An Introduction to Alternative Investments

What Are Alternative Assets?

Alternative assets are generally defined as investments that fall outside traditional equity and bond investments. Assets under management (AUM) for alternatives have already almost tripled over the last decade to roughly $13.3 trillion in 2021 and could grow to over $23.2 trillion by 2026 (Exhibit 1).

Source: Preqin Forecasts, as of Q3 2021, 2021 figure is annualized based on data to March, 2022-2026 are Preqin's forecasted figures.

The continued growth of alternative investments may be broadly related to two themes. First, some investors may be concerned that the returns from traditional asset classes in recent years may not be easily repeated in the coming years, particularly as inflation and interest rates rise. Alternative asset classes may offer the potential for higher returns because they tend to take on more risk.

Other investors may be exploring alternative asset classes as they seek differentiated sources of return that may be less correlated to traditional asset classes and could help diversify a portfolio (Exhibit 2).

Source: Preqin Investor Survey, November 2021.

These themes – potential for higher risk/reward and diversification – can result in some characteristics of alternatives that differ from traditional investments.

• Longer-Term Investments: Many alternative investments need time for their value-creation strategies to play out, often requiring a multi-year investment horizon.

• Access to Less Conventional Investments: Alternatives may offer the opportunity to invest in assets that can be harder to access through traditional investments, such as infrastructure, natural resources, early-stage private companies, and niche real estate, to name a few.

• Private and Less Regulated: Alternative investments are generally private investments and subject to limited regulations compared to public investments. This contrasts notably with traditional assets like stocks and bonds, which can be traded directly on exchanges or owned in funds, such as mutual funds and exchange-traded funds (ETFs), both of which are relatively liquid, transparent and regulated.

• Liquidity: Alternative investments are generally less liquid than traditional asset classes because the funds and many of the underlying assets are not publicly traded and may lack a secondary market. In addition, in many cases, alternative funds require capital to be locked up for periods of years because of the time it takes to execute on the investment strategy.

• Institutional/Qualified Investors and Minimum Investments: The higher level of risk associated with many alternative investments has often restricted ownership to institutional investors or those deemed capable of understanding the investments and their associated risks. Similarly, minimum investments are typically set higher, although this is beginning to change with some innovative product development.

What Are Some of the Different Categories of Alternative Investments?

Alternative assets share some common characteristics that set them apart from traditional assets, as noted above. But it is important for investors to understand that within alternatives, asset classes and strategies may function in a unique way from one another and offer a wide variety of risk and return profiles (Exhibit 3). For example, while a long/short equity hedge fund and a timber fund may both be classified as alternatives, the underlying assets they own, the way they generate returns and their resulting risk profiles are considerably different. We describe five broad types of alternative asset classes to illustrate the range of characteristics.

• Hedge funds are commonly described as private, actively managed, pooled investment vehicles subject to less regulation than many traditional investments, such as mutual funds. This may allow hedge funds more flexibility in terms of the assets they can invest in, their investment style and the management of the fund. This flexibility may be important because the goal for many hedge funds is to earn positive risk-adjusted performance in all market conditions. As a point of reference, Preqin reports that hedge funds returned 10.8% with 7.6% volatility over a 5-year period.¹

• Private equity is the broad term for investing in a privately owned company rather than owning shares in a public company that can be traded on an exchange. Private equity has the potential to offer higher returns than both public equities and some other alternative investments over the long term,² a reason some investors consider adding an allocation.

• Private debt, also called private credit, typically refers to loans that are privately negotiated between two parties, as opposed to traditional syndicated loans or bonds issues that are more broadly available to fixed income investors. While viewed as comparable to non-investment grade syndicated leveraged loans and high yield bonds, private debt is not rated, which can make it riskier, but also contributes to its potential for higher yields and returns.

• Real estate is generally defined as tangible property consisting of land, buildings and related structures. Private real estate investments can be made through a direct transaction for a single property, direct acquisition of a portfolio of assets or through a diversified commingled fund.

• Real assets is the broad term for investments in physical assets, commonly including infrastructure and natural resources, and sometimes real estate. Infrastructure assets are related to a wide variety of physical assets that tend to play critical roles in helping economies run, ranging from gas pipelines and power grids to airports and data centers. Natural resource investments may be related to infrastructure or land involved in the development or processing of natural resources, such as forestry, as well as the commodities themselves.

How Is the Alternatives Market Evolving?

For years, many institutional investors have been increasing their allocations to alternatives (Exhibit 1), typically in search of higher returns and diversification. This has contributed to the growth of the alternatives market, in terms of assets under management and innovative product offerings.

Institutional investors have also helped alternatives become more transparent by demanding higher quality reporting and analysis, as well as carrying out their own due diligence. The increase in data and research on alternative asset classes by independent providers may also contribute to better information for investors and could lead to further allocations.

As the alternatives industry matures, a wider audience may be able to access the asset class. Newer types of investment vehicles, notably interval funds and liquid alternatives, may offer better liquidity than typical alternative investments and require smaller minimum investments.

Allocations to alternatives could grow further, as many investors continue to seek differentiated sources of returns. Furthermore, continued product innovation could fuel growth in alternative assets under management and expand the investor base through improved access.