Text on screen: PIMCO
Text on screen: TITLE – Myths of Alternative Investments; SUBTITLE – with Devin Ekberg
Text on screen: Devin Ekberg, SENIOR CONSULTANT, ADVISOR EDUCATION
Image on screen: Devin speaking to camera in PIMCO offices
Devin Ekberg: My name is Devin Ekberg from the PIMCO Advisor Education Team. I'm here to talk about a very important topic of alternative investments. Now there's a lot of interest, and innovation, and opportunities for advisors to add significant value to their client's portfolio in this investment space. There are also a lot of misperceptions about alternatives. And I'm here to address two in particular.
Text on screen: TITLE – Agenda
Image on screen: Two boxes side-by-side highlight two myths of alternative investing. The box on the left, representing Myth 1, says alternatives are only available to institutions and the top 1%. On the right, Myth 2 is that alternatives are too risky.
The first misperception is that alternative investments are only for institutions or only the top 1 percent. We're also going to address whether or not alternatives are just too risky.
So let's talk about institutions.
Devin Ekberg: Now it's actually true that institutions have been investing in alternative investments for the last several decades. Institutions like endowments, and foundations, and pension funds.
Text on screen: TITLE – Why do individuals want access to alternatives? SUBTITLE – For the same reasons institutions do
Image on screen: A pie chart shows the asset allocation of Yale University’s endowment. The chart notes that about 70% of the assets are in alternatives, with the following breakdown: 24% in hedge funds, 24% in venture capital, 18% in private equity, 9% in real estate, 12% in foreign equities, 7% in bonds and cash, 4% in natural resources, and 2% in U.S. equities.
The most famous example is the Yale endowment model. Now Yale has allocated almost 70 percent of their portfolios to some form of alternative investments over the years.
And when you ask them why, they give you a lot of reasons. One of the biggest reasons is that their expectations for future returns in the traditional markets like stocks and bonds are a little bit less optimistic.
Text on screen: TITLE – Projected lower equity returns; SUBTITLE – Long-term capital market assumptions below historical averages
Image on screen: A table shows average expected returns and volatility for five different asset classes. The table divides the asset classes in two groups: public markets in two columns on the left, and private markets in three columns on the right. The numbers in the table show that public markets have lower expected volatility, but also lower expected returns compared with their private market counterparts. Global equities have an expected return of 7.3%, with volatility of 14.7%, while fixed income has an expected return of 4.3% and volatility of 4.4%. By contrast, private equity has an average expected return of 11%, with a volatility of 29.4%. Private credit has an expected return of 7.7%, and volatility of 13.1%. Real estate has an expected return of 8.5%, with volatility of 13.9%.
They think that the opportunities maybe lie in some of the alternative investments like private equity, private credit, and real assets. And they've certainly allocated to those investments over the year in anticipation of potentially higher returns.
Also what they've noticed is that the correlations between traditional asset classes like stocks and bonds have largely started to become more positive. Now that for diversification purposes is a little bit challenging when you're seeing correlations rise amongst traditional asset classes.
Text on screen: TITLE – Elevated correlations between asset classes; SUBTITLE – Difficult to find uncorrelated assets
Image on screen: A bar chart shows historical 10-year rolling correlation between stocks and bonds for each year from 1937 to 2021. Correlation is shown on the Y-axis, and the time span on the X-axis. Over the last three years, the correlation has been slightly positive, increasing from about 0.05 in 2019 to almost 0.1 in 2021. From 2005 to 2018, the correlation was negative, ranging between negative 0.2 and negative 0.6. This is the only period of negative correlations other than from 1962 to 1968. The chart also notes a period of inflation between 1965 and 1982, when correlations ranged between about 0.1 to 0.8.
In this particular chart you can see 10 year rolling correlations increasing over the last several decades, and might continue to increase as well. I also want to point out that in the periods during the '60s and '70s when we were experiencing high inflation, those correlations tended to be highly positive as well between stocks and bonds. And that may be a situation that we may be headed for in the future, at least to some degree institutions are predicting.
Devin Ekberg: Now there is a case for continued outperformance in some of these areas like private equity, private credit, and real assets.
