15 Jun Study on alternative management in Europe
The visibility of alternative management over the last few years, following an increase in the volatility of traditional equity markets and a gradual decline in the interest rates in the eurozone, has led to a greater interest in it on the part of investors, who are progressively looking for profitable alternatives to diversify their investment portfolios. However, it remains an activity where some investors have a high level of ignorance in certain Eurozone countries.
This article aims to shed some light on the sector in the European Union by providing information on the main characteristics and different styles of alternative management, and provide an overview of the perception that the different members of the financial markets have about it.
In the second part of this study it will be described the evolution of alternative management in Europe and it will be shown data about the growth of the sector over recent years, analyzing it by countries and types of asset.
At Laurion we are aware that this type of funds should be present in the investment portfolios of any institutional investor, who is increasingly looking for alternatives that are profitable and without fluctuations. Therefore, we tried, in this study, to present valid information that can help investors to know better the market, and be a part of it with greater confidence and less fear.
Definition of alternative investments
Many sources agree that there does not exist an exact definition of such assets. According to a study by AFI (Spain) and Aberdeen Standard, published in September 2019, it is possible to define alternative assets by exclusion, that is, to consider them as everything that comes out of the universe of traditional assets. In other words, and in its literal definition, alternative investments are those that do not belong to traditional asset classes such as liquid assets, stocks, bonds and those classes with which the investor is more familiar and more experienced.
In addition, the AIFMD uses the term “alternative” in a way to include all investment funds that are not governed by the UCITS Directive.
According to this definition, «alternative investment» includes investments in real estate, hedge funds, raw materials, infrastructure or luxury assets such as art or cars. However, in this analysis we will focus on those types that have historically been accessible to investors and institutions through investment funds and that have played a more important role in the evolution of the industry. Those are: Real Estate, Private Equity and Venture Capital, Hedge Funds and Private Debt.
Chart 1: Different types of investments Source: World Economic Forum Investors Industries into “Alternative Investments 2020: An Introduction to Alternative Investments”)
The principal characteristic of alternative management is its absolute return objective. Alternative management does not aim to beat a benchmark or a relevant market but aims to generate positive returns under entirely different market conditions, providing the investor with a positive and constant return, with a very low correlation with traditional assets and markets and a tighter return-risk relationship. In turn, alternative investments provide new sources of return that are inaccessible from traditional investment options, allowing the investor to achieve added value and a greater degree of diversification in their portfolios.
At the same time, they tend to be less liquid investments than traditional ones and thus offer a premium on their illiquidity. Their initial minimum investment is also normally higher, making it difficult for them to access a large part of the retail market, as we will see later.
Another important aspect to consider is that alternative investments usually have a certain cost structure, based on a management fee, similar to those of traditional management (typically between 1-2% per year on the capital invested) and a success fee, that is not so common in previous ones and that is usually 20% on the annual profits of the fund[1].
On the other hand, another aspect to bear in mind is that the investor’s contribution to alternative investment funds is not usually invested as quickly as in traditional funds (usually on a business day), since many funds accept «capital commitments» of its investors, and such a contribution may not be invested in the fund immediately but when there is an investment opportunity or in the agreed time frame.
Regarding on the legal structures of funds used by the different alternative management assets, these differ significantly from common fund structures (UCITS in EEA, Unit Trusts in UK or mutual funds in USA) and there is even differences between countries and territories of the European Union. There is no doubt that alternative structures are more flexible and allow their managers to have a broader and less restrictive investment policy, as they can employ different techniques and investment strategies often not allowed in UCITS funds (leverage, short sell securities, invest in illiquid securities, derivatives)[2].
In addition, the recent and different regulation in the EU countries has led to different and heterogeneous[3] structures and regulations between their territories and greater freedom in terms of investment philosophies and remuneration policies.
Alternative investments still have certain limitations for investors when comparing to traditional management. One of them is that it is only available to qualified and institutional investors, about whom the regulators accept that they are capable of understanding and assuming the liquidity constraints of alternative management and its high risk.
Chart 2: Investment categories
Source: “An introduction to Alternative Investments”, by Sameer Jain, AR Capital, page 2.
There are many types of alternative or non-traditional investment management:
– Private Equity funds: are those that purchase and acquire control of a non-listed company[4]. This includes common stock, preferred stock and debt securities of firms that are not publicly traded. This category also includes Venture Capital, the best-known alternative asset class that can trace its history back to 1946.
-Hedge Funds: invest in traded assets such as stocks bonds, currencies commodities, and derivatives.
-Real Estate: invest in real estate or real estate holding companies.
– Funds of funds invest in different investment funds and have the goal of diversifying and reducing the risk of a portfolio and are easier to access for retail investors.
-Other alternative investments: the residual category covers commodities, infrastructure funds and funds investing in traditional asset classes, such as equity or bonds, but using strategies different from traditional funds.
What are investors’ perceptions of alternative management?
An important fact to understand the lack of knowledge and experience in this type of investment and its weight in relation to the market, is the perception that several market agents have in relation to alternative management.
According to the study of AFI Spain and Aberdeen Standard, published in September 2019, institutional investors (insurers, pension funds, private banks, Eafis, Family Office and other institutions) generally consider that alternative management is difficult to analyze. On the contrary, among their most outstanding qualities, they value the lack of correlation with traditional markets and their high potential for profitability.
Chart 3: Advantages of alternative management
Source: Investment in alternative assets, September 2019. AFI Spain and Aberdeen Standard Investments.
Chart 4: Disadvantages of alternative management
Source: Investment in alternative assets, September 2019. AFI Spain and Aberdeen Standard Investments.
To confirm the idea mentioned above, more than 90% of institutional investors consider that there is a general lack of knowledge of alternative assets. In terms of knowledge by asset type, most investors have a better understanding of private equity and real estate investments versus the rest of alternative classes.
[1] World Economic Forum (2015), Alternative Investments 2020: An Introduction to Alternative Investments
[2] World Economic Forum (2015), Alternative Investments 2020: An Introduction to Alternative Investments
[3] CNMV, Study on the hedge funds industry
[4] Art 26 1 a of the AIFMD.