The increasing size of alternative investments may be driving down their benefit for institutional investors, says Stephen Johnston, director at Omnigence Asset Management.
“There are trillions of dollars in those strategies. How can they generate alpha now? Because when you get to that size you start to replicate market returns.”
Read: 66% of institutional investors increasing private asset allocations: survey
Johnston says his theory could be deemed heretical since the addition of alternatives to traditional 60/40 institutional portfolios improve risk-adjusted returns, but he believes even a good thing can be taken too far.
“The critical thing to remember is these illiquid, non-traded investments are meant to be alternative, they’re meant to be unique sources of returns. . . . 30 years ago, that was always the case [and] the alternative sector wasn’t that big. There was a lot of unique alpha in the strategies but fast forward to today and you have [a] sector [that’s] enormous.”
Canadian institutional investors are making dramatic changes to accommodate the demand for alternative investments, according to a 2024 report from Crisil Coalition Greenwich. It found in 2023, hedge funds, private equity, real estate, infrastructure and private debt accounted for 41 per cent of institutional assets in Canada.
According to Johnston, alternatives were designed to offer diversification and correlation benefits as well as unique return drivers, unique expertise and an illiquidity premium. But now, he’s expecting the returns to offer “beta disguised as alpha because everybody is doing the same thing.”
The renewed interest in the asset class, he says, is driving up competition and the cost of entry for different strategies on top of the existing liquidity challenges from this style of investment.
“It was meant to be alternative in the strict sense of the word, things [with] different return profiles than what you got in the public market. . . . Now that is not the case.”
There’s a scramble to sell positions off in the secondary market at discounts due to the change in expectations surrounding returns, he says. If the cash-flow generation of alternative strategies can’t satisfy the obligations of beneficiaries at a pension plan, he adds, it could create greater risk and put into perspective the approach for long-term buy and hold strategies.
“It’s much easier to write a cheque for $10 billion to a manager that’s managing $200 billion and forget about it [instead of making] 40 investments in much smaller managers, in unique strategies. That’s harder, that’s more work but I think it’s work [pension funds] need to start.”
Moving forward, he expects to see a shift in alternatives strategy from leveraged long, middle-class growth and short inflation to instead long inflation and short middle-class growth.
Read: Private debt helping institutional investors meet their goals in 2023