Think big: smaller investors deserve diversification through alternative investments

What do London City Airport, Vancouver’s Canada Line SkyTrain, and the Toronto Maple Leafs all have in common? They’re all currently or formerly owned, at least in part, by a major Canadian pension plan.

This fact should come as no surprise to sophisticated investors. Canadian pension plans—some of the largest and most respected in the world—are renowned for their early and often adoption of alternative investments such as private equity, real estate, infrastructure, and natural resources.¹ This trend began in the early 1990s, but the continual decline in rates and the associated hunt for yield, along with the need to diversify portfolios away from traditional asset classes, have led to a significant increase in alternative investments’ prominence among Canada’s largest investors in recent years. Today, it’s not uncommon for some of these investors to allocate half of their portfolios to nontraditional assets.

It’s not only pension plans with hundreds of billions of dollars that have turned to alternatives as a way of broadening their exposure; indeed, many medium-sized plans still have significant allocations. For example, as of September 2020, pension plans in Canada with over CAD$500 million in assets under management (AUM) had roughly 35% of their portfolio in alts. Where we begin to see a significant difference is among smaller pension plans; those with less than CAD$500 million in AUM had just a fifth of their portfolio allocated to alternatives.²

So what’s preventing these smaller yet still capable institutions and high-net-worth (HNW) investors from allocating capital into alternative investments? We’d argue that two key roadblocks are accessibility and liquidity.

Regarding the former, there was a time when alternative asset managers, intent on growing their funds, would gladly accept capital allocations of all sizes. But with so many institutions seeking additional returns of late by adopting alts, we’ve reached the point of too much money chasing too few deals. Dry powder—yet-to-be-deployed cash in the hands of alternatives managers—continues to make new highs year after year, topping US$2.5 trillion at the end of 2020.³ This means that alts managers that were in heavy fund-raising mode just a few years ago are now in the enviable position of being able to choose their clients and dictate fees. Smaller players may, therefore, be passed over or forced to pay higher fees for the “privilege” of investing their capital.

“You've got a huge wall of money around the world looking for fixed-income, government-bond alternatives when you have zero-to-negative interest rates."

– Mark Machin, CEO, Canada Pension Plan Investment Board⁴

Liquidity—or lack thereof—is the second major impediment to smaller institutions and HNW investors increasing their presence in alts. Selling stocks and bonds to meet obligations can be done fairly easily, but selling bridges and wind farms can take months or years, so liquidity is always a concern when investing in private alternatives. This hurts smaller investors more than bigger ones, as the latter generally have significantly deeper cash reserves and/or lines of credit to meet payments to their depositors or clients or, in the case of HNW investors, to fund personal obligations.

Facing hurdles that large firms may not have, smaller institutions and the HNW segment have a significant disadvantage in their ability to allocate capital to nontraditional assets. As a consequence, buy-side portfolio managers must make difficult decisions around the inclusion of alternatives. For example, with a limited amount of capital to invest and with alternative fund managers raising their minimum investments, these smaller investors may be forced into choosing between asset classes—they might decide to invest, perhaps, in timberland rather than real estate, even though both may be complementary and beneficial to the portfolio. This could result in less diversification than could be otherwise achieved by investing in multiple alternative assets.

The consequences of these difficult decisions can be highly detrimental to portfolios’ risk/reward dynamics. By underallocating to alternative investments, or neglecting them entirely, smaller plans may be missing out on their significant diversification and returns potential. For example, a fund invested in both U.S. equities and public real estate (perhaps through real estate investment trusts) may consider itself diversified, but remember that these asset classes are fairly correlated, with a coefficient of about 0.68. Replacing a portion of the public real estate portfolio with private real estate investments could be highly beneficial—the latter’s correlation with U.S. equities is significantly less, at 0.13. Or consider a manager holding U.S. bonds along with U.S. public equities—the two asset classes are negatively correlated, with a coefficient of ‒0.34. Certainly, that’s a good thing, but the correlation between U.S. bonds and U.S. private equity is nearly identical, at ‒0.36. The difference here is that U.S. private equity’s performance over long periods has been vastly superior to that of U.S. public equities, so by overlooking private equity, managers may be leaving money on the table.⁵

We can see the potential for improved risk/reward dynamics by comparing a hypothetical equity and fixed-income portfolio’s efficient frontier against the efficient frontier of the same portfolio but with a 25% allocation to alternative assets (i.e., 5% each to private equity, infrastructure, real estate, timberland, and farmland).⁵ The aforementioned diversification benefits and potential for improved long-term returns push the frontier up and left, meaning better potential reward for a given level of risk or reduced risk for a given level of expected returns.

Of course, all of these benefits are a moot point for smaller institutions and HNW investors if they can’t access these strategies, or if they choose not to out of liquidity concerns. Thankfully, there are much-needed changes and solutions on the horizon.

