Once the province of institutional investors and the ultra-wealthy, alternative investments have gone mainstream, drawing significant interest from all corners of the investing world.
Seeking growth, yield and diversification, individual investors are following the path pioneered by institutional investors in pursuit of new, more tangible investment opportunities, particularly after traditional asset classes were roiled in the global financial crisis. Flows into the alternative asset category show this; a 2015 McKinsey article notes that global alternative assets under management grew at a 10.7% annualized rate between 2005 and 2013, twice as fast as traditional investments.
The appeal to investors is straightforward: enhanced portfolio diversification by exposure to investments whose risk and return characteristics are historically uncorrelated with traditional investments, along with the potential to produce higher returns than available in a more traditional investment universe.
Evolving With Investor Goals
Despite the lure of potentially higher returns, it is structural forces, not performance trends, that are fueling the popularity of alternative investments. Many investors and their advisors have moved on from a strict focus on alpha generation 1 and instead are pursuing investment outcomes such as absolute returns. They are also increasingly looking to alternatives to deliver on other crucial outcomes like inflation protection and income generation.
As a result, lines have blurred between traditional and alternative asset classes as investment managers battle for an overlapping opportunity set. But not all investment vehicles are created equal – some traditional investment managers have struggled to shift from a relative-return approach that has defined their business for decades. On the other hand, not all alternative specialists are equipped to build and manage investment products for the masses. Thus, the market for alternative investments remains fragmented.
Closed-End Funds: Delivering Alternatives Exposure
As investment managers scramble to launch the latest alternative portfolio, typically only to an ultra-high net worth audience, there exists a perhaps less obvious but well-established option for delivering alternative investment strategies: closed-end funds. The closed-end fund structure is well suited to offer alternative securities and strategies. Lacking daily inflows and outflows, their relatively stable capital structure makes CEFs particularly good for investing in niche, less liquid assets that may be ill-suited for other investment structures because they are difficult to sell quickly.
CEFs can also invest in assets that may be otherwise unavailable to individual investors, or in some cases greatly simplify the way investors can access more complex assets. In effect, they can democratize the process of investing in alternative assets. Unlike both institutional and retail alternative products, CEFs do not have a minimum initial investment requirement, and they do not have the stringent lockups that private limited partnerships usually require.
A closed-end fund is an investment structure – not an asset class – with shares that trade like a stock on the open market, where their market prices may be higher or lower than their underlying net asset value or NAV. Closed-end funds generally raise money for investing only at inception, offering a fixed number of shares in an initial public offering. Since they do not need to manage inflows and outflows of assets like their open-ended cousins, CEFs can generally remain fully invested. A CEF portfolio manager can commit to a strategy and take a long-term view, rather than sell assets to meet withdrawal demands or buy assets to meet targets when new deposits arrive.