Institutional investors are increasing their exposure to alternative asset classes in an effort to diversify their portfolios, generate higher returns and minimize risk.
Demand for alternative asset classes such as private equity, hedge funds, infrastructure, private debt, real estate and natural resources has increased and is expected to increase further in the coming years.
Assets under management (AUM) across all alternative asset classes are expected to hit $23 billion in 2026, up from $11.32 billion in 2021, according to data provider Preqin. This shows consistent growth since 2015, when AUM was just $7.23 billion.
Lose the taste of regular vanilla
The shift towards alternative investments comes as institutional investors move away from traditional assets such as fixed income securities in search of higher yields. Some investors may choose to invest across the full spectrum of alternative asset classes, while others may choose classes that best suit their risk profile and level of sophistication.
Retail investors tend to allocate less to alternatives, while more sophisticated investors will typically devote more than 10% of their portfolio to these asset classes.
Research from Manulife Investment Management shows that the largest Canadian pension funds allocated between 34.7% and 54.3% of their portfolio to alternative assets in 2020. This is about 10% more than in 2015, when the allocation to alternatives varied between 24.6% and 44.1%.
The data shows that the Ontario Teachers’ Pension Plan had the highest allocation to alternatives in 2020, followed by the Canada Pension Plan Investment Board, the Board of investment from public sector pension plans, the British Columbia Investment Management Corporation and the Caisse de depot et placement de Québec. .
Inflation drives investors to allocate more to alternatives
Macroeconomic indicators such as inflation also play a key role in pushing institutional investors towards alternatives.
In fact, a snapshot poll by advisory firm Bfinance shows that macro conditions are driving allocations to illiquid strategies, with real assets leading the way. Specifically, 46% of investors expect to increase their exposure to infrastructure, with inflationary conditions providing additional stimulus to infrastructure investors.
The survey also reveals that there is strong momentum behind investments in private debt and real estate, with institutional investors planning to increase their exposure to these asset classes over the next 12 months, far more than they have not done so in the last 12 months.
Additionally, the survey shows that institutional investors plan to reduce their exposure to all public stocks and inflation-linked bonds over the next 12 months.
The most attractive sectors in private markets
According to a report by Natixis Investment Managers, “the hunt for yield leads to alternatives” was seen as one of the key themes that would shape the strategies of institutional teams looking to position their portfolios to handle the unknowns ahead in 2022.
The Institutional Outlook 2022, which presents the results of a survey of 500 institutional investors, reveals that information technology, healthcare, infrastructure, energy, real estate and finance were considered the sectors most attractive for private markets before 2022.
The report also indicates that inflation was ranked as the main concern, with the majority believing it to be transitory. Other key risks include interest rates, valuation, volatility and environmental, social and governance (ESG) issues.
Indeed, ESG has been a key topic within the institutional investor community, with all types of investors seeking to embrace it. However, it is important that investors avoid approaching ESG as a short-term opportunistic engagement and instead view it as a long-term strategy.
The same goes for alternatives, as it is essential to have a longer investment time frame when allocating to such assets. In short, investing in alternatives can provide institutional investors with opportunities to generate higher returns, manage inflation and volatility, and minimize risk by diversifying their portfolio. There are also challenges, as the alternatives are considered riskier assets compared to the regular vanilla variety. However, investors are willing to move beyond their risk curve in order to generate higher returns and beat rising inflation rates.