Implementing Illiquid Investments
Because we have not found traditional stock and bond asset classes attractive for over two years, we have been overweight diversifying alternatives. We have further covered the pros of alternatives and the cons of traditional asset classes in our quarterly publication – Twelve Points Perspectives.
Most of the alternative investment vehicles historically available via traditional (40-act) mutual funds and ETFs to non-institutional investors have been of the “risk-reducing” kind. Examples of the risk-reducing “hedge-fund-like” alternative strategies used in our portfolios over time include:
- Absolute Return
- Event Driven
- Long-Short Equity
- Managed Futures
- Market Neutral
While these strategies offer an expectation of capital preservation and non-correlated diversifying returns, their defensive nature does not allow for high upside. At a time when traditional asset classes have low return expectations, and risk-reducing alternative strategies also do not promise significant total returns, we have been looking to implement “return-enhancing” alternatives.
The lone hedge-fund-like return-enhancing 40-act alternative strategy historically available to non-institutional investors has been Global Macro, which has also been used in our portfolios. While quality Macro managers should outperform (a balanced Global benchmark) on a risk-adjusted basis over a full “market-cycle,” many of them have struggled. These managers have been overweight the fundamentally attractive asset classes – International & Emerging Markets Stocks & Emerging Market Currencies, and underweight the unattractive U.S. Stocks and Developed Bonds. Unfortunately for the Macro managers, these unattractive asset classes have continued to get even more expensive over the past couple years.
We have an “Endowment-like” approach to portfolio construction. The biggest asset-allocation difference between our portfolios and the typical Endowment portfolio has been the lack of return-enhancing illiquid asset classes – Private Equity and Credit. We have had an allocation to Private Real Estate, the other Private asset class mainstay – and it has been one of our best risk-adjusted performers.
These Private asset classes are attractive for a number of reasons, for instance:
- The Illiquidity Premium leads to an expectation of higher returns.
- Due to their illiquid nature, these asset classes are less volatile than the public markets.
- This illiquidity also reduces the Behavior Gap, as investors are somewhat protected from their own worst (behavioral finance) instincts – i.e. panicking and selling at market bottoms.
- The stable asset base of these investments allows the portfolio managers to be the liquidity providers in times of market dislocations – i.e. being able to buy a $1.00 asset for $0.75, as public market managers are forced to sell due to investor redemptions.
- The sizes of some of these illiquid asset classes are vast, yet they are completely under-owned by a typical non-institutional investor. The total investable Private Institutional Real Estate market in U.S. is approximately 1/3 the size of the U.S. stock market. Likewise, there are exponentially more Private Middle Market companies than there are Publicly Traded ones, and these Private Middle Market companies are typically less expensive (P/E, P/B) and often grow at a faster rate.
- Many Private asset classes produce high income and/or give access to “real” inflation fighting investments.
- Many of the currently attractive asset classes simply can’t be owned via a daily liquidity vehicle.
The summer of 2012 saw the birth of a new investment structure – the Interval Fund. This continuously offered, semi-illiquid (typically quarterly liquidity, with at least 5% of the fund’s assets made available for redemption) investment vehicle blends some of the attractive elements of mutual funds and Closed End Funds. Its limited liquidity makes this vehicle well suited for alternative asset classes, while its 40-act status makes it available to non-institutional investors.
The 1st interval fund was created to make Private Real estate available to non-institutional investors. Over the next few years, a number of additional alternative asset classes and strategies were launched via the interval fund structure (and other similar Registered Investment Vehicle, RIC, structures). At last, the Endowment asset classes, such as Private Equity, Private Credit, and Insurance Linked Securities, which were previously out of reach for non-institutional investors became available for investment.
After making our first interval fund allocation (to Private Real Estate) in 2014, we have been studying the new interval funds and RICs coming to market, and have recently made two additional allocations – to Marketplace Lending and Insurance Linked Securities. Additionally, we are considering allocations to Private Equity and Real Assets (such as Infrastructure and Timber).
Stay tuned for the follow-up blogs where we will dive deeper into the reasons behind the current relative attractiveness of these Private asset classes, and the specific benefits they bring to a well-diversified portfolio.