The economic conditions being shaped during 2016 could be the vanguard of the investment environment for the years to come and there is certainly one winner: alternative investments. Over the last decade, the industry has grown exponentially, with alternative funds managing currently near $10 trillion, with huge demand being originated from the U.S. and European investors. There is a variety of strategies/asset classes within the alternative investment spectrum from hedge funds and private equity to stamp, comic books and classic car collection, but this perspective’s focus is on institutional quality alternative investments and specifically hedge funds, private equity and private debt comprising the largest piece of the spectrum.
The role of alternative investments in the financial and social ecosystem is multidimensional, which amplifies their importance and attracts further attention from investors and authorities. First of all, the plethora and diversity of strategies allows investors to gain their desired exposure, adding liquidity to both financial and real-world markets. Alternative managers are focused on innovation and designing new, unique and sometimes complex trading/investment strategies, which provide institutional investors with alternative, diversified and uncorrelated to traditional investments source of alpha. Investing in alternative managers requires expertise in risk management, thorough knowledge and deep understanding of alternative investments due to their complexity in nature, including both strategy and structure.
Sophistication within alternative investments has developed providing a variety of access possibilities for institutional investors across the corporate capital stack from traded debt in high yield bonds, collateralized loan obligations (CLOs) to more illiquid private debt strategies of levered loans, direct lending, and private equity featuring buyout and secondaries.
An important aspect of alternatives investments is the regulatory landscape in which alternative managers are operating. Regulatory authorities force managers to provide high level of transparency to their managers enabling for building better relationships between General Partners and Limited Partners, attracting more capital and enhancing alternatives’ public profile. But how much are alternatives affected and are the regulations assisting in the growth of the industry? The regulations targeting alternative investments are Undertakings for Collective Investment in Transferable Securities Directive (UCITS V) and Alternative Investment Fund Managers Directive (AIFMD), but others may also affect alternative vehicles such as IFRS, MIFID II, Basel III, Solvency II in Europe and Dodd-Frank, Volcker Rule and FATCA in the US. The crucial question is: do regulators add value to investors with their regulations and more importantly do they understand what they regulate? The pursuit of innovation is leading funds to adapt complex techniques and strategies that are not conceivable to an audience with a solid financial background, which makes the understanding of non-financiers equivocal. UCITS funds have not been yet through an actual crisis and the regulatory framework could be proven to be shadow-protecting investors. AIFMD is considered to bring a breath of fresh and positive air to the alternative space, by providing better risk management policies, better and more transparent reporting and by upgrading the role of the depository in the funds’ structure and management equation.
Hedge funds is the most discussed asset class occupying the press with both positive and negative news and currently manage around 40% of the capital allocated in alternatives. On the positive side, we witness their comeback after a struggling start in January and February this year with event-driven and quant strategies leading the way. CTAs recorded a net inflow of $16.6bn in the first half of 2016, while the rest of the asset class recorded net outflows of $34.2bn according to Preqin. The leading strategies of the revival of the industry could be new, exotic strategies that will provide investors with uncorrelated sources of alpha. Investors need alternative strategies within the alternative investment industry and such strategies can be from cryptocurrency like bitcoin and volatility strategies to art and classic items strategies. But not all of them qualify as institutional quality strategies and this perspective is focussed on finance related strategies. Funds focussing on shipping and aviation, bitcoin, directors’ dealings and volatility could offer more opportunities in the current saturated financial environment.
Hedge funds struggled so far this year and despite their recent streak of “green” months they still underperform traditional investing. The departure of big pension names and the fee structure of the industry monopolised the interest from the press, overshadowing the new opportunities sought by other institutions in the space. Equity and macro strategies are popular amongst investors, followed by multi-strategy funds and CTAs, despite CTAs’ better performance and diversification profile to long/short equities.
Sophisticated investors are able to play the entire corporate capital stack from traded and liquid debt in high yield bonds and CLOs to more illiquid private debt in levered loans and direct lending, to illiquid private equity in buyout and secondaries. Figure 13 describes European and U.S. differences in return and volatility for lower middle market corporates with BB and B ratings.
Figure 14 demonstrates diversification benefits of private markets due to low positive or negative correlation of middle market loans with traded bond and equity markets.
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