.

Direct Investment—For proper diversification, institutional investors need to invest in 10-15 funds. In addition, access to good funds may prove difficult. Direct investment also requires significant commitment to initial and ongoing investment and operational due diligence. Finally, cash flow management is a significant issue for private asset vehicles that are dealing with multiple capital calls and distributions to maintain the desired allocation.
Fund-of-Funds—Investing in fund-of-funds can provide an extra layer of due diligence and monitoring as well as potentially superior access to high-quality managers. This is coupled with the potential for more streamlined cash flows and reporting. However, these vehicles are more expensive, as fund-of-funds managers earn a fee over and above the underlying manager fees.

Access the Virtual Conference to Learn More

The Investments in Today’s Climate and Beyond virtual conference is available on demand. The conference explores the issues impacting your fund’s investment strategy and provides guidance to help maintain stability during these turbulent times. Register now for access to the full event. International Foundation VIP members receive free access!

Justin Held, CEBS
Senior Research Analyst at the International Foundation

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