Playing the long game
The trick to purchasing assets which have an important role to play in a portfolio but are currently trading at high valuations is to map out a multi-year phase-in which will allow the investor to benefit from some of the dips in the market.
“This enables the investor to neutralise the high valuation while still achieving the ideal asset allocation,” Hentov says.
While public pension funds have been embracing alternative investments, it’s at a much slower pace than for SWFs. Hentov points out that allocations to alternative assets have roughly doubled since 2008.
Total global allocations of public pension funds are lower than that of SWFs at 12%. “Despite the ageing population, these funds are forecast to be the net recipients of cash until the mid-2020s,” Hentov says.
Finding matching assets is not the only benefit of investing in alternatives, investors can still benefit from an illiquidity premium – despite the higher valuations. An example is that many of the fixed income alternatives are giving investors an illiquidity premium of around 1% relative to investment grade debt.
But the illiquidity premium is not constant. Datta says: “Like many other investment characteristics, it goes through cycles.”
Just as other investment characteristics move out of line with their fundamentals when an asset becomes too popular so does the illiquidity premium. “It would be wrong to assume this premium is immutable and guaranteed,” Datta adds.
The dynamic nature of the illiquidity premium behoves investors to be sceptical. Datta says: “Some of the illiquidity promises may be excessive.”
The illiquidity premium is also notoriously hard to measure. “It tends to be specific to each asset class,” Datta says. Attempts to measure a generic illiquidity premium has had difficulties. Datta puts this down to investors not selecting such assets based on their relative illiquidity premiums.
As illiquidity premiums are asset class specific, it is determined by how cheap or expensive it is relative to that asset’s long-term cash-flows.
Datta says: “Rather than investing in an asset on the assumption the investor will be paid for locking up their capital, they should take a hard look at expected return and the risks involved.”
Even if there are question marks around the persistence of the illiquidity premium, the returns of alternative assets remain attractive relative to other asset classes, despite recent declines. For example, long-term private equity returns have declined to around 12% from 19%, but this is still attractive compared with other assets.
Return issues
But those performance statistics might not be as good as they first appear. “There are measurement issues surrounding some alternative assets,” Datta says.
There are, for example, issues around measuring the returns of private equity and infrastructure. Datta says: “With private equity there is a lack of information and it’s hard to translate the internal-rates of return used by infrastructure investors into performance.”
The problem is particularly acute for long duration asset classes which are difficult to measure in a way which can be compared with public markets. Datta says: “These issues have yet to be fully resolved.”
Sourcing of deals can also impact the returns of private equity. “There are more private equity firms competing for fewer opportunities,” Datta says. “That will result in taking longer to invest capital which will affect the fund’s ability to generate returns.”
