June 20, 2022

Alternative investments can enhance diversification and returns of a public markets heavy portfolio. Here’s how.

Exposure to alternative investments, specifically, private equity, private credit, private real estate, and hedge funds, may complement traditional portfolios by providing uncorrelated returns that increase diversification, as well as the potential for enhanced capital appreciation or income. However, investors trade off the liquidity of being able to sell securities at any time through the public markets in order to have the opportunity to realize the performance premium that alternative investments offer through longer term strategies.

Different alternative investment strategies separately address different investment goals. Private equity may provide greater capital appreciation that complements publicly traded stocks, while private credit can offer enhanced income that complements public debt securities. In addition, private real estate can offer both income and capital appreciation, while fund of fund strategies that invest in hedge funds can mitigate risks.

Private Equity

The number of publicly traded stocks has fallen by roughly half in recent decades through mergers and bankruptcies, making private equity an attractive option to seek companies creating new markets. But private equity previously acquired a negative connotation due to past practices that were perceived as greedy. Paying down debt and seeking a higher multiple to realize returns, often led to cost cutting that negatively impacted employees and their communities through layoffs and facility closures. However, value drivers have changed over time. Managers today seek to improve operating performance by increasing revenue and expanding profit margins through proactive intervention to provide support. Furthermore, private equity is not at the mercy of traders and quarterly earnings guidance that may result in volatility from negative surprises, which are uncorrelated to returns based on a company’s fundamental improvements.

Private Credit

Recent decades have also seen a significant decline in the number of banks due to consolidation, regulation and bankruptcies, creating a need for new lenders to corporations. Private credit has helped bridge this funding need while offering investors better terms than corporate bonds provide. Terms include floating rates that increase with rising market interest rates and provide a hedge against inflation, while bonds with fixed rates decline in price to offer higher yields to attract purchasers in public markets. Floating rates enhance uncorrelated returns relative to fixed rates. In addition, private credit may have protection from bankruptcy by having as collateral the assets of a company that unsecured bonds do not.

Private Real Estate

Private real estate offers current income from rents as a primary objective and capital appreciation as a secondary objective from the sale of properties. Real estate historically was negatively correlated to stocks. However, publicly traded real estate investment trusts (REITs) have increasingly greater positive correlations to stocks due to market-related beta returns following central bank liquidity injections. Private real estate offers uncorrelated returns to public REITs by being valued on net assets based on methodologies such as discounted cash flows or recent property sales.

Each of the above strategies provides uncorrelated returns based on current fundamentals and over-time improvements in the underlying companies or real estate assets. This, compared to their traditional public counterparts based on market prices that are subject to swings in investor sentiment.

Hedge Funds

Industry leading hedge funds formerly attracted inflows by generating outsized returns year after year. But other hedge funds attracted notoriety by failing, due to using debt to take concentrated positions in securities that performed dismally. As a result of growing competition using similar strategies, the expected aggregate returns from hedge funds as an asset class have been substantially lower since their heyday. Alternative investment managers now employ hedge funds to reduce risk in client portfolios. By structuring fund of fund strategies that invest in hedge funds across multiple asset classes, managers seek to deliver relatively steady equity-like performance with uncorrelated returns from lower risk targets than expected market volatility.

Implemented together, alternative investments can provide risk mitigation from uncorrelated returns, along with the potential for enhanced capital appreciation and income. The benefits of alternative investments can be measured over time by how efficiently they generate returns relative to their risk, or their risk-adjusted returns. By adding a mix of alternative investments that have a higher risk-adjusted return than a traditional portfolio, the blended results can enhance an investors potential to achieve their specific financial goals.

Stay tuned for our next blog that outlines why these financial opportunities have been historically accessible to institutions and high net worth individuals alone and how Poolit is aiming to expand that access to all accredited investors. Join the waitlist at www.thepoolit.com to gain early access to alternative investments when we launch our app this fall.