Why Smart Investors Are Betting Big on Alternatives (And You Should Too)

Per JP Morgan’s 2024 Global Family Office report, Family Office allocations to alternatives are averaging to 45,72% across their circa $164,2 billion assets under supervision. With an estimated $84 Trillion in global wealth transfer via family offices to take place between now and 2045, it is clear that the growing allocation to alternative assets is one not to be ignored. With a plethora of alternative investments to choose from, ranging from your traditional long/short equity hedge fund, to exotics like alligator farming, how does one decide on alternative allocations? Why Should you have them present in your portfolio? And how does one select managers and strategies in a world so vast?

What are alternatives and their role in portfolios?

Alternative investments refer to any investment strategy that is not traditional instruments, namely cash, stocks and bonds (stay with me). Private Equity, Venture Capital, Commodities, Real Estate and Hedge Funds all fall into realm of alternative investments. Why do they exist? On an individual level, these investment strategies create differentiated risk return and liquidity profiles from traditional investments. In a portfolio context, they are included to create a source of outsized alpha generation, PnL stability via their segregated risk profiles to traditional investments and as a result, act as a diversification tool (the investment profile of non-correlated, high returns is referred to as an absolute return strategy). Over the years, alternative investments have been reserved for the ultra wealthy and institutional investors resultant of high minimums and fees. With what is being called the ‘democratisation of alternatives’, more and more investors are gaining access to these strategies without the barriers to entry that were once present.

Why do we need non-correlated alpha now more than ever?

Since the introduction of derivatives (a contact between 2 or more parties that derive its value from an underlying asset, typically to increase exposure above one to one to the underlying asset) via the CME in the 1970’s following the collapse of the Bretton Woods System, which fixed global currency exchange rates, and the subsequent deregulation of derivatives in the 1990s, the global economy has become exponentially more susceptible to asset correlation via systemic market crashes, otherwise known as deleveraging events. These events tend to cause chaos throughout the financial ecosystem with extreme fear reducing asset prices to a fraction of their average price, further exacerbated by a dwindling of liquidity. One can seek no further than the 2008 property market crash as a result of Credit Derivative Swaps and Mortgage Backed Securities, and the Dow Jones Flash crash in 2010.

Taking a step back, its challenging to grasp the problem that investors face when it comes to derivatives in relation to their systemic risks. For a sense of scale, if we were to add the total market cap of all cryptocurrencies, the world’s gold reserves, the central bank balance sheets of the US, EU, China and Japan, and all the world’s global money supply, we would have figure in the realm of $123 Trillion. Thats a lot. The derivatives market? $600 Trillion, twice the size of the world’s global debt, including that of households, corporations and government.

For a visual sense of the absurd sense of scale between the global economy and derivatives, see Visual Capitalist’s infographic below:

Beyond offering a sobering perspective on the interconnected nature of modern markets, how does this relate to the role of alternatives in portfolios? Derivatives, due to their leverage, amplify market volatility. When large players face liquidation events as a result of said volatility, they may be forced to sell other holdings to maintain liquidity across the board. This triggers a cascade effect, as large liquidations of one player drive additional liquidations and subsequent momentum in unrelated markets—a phenomenon known as contagion. In essence,

The challenges faced by portfolios before the advent of derivatives were vastly different. Today, with increased liquidity, more complex risk-return profiles, and heightened return volatility, investors face a far more demanding landscape, hence the need for alternative sources of alpha.

Strategy Selection & Allocation

As mentioned, the world of alternatives is as wide as it is deep, with strategies varying from vanilla long / short equity funds to whiskey and timber investing. Given that this universe is a challenging one to cover holistically, a better starting place would be with the portfolio goals, with the following considerations:

Liquidity / time requirements

Many exotics / alternative alternatives, like whiskey investing, require significant holding for alpha to materialise. In the case of whiskey, a 5-year holding period may be unachievable for many portfolio’s aiming to obtain predicable cashflows. In the case of a small family office with serviceable Real Estate Assets requiring debt obligations, liquidity is a priority. In the case of large institutions or endowments with an effectively infinite investment horizon, these holding periods are inconsequential to their fund performance.

