Are Alternatives Still Able To Provide Outsized Returns?

We live in a world of low interest rates with little sign of reversing in a meaningful way anytime soon while major equity markets move higher on a seemingly daily basis. Active fund managers around the globe struggle to produce outsized returns compared to passive benchmarks. Seeking and diversifying alpha from traditional sources has become more difficult as managers pile into the same trades and strategies.

In the past alternative investments consisted of hedge funds, private equity, and commodities sourced through private networks of bankers, investment advisors, and friends. While typical strategies became more crowded, new managers emerged with a focus on new asset classes. Now, investors are able to source opportunities in funds focused on competencies like insurance linked products (ILS), peer-to-peer lending, direct lending, litigation finance, trade finance, and others.

Many of these new alternatives are opaque, illiquid and don’t exhibit a typical equity curve that might be marked-to-market or to a model on a daily basis. The result can be a very linear, very straight line that is hard to quantify in terms of coordinating it in a profile. Some funds in these categories have little or zero drawdown. In many cases, the fund’s underlying holdings are not stocks or bonds and carry little traditional beta, or systematic risk. The graph below highlights the equity curve observed by many funds with these characteristics.

Graph_for_Article

As an example, consider the trade finance industry. Trade finance facilitates movement of goods around the globe by providing transaction confidence to both buyers and sellers in the form of bank-like products. There is no comprehensive statistic for the size of trade finance; however, the Bank of International Settlements estimates it to be more than US $12 trillion.

Funds offering trade finance services account for a fraction of the activity in the space. In an interview with Kimura, Mead Welles of Octagon Asset Management said, “If all the [trade finance] funds out there raised a billion dollars each, it wouldn’t even scratch the surface.” According to the Asia Development Bank, there is an expected US $1.6 trillion shortfall in trade finance funding needs.

Trade finance is one example of new opportunities emerging in the alternative investment space and reflects a global desire for uncorrelated, diversified assets. Along with trade finance funds, investors should also consider peer-to-peer, direct lending, and insurance linked alternative investments.

For alternative investment managers, the alpha and diversification opportunity in these new assets is incredible; however, selecting the right fund at the right time is crucial to success. These new risk premia and untraditional equity curves makes it difficult to appropriately model in a portfolio. The role of an active community of users as an input to the construction process is a key component in creating a diversified and robust portfolio.

An active investor community connects investors and relevant fund managers based on behaviors of the group. Following the logic of philosopher Aristotle, “the whole is greater than its part,” means the knowledge of the group of investors will be more valuable than any one opinion. An intelligent investment platform uses a variety of factors and algorithms to identify behavior-based trends. Funds perceived as higher quality can be identified based on individual investor behaviors. Every investor weighs different investment considerations differently. Some favorably weigh assets under management relative to performance, while others give considerable weight to corporate governance procedures within the fund.

While the holdings may be opaque, investors receive a certain level of confidence in analyzing new investments based on behavioral advantages of the community.

The community is the foundation to creatively source alpha. This method narrows down a list of investible funds into a small, manageable list, to quickly find potential opportunities. It doesn’t yet replace traditional qualitative checks, like manager calls, on-site due diligence and service provider checks.

New alternative investment funds offer new sources of alpha by opening asset classes to investors previously left to large multinational institutions. Due to the small size of many of these funds and their young age in the world of alternatives, alpha opportunity is prevalent. Investors simply need a way to rapidly source and verify performing funds based on the sum of all individual investors. Behavior-based technology providers, like Fundbase, are a critical component in delivering alpha in the world of tomorrow.

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