Text on screen: TITLE – The case for potential outperformance
Image on screen: A diagram highlights the case for potential outperformance with three reasons, represented as columns left to right. Reason one is to seek active alpha, shown on the left, with bulleted points underneath, noting position-level intervention, control, and long-term horizons. Reason two, information, is in the middle column, noting different rules for material non-public information, information asymmetry, and operational intelligence. Reason three, on the right, is opportunity, noting there are larger opportunity sets than public markets, illiquidity premium and lower multiples, and a complexity premium.
One is that asset managers actually have an opportunity to add what I would call active alpha at a security level. In other words, they have an opportunity to construct an investment with the issuers to give it the best chance of success, aligning their objectives with the asset managers, and maybe providing some expertise and knowledge in some of those areas to produce the best result.
Secondly, there is an information asymmetry involved in some of these private markets and alternatives. Some of that information can actually be helpful to make the case for outperformance. And then thirdly, the opportunity set for alternative investments is typically broader and deeper. You simply have access to other types of investments that are not available in the traditional markets and traditional public markets.
Now individual investors are starting to see some of the benefits of this type of investing.
Text on screen: TITLE – Individual investors are increasingly allocating to alternative investments; SUBTITLE – What do HNW and affluent investors want?
Image on screen: The figure is a bar chart showing the intention to allocate to alternatives by high-net-worth and affluent investors. Bars from left to right show the percent of respondents who either own or intend to allocate to five different alternative asset classes. On the left, a bar shows 22% of respondents either own or intend to own private credit. Moving to the right, the percentage increases for each asset class: 32% for hedge funds, 34% for venture capital, 41% for private equity and 48% for real assets. Each bar also shows the amounts respondents actually own, which are about half or slightly less than half of the percentage totals.
And they're intending and indicating that they intend to allocate more to these types of investments. So in areas again of private equity, private credit, real estate, and others, these individual investors, high net worth and other affluent investors, are indicating their interest in this area.
Also some of the barriers and friction that individual investors have experienced in these areas are starting to be removed.
Text on screen: TITLE – Barriers are being removed
Image on screen: A table shows three columns, showing how structural problems of alternatives led to practical problems, which can be addressed by technology and products. The first column, on the left, lists seven structural problems of alternatives: capital calls, cash drag, large minimums, no liquidity, K1s versus 1099s, no IRA or ERISA eligibility, and no investor protections. This leads to practical problems, listed in the middle column: limited to QPs, un-investable by IRAs and DCs, limited interest and education, sporadic availability, and difficulty of assembling portfolios. A third column on the right shows how the problems can be addressed by technology and products, such as advisor platforms, next generation structures with liquidity, 1099 tax treatment, smaller minimums, and availability to accredited investors.
Traditionally in alternative investments and especially private markets, you had to deal with things like capital calls, dealing with situations of cash drag and illiquidity. There may have been complicated tax forms like K1s that they had to deal with.
Often times they weren't eligible to be inside their IRA or other ERISA covered accounts. And really, regulatorily speaking, they really didn't have as many investor protections for these types of investments. Now this led to a lot of practical problems for individual investors to involve. But as the market has evolved, we've seen these practical problems being removed. And we've seen the adoption of other technology and products, things like advisor platforms and next generation structures with liquidity.
We're seeing 1099 tax treatment, which is a little bit more favorable. And we're ultimately seeing some of the minimums come down to a smaller degree. All of those things are increasing the interest of these high net worth investors to alternative investments in their portfolio.
Text on screen: TITLE – Agenda
Image on screen: Two boxes side-by-side display two myths. The box on the left shows Myth 1, which is that alternatives are only available to institutions and the top 1%. On the right, Myth 2 – highlighted for discussion – is that alternatives are too risky.
Which leads me to the second misperception, which is alternatives are just simply too risky.
Now it's true that some alternatives may have a higher risk profile than some of the traditional investments. And it's also true that the manager dispersion of returns is much wider in the alternative space compared to traditional investments.