Exogenous and Endogenous Risks

With differentiated sources of alpha come equally differentiated sources of risk. The more exotic the strategy, the more niche the risks—and often, liquidity constraints during associated risk-off periods. Take timber investing as an example: natural disasters are a common threat. Imagine a fund with $1 million exposed to timber in Country A. If the fund is alerted to an impending natural disaster, such as a tornado, within three days, selling the timber in such a short timeframe in a relatively illiquid market is virtually impossible. Weather derivatives may already reflect the heightened risk premium, leaving few immediate options.

Challenges like these demand specialised expertise from managers—solutions that often lie beyond the scope of the average investor. This makes thorough research into both the exogenous and endogenous risks of alternative investments critical. Don’t hesitate to ask managers directly about the risks they foresee and their strategies to address them.

Risk-Return Profile

With sophisticated investments comes sophisticated risk return goals. Information, Sortino, Calmar and Sharpe ratios all come into play when evaluating the elements that make up the volatility of PnL and return distributions relative to benchmarks. With the rise of collateralised loans against investment portfolios, the intricacies of risk-return profiles become an ever-increasing topic of discussion depending on the needs and values of the portfolio. Globally, the average targeted return amongst family offices is 11% annually, with the upper end of target returns stretching as far as 21%.

These levels of dispersion are likewise echoed between alternative’s themselves, and are far wider than those of traditional asset managers. Typically, industry standards hover around 100 basis points of dispersion within the asset management sector. As a whole, alternatives see levels in excess of 200% of asset management, near to 200 basis points - it is clear that manager selection is everything.

With different levels of risk associates with managers and strategies, it is imperative to consider the following: Alternatives, generally speaking, are skill-based. This forms a firm segue into the final and most important point -

Manager Selection

With family offices increasing their allocations to alternative investments while maintaining a focus on liquidity, they have become leaders in selecting both emerging and established managers. While the quantitative factors of such decisions are crucial, qualitative aspects often play a decisive role. Family offices, viewing their investments as extensions of their family and values, typically seek managers and strategies that align with their ideologies—an often-overlooked aspect of modern investment strategy.

Quoting Anastasia Amoroso of iCapital during her interview with J.P. Morgan on their show Alternative Realities: Private equity (PE) funds have often been criticised for relying on financial engineering and leverage rather than demonstrating skilful opportunity selection. Simply put, leverage has frequently served as a crutch to inflate returns artificially, resulting in a poor risk-reward profile.

The private equity sector achieves an average annual return of approximately 14%, but with significant dispersion—ranging from just over 0% in the bottom decile to nearly 30% in the top decile. This stark contrast underscores the critical importance of manager selection. Identifying top-tier managers is essential, as the difference between good and poor performance can be substantial.

As we transition to a more normalised interest rate environment, there has been a noticeable shift toward PE managers who can generate returns through prudent opportunity selection, as the "low-hanging fruit" of leverage-driven returns has largely disappeared. Why is this important? Consider a manager who has relied on leverage to drive performance over the past decade. Shifting to a strategy focused on skillful opportunity selection represents a daunting challenge. If you had invested with such a manager during their prime, would they have the character and capability to adapt and perform under these new conditions?

There is no clearer commentary on the above than Ash Williams, who echoed this sentiment on Alternative Realities, stating

Key Takeaways:

• Alternatives are non-traditional sources of outsized alpha

• Now more than ever, alternatives are an imperative component of portfolio divserfifiaction as a result of the correlation between traditional assets, caused by derivatives and systemically large balance sheets.

• Family Office’s have taken a strong stance toward alternatives, with average allocations in the realm of 45% of portfolios.

• Start by considering the quantitative goals of portfolio’s, namely in relation to target return, risk reward profiles, liquidity and risks to refine strategies to be short-listed.

• Select managers based on their value system and alignment to your portfolio goals - this is objectively the most important element of the process given the wide dispersion of returns in the alternatives sector.

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