We live in unconventional times. Financial markets are behaving in ways that would have seemed inconceivable to investors whose historical frame of reference was major financial markets in the second half of the twentieth century. On almost all long-term valuation metrics, traditional asset classes look expensive, bond yields are at historic lows and equity markets are expensive relative to earnings. These abnormal circumstances have persisted for so long they are becoming the new normal.
The cause of these distortions is relatively clear. In an attempt to support flagging economies, central banks have been pumping major economies with liquidity. While there is plenty of debate about the related growth outcomes, there is no doubt this wall of money has driven down interest rates and boosted asset prices.
In the domestic context, very low interest rates have encouraged investors to seek out yield beyond traditional term deposits, driving up valuations for almost any asset able to deliver income to cash-hungry investors. While the future path of interest rates is always uncertain, it is difficult to argue that falling interest rates will provide the same tailwinds to asset valuations in the future as they have in the recent past.
In this context, investors are increasingly focusing on alternatives: assets that sit outside the traditional equities and fixed income. Typically, alternatives include: private equity and venture capital – equities in companies that are not listed on a securities market; private real estate – unlisted real estate investment opportunities; real assets – tangible assets including infrastructure, agriculture, timber and water; and hedge funds.
International investors have long been strong believers in alternatives, US university endowments for instance allocate between half and two-thirds of their portfolios to alternatives. Recognising the outperformance of this strategy, the Future Fund in Australia has allocated over a third of its portfolio to alternatives. With awareness growing, alternatives have become the fastest growing asset class in Australia. Rainmaker expects allocations to increase from 16 per cent today to 20 per cent over the next two decades.
The common thread across the alternative asset classes is a risk, return, liquidity and correlation profile that differs from the traditional asset classes of equities and fixed income.
When done well, alternatives deliver on three really important components. They are usually less correlated with financial markets, providing actual diversification benefits in the tough times. They give investors access to asset classes not available on public markets. And they provide for investment outperformance as a price for their relative illiquidity.
The alternative investing universe is broad, with managers pursuing a range of strategies to deliver returns and portfolio diversification. These are worthwhile objectives for investors at any point in the investment cycle, but become even more important during periods of market extremes like those that exist today.