In recent years, managers of alternative investments have recognized the need to bring their strategies to smaller investors and have responded with new fund structures that are leveling the playing field for these smaller investors.

These new strategies incorporate multiple alternative asset classes into one investable fund. Built as open-ended funds of funds, they offer the ability to invest in several alternative investments under one umbrella and generally with lower minimum investments than fund managers would otherwise require, meaning that smaller investors don’t have to choose one alternative asset class over another. This also improves diversification potential, as the asset allocator is able to invest in several different alternative investments at once, leveraging each one’s different risk and return dynamics.

We caution with two caveats. First, this structure has additional costs of administration (e.g., the fund flows) and therefore has slightly higher fees than a similar stand-alone fund. Second, manager research and selection are absolutely critical, as performance and risk characteristics of the funds of funds (and of the underlying funds as well) can vary widely in the alternatives space—arguably, more so than in public markets. Still, for those investors who are unable to otherwise invest in alts, we believe the potential improvement in risk/reward dynamics far outweighs these additional fees.

Importantly, the open-ended structure of these funds means that the issue of liquidity can also be managed. Traditionally, many private alternative funds are closed ended, meaning that new investors can’t enter the fund after it closes and current investors can’t exit until the fund terminates and liquidates. Under an open-ended structure, liquidity windows can be offered to those current investors seeking it as new ones take up the slack. This can help ease investor concerns surrounding the need to meet their obligations.

Finally, open-ended funds that are managed wisely can also mitigate the J-curve effect. New entrants to the fund would benefit from a portfolio of investments (whether they be private companies, farms, bridges, or office buildings) that are already performing well, meaning the J-curve effect is diminished. At the same time, as the fund grows and fresh capital is deployed into new assets, investors also see return patterns associated with small but quickly growing assets. In other words, investors can benefit from return patterns associated with both greenfield investments (not yet profitable or income generating but with significant potential for capital appreciation) and brownfield investments (profitable and generating income but with less capital appreciation potential). Key to this is that new capital must be quickly and efficiently deployed; strategies that sit on cash for too long end up eating into investor returns, as fees are charged on committed capital. The responsibility is, therefore, on the portfolio manager to make sure that capital can be put to work quickly to further reduce the J-curve effect on end clients.

The J-curve is a graphical representation of the return patterns of many alternative investment funds, particularly in private equity. It demonstrates that young portfolio companies may not be profitable for several years, meaning unrealized returns to end investors are lower (even negative) early on, before recovering and ramping up quickly thereafter. Fees on capital committed but not yet deployed also contribute to the J-curve effect. Both of these factors—young investments and fees—can be managed in a proper open-ended fund structure and, therefore, the J-curve effect can be diminished.

The increasing presence of alternative investments is undoubtedly a good thing for the financial community at large, but until recently, their benefits have been limited to the largest investors. Going forward, we expect HNW investors and smaller institutions to seriously consider new structures that are tailored to clients that can’t meet traditionally large investment minimums but that provide the same diversification and returns benefits that larger investors enjoy. The ongoing democratization of alternative investments continues to progress—we’d suggest clients of all sizes keep a close eye and think big.

1 For example, see https://www.economist.com/finance-and-economics/2012/03/03/maple-revolutionaries, 2012. 2 Canadian Institutional Investment Network, as of September 4, 2020. 3 Preqin Ltd., as of January 19, 2021. Alternatives here includes private equity, infrastructure, resources, and real estate. 4 https://www.bnnbloomberg.ca/cppib-sees-wall-of-money-chasing-private-deals-in-frothy-times-1.1540239 5 For example, in the 25 years to June 30, 2020, the Cambridge Associates US Private Equity Index returned 13.51%, annualized, to the S&P 500 Index’s 8.54%. Those figures are made comparable to each other using Cambridge Associates Modified Public Market Equivalent. See www.cambridgeassociates.com/wp-content/uploads/2020/11/WEB-2020-Q2-Global-Private-Equity.pdf, June 30, 2020. 5 See notes on the hypothetical efficient frontier in the disclosures. 

Efficient frontier disclosures

The efficient frontier model portfolio is unaudited. The results presented are hypothetical, are not based on the performance of actual portfolios, and are provided for informational purposes only to indicate historical performance of a model portfolio.

The results reflect performance of a portfolio not historically offered to investors and do not represent returns that any investor has actually attained.

Changes in these assumptions may have a material impact on the result presented. Certain assumptions have been made for modeling purposes and are unlikely to be realized. No representations are made as to the reasonableness of the assumptions, or that any portfolio that follows such assumption will or is likely to achieve profits or losses similar to those shown. This information is provided for illustrative purposes only.

Assumptions used: