The alternative market, especially private capital, has emerged as a strong contender for steadier yields as public markets like equities and fixed income face unprecedented pressure following the pandemic. However, the proclivity towards alternatives has not been an after-effect of the pandemic but something that has seen a growing trend over the past few years. However, the growth hasn’t scaled well with the outdated technology that is still prevalent in many modern family offices.
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What are Alternatives?
After the 2008 financial crisis exposed the dangers of bingeing on cheap credit, family offices along with other institutional investors started to move away from the tried and tested 60-40 portfolio model, i.e, 60% allocation to equities and 40% to fixed income securities. These investors started allocating increasing resources to higher-risk assets that had the potential to generate consistent, inflation-beating returns if done right. These asset classes are collectively known as alternative investments.
The potential of alternatives as viable investment classes can be highlighted by taking the example of the Yale Endowment Fund (YEF) where alternative asset classes make up more than 60% of its portfolio. YEF has consistently outperformed its domestic equity index and generated an approximate 10% annualised return over the last 20 years until 2020.
These asset classes can broadly be divided into the following categories:
- Hedge Funds – pooled investment funds that are privately offered and mostly restricted to accredited, high-net-worth investors.
- Private Equity – ownership stakes in non-publicly traded companies. Venture capital is basically private equity investments into tech companies which are in their startup phase.
- Real Estate – includes direct investments, REITs, real estate hedge funds, and crowdfunding. Investments can either be made through equity or debt.
- Commodities – these include products exchanged on authorised commodity exchanges like the New York Mercantile Exchange and the Chicago Board of Trade. These products can include future contracts, ETFs, as well as physical commodities.
The Advantages and Disadvantages of Alternative Investments
Alternatives can be an excellent vehicle for portfolio diversification because of the following advantages they offer over traditional investments:
- Many UHNW families prefer owning tangible assets from the investments they make. That is exactly what alternate investments offer – direct ownership with no middleman.
- Alternatives, especially private assets, are largely uncorrelated to the stock market and can therefore act as a counterbalance for the volatility created by the equities and the derivatives market.
- Although the rate of return of any investment is never a guarantee, alternative assets generally tend to yield better returns than traditional investments.
- Since alternative investments offer direct ownership, investors are also rewarded with tax benefits like pass-through depreciation and long-term capital gains (LTCG) treatment.
However, the better returns that alternatives offer come with a cost – they are extremely illiquid with lock-in periods often extending between 3-10 years. This also means that these investments need to be selected and monitored with greater care – the technology which most family offices lack.
The Role of Technology
The emergence of alternative investment management software has played a significant role in the unprecedented growth in the sector after the pandemic. They use Extract, Transform, and Load (ETL) technology to gather data from multiple sources and present them in user-friendly dashboards for easy and efficient decision-making.
This software has simplified the management workflow of alternative assets to a large extent by automating the investors’ accounting, compliance, and monitoring needs. Companies like Arch also offer real-time portfolio insights and automatic anomaly detection and corrective measures across the entire portfolio while others like Canoe employ Artificial Intelligence and Machine Learning technology for advanced data extraction and analysis.