Simplistically, Alternatives are an asset class which falls outside traditional assets such as Stocks, Bonds and Cash. This broad asset class includes sub-asset classes such as Private Equity, Private Debt, Hedge Funds, Venture Capital Funds, and various Collectibles such as Wine, Cars, Art and now Digital Assets. Within each of these, there are different flavours so that the investor can get exposure to almost anything, e.g., Private Equity could be focused on Commercial Real Estate, a Sports Franchise or Healthcare to name a few.
Alternatives are typically used to diversify an investor's portfolio. However, despite being pooled into one bucket, the sub-asset components can have different risk profiles, liquidity, minimum investments and correlations to one another.
A good way to understand how Alternatives have been used to diversify a portfolio is to look at a typical Family Office's asset allocation.
The UBS 2022 Global Family Office Report, cited an average allocation of 43% to Alternatives. However, the real insight was how these allocations were split within the sub-asset classes. For example, half the Alternatives allocation was to Private Equity, with the second largest allocation to Real Estate and much smaller allocations to Hedge Funds, Private Debt, Commodities, Collectibles, and Infrastructure.
Furthermore, different Family Offices allocated differently depending on where they were based. A typical US Family Office allocated almost twice as much of their portfolio to Private Equity than their Western European counterparts. Middle Eastern Family Offices allocated over three times of their portfolio into Real Estate than their Latin American counterparts. And 25% of the overall cohort believed they would increase their allocation to direct investments in Infrastructure. Interestingly, some Family Offices have explored digital asset investing albeit with greater intentions to learn about digital ledger technology as opposed to trying to derive a return.
To understand why Family Offices' distribution within the asset class is not as straightforward as one might think, we need to look at the 5 metrics below:
Gaining exposure to Alternatives is sometimes seen as a cost to liquidity. Unlike listed instruments that tend to have daily liquidity, there is an increasing degree of illiquidity as you move into Alternatives. For example, Private Equity Funds can have locks up of 5-7 years. However, Hedge Funds can have redemption schedules from less than a year and some Mutual Funds and ETFs with underlying Alternative investment exposure, offer daily liquidity.
Volatility measures how large an asset price swings around its mean. For equity like Alternatives, such as Private Equity, it is true that those investments could be considered volatile, especially as they typically employ leverage and invest in small to mid-cap firms. However, there are debt-like Alternatives, such as Private Credit, where volatility is considerably less.
Again, it depends on the underlying exposure. An income generating Real Estate asset will have far less returns, albeit more predictable, than say a Global Macro focused hedge fund investment.
Previously, Alternatives were considered the domain of the ultra-rich with very high minimum investment thresholds. However, not only are there mutual funds and ETFs offering exposure to Private Equity, Global Macro investments, Commodities and Real Estate, you can also get direct exposure to individual Alternative assets such as Wine, Vintage Cars and Commercial Real Estate through fractionalization.
Investing in one Alternative sub-asset class, may not provide an investor with the necessary diversification benefits they seek. For example, in an Equity heavy portfolio of public market securities, investing in a Private Equity fund is likely to have high correlation. However, if investors look to spreading out their investment in Alternative sub-asset classes, much like they do across traditional Asset classes, it is possible to get some uncorrelated exposures.
Alternatives as an asset class have always been the bedrock of Family Office portfolios. However, the sub-asset classes are not homogenous and it is this secondary allocation which determines the overall success of this type of investment.
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