Alternative assets are enjoying new highs, apparently off the back of new lows in yields and fixed income performance.
But I’m concerned that this switch is driven by a fundamental misalignment of needs and expectations. This is definitely an issue in the alternatives space, where pundits speak persistently of “alignment of interests” as a lynchpin of the private fund structure.
Of course, investors are entitled to switch into other assets if one of their bedrock asset classes isn’t performing. But they should understand what they’re switching into and not carry over the expectations, requirements and targets from the old asset class.
For one thing, there’s the issue of performance. The quoted year-on-year internal rates of return for private funds may look impressive to fixed income investors. However, private equity, for one, has been used to look at returns in terms of whole multiples rather than a few extra basis points, and institutions that bring fixed income returns expectations to the asset class are not necessarily ready to ask the best from their fund managers. And hedge funds have seen returns fall from a cumulative 225% from 1997 to 2007 to just 25% over 2008-16, but their fee structures remain largely the same.
Then there’s the issue of scale, which cuts a couple of ways. First, competition for assets between ever-larger funds is inevitably going to drive up asset prices – and drive down returns – never mind the erosion caused by funds buying scarce assets from each other.
There is also the question of compensation. The bigger the fund, the less incentive the general partners have to perform.
General partners traditionally justified their high fees from outperformance, but the management fees off a vehicle like Blackstone’s anticipated US$30 billion flagship fund will keep its partners very well compensated for a very long time under the traditional two-and-20 fee structure.
That two-and-20 structure still applies across very many alternative asset classes, from infrastructure to private debt. The old adage that hedge funds are a compensation structure masquerading as an asset class can be applied across too many of them.
For some, it may fit their investment dynamics, but does that apply to all? What if others experience the same performance collapse seen in hedge funds?
The saturation of these asset classes by over-eager institutional money managers may drive down their performance through the law of diminishing returns; but can they ever really fill the space in portfolios originally mapped out for bonds by pension plans and other institutions? Perhaps there really is no alternative to a wide, deep and dynamic fixed income market.
