One of the biggest developments in asset management over the last decade has been the tremendous growth of investment products in private equity, venture capital, real estate and infrastructure.
Investors have poured over US$10 trillion into private investments, which are often also known as alternative investments. Typically, the investors are institutions such as pension funds, endowments and trusts, but they are also marketed to high net-worth individuals.
A big factor in their growth is modest expectations for future returns from public stock and bond markets in light of the current historically low interest rates. That has led investors to seek higher yields from other sources. Other selling points are low correlation and low volatility of these investments compared to the public markets.
While alternative investments are being heavily promoted by the investment industry, there are reasons for caution:
- Will returns be higher? Low interest rates mean a low cost of capital for businesses and, by extension, low expected returns for investors. That’s equally true for public and private companies. In addition, a lot of money is chasing a finite number of opportunities, which normally means higher prices and lower returns. Therefore, the idea that private investments will generate higher returns may not be justified. Indeed, over 10 years to June 2018, private equity and venture capital funds respectively underperformed and slightly outperformed the U.S. stock market, while hedge funds underperformed both U.S. equity and fixed income markets, according to the 2018 NACUBO-TIAA Study of Endowments.
- How much risk are you actually taking? In theory, you should be compensated with higher returns for taking more risk. Is this the case with today’s private investments? For example, private investments are less liquid than public ones and generally less diversified. That may not be a concern when markets are rising but can cause serious losses in a bear market as we learned in 2008. Other risks include the complex and opaque structure of many investment vehicles and their, often, heavy use of leverage.
- How much are you paying in fees? Typically, alternative investment managers charge high fees—a 1% to 2% management fee, plus 20% of profits over a certain threshold. But some managers charge much more, with some private equity funds taking as much as 7%. That provides a powerful incentive for the industry to promote these funds over public investments. However, those fees eat into your returns and make it harder for fund managers to beat public markets.
- Do you know what your returns are? Due to the opaque nature of private investment funds and the absence of disclosure requirements, it’s often difficult to gauge the performance of a fund. For example, this article questions whether the private equity industry really does produce higher returns, lower volatility or low correlation as advertised.
There’s a lot of hype about alternative investments, but there is also much to be wary of. Will they produce returns above those available in the public markets? Are those returns worth giving up liquidity, diversification and transparency? A skeptical approach is warranted in light of so many questions.