Text on screen: TITLE – Alternatives and manager selection; SUBTITLE – Public and private
Image on screen: A bar charts shows manager dispersion for the 10-year period ended Nov. 30, 2021, for traditional and alternative asset classes. Alternatives show much wider ranges of dispersion. The first three bars of the chart on the left-hand side show tight ranges for traditional asset classes. Global equities show an actual range of 11% to 12%, for bonds it’s 1.8% to 2.4%, and U.S. core real estate, 9.6% to 10%. Alternatives, represented by the next four bars to the right, show much wider ranges. The ranges are about 8.1% to 14% for U.S. non-core real estate, 7.3% to 19% for global private equity, 8.4% to 24% for U.S. venture capital, and 1.9% to 9.3% for hedge funds.
So it's that much more important to find a top quartile, a manager, or an effective manager. If you find a bottom quartile manager, you're simply going to have a worse experience. So it's important to do your due diligence and align yourself with a good manager, much more so than it is in traditional markets.
But it's always important to analyze risk not just at an individual security level, but in the context of an entire portfolio.
Text on screen: TITLE – Improved portfolio efficiency
Image on screen: A graph plots annualized returns versus annualized standard deviation for six different portfolio allocations. The plots show portfolios with alternatives have higher returns and lower volatility. Returns are expressed on the Y-axis, and standard deviation on the X-axis. A table below the graph includes the data for the plots in the graph above. For a portfolio of 40% stocks and 60% bonds, whose plot is shown on the bottom left-hand side of the graph as a pie chart, has a return about 6.85% and standard deviation of 7.98%. Yet when the allocation shifts to 30% stocks, 40% bonds, and 30% alternatives, the return is 8.09%, and standard deviation is 7.18%, represented by a pie chart higher up and to the left. It’s a similar result for adding a 30% allocation to portfolios with higher amounts of stock, with the pie charts shifting upwards and to the left. For example, on the bottom far right, the graph shows a plot of a portfolio of 80% stocks and 20% bonds. When the mix is changed to 50% stocks, 20% bonds, and 30% alternatives, return rises to 8.44%, up from 7.45%, while standard deviation falls to 10.13%, from 13.74%. The result is the plot moving upwards to the left.
And some of the historical data has suggested that an allocation to alternative investments, along with other traditional investments in a portfolio, can cause the portfolio to achieve potentially higher returns at a lower potential risk. That causes an upward left shift in the efficient frontier, which is what a lot of portfolio managers are looking for.
So it's always important to analyze the risk of a security or an investment in the context of an overall portfolio. Now it's also true that alternative investments may come with additional risks on top of traditional investments,
Text on screen: TITLE – Beyond investment risk
Image on screen: The figure displays six risks, in two rows of three, with diagrams representing each one. The top row is represented by regulatory, liquidity and information risks. The bottom row includes counterparty, operational and manager risks.
things like regulatory risk. These markets are simply not as regulated and don't offer as many investor protections as some of the traditional markets. There may be significant liquidity risk. There may be, as we mentioned, information risk which can be an opportunity, but can also certainly be a risk as well.
We may end up with additional operational risks if an asset manager is not set up properly to deal with some of the operational issues in investing in these types of securities. And also manager risks among others as well.
Devin Ekberg: Now we hope we've cleared up some of the misperceptions about these types of investments. And we hope that it's clear that we can potentially add value by meeting other multiple investment needs within the portfolio.
Text on screen: TITLE – Adding value by meeting multiple investment needs
Image on screen: A diagram shows how alternative investments meet five investment needs, which are listed in a column on the right, and include the following: income potential, lower correlations, downside risk management, expanded opportunity set, and better liquidity matching. Each of these items, color-coded, are represented as clockwise-pointing arrows as part of a circle on the left-hand side of the diagram.
We hope that we can achieve more income potential through things like private credit and real assets.
We also hope to overcome maybe some of the higher correlations in the traditional markets by adding a lower correlated asset as a diversifying benefit to the portfolio. We hope that we can manage some of the downside risk associated with some of these securities and the portfolio in general. We hope to take advantage of an expanded opportunity set just beyond the traditional public markets. And we hope that we can create better liquidity matching to different time horizons within an investor's portfolio.
Devin Ekberg: If you'd like more information on this and other topics, please check out PIMCO's website or reach out to your account manager for more information. And look for more opportunities to receive PIMCO's advisor education.
Text on screen: To learn more visit pimco.com/advisoreducation or speak with your account manager
Text on screen: PIMCO
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