Managing director explains that as private markets grow, advisors need a full understanding to protect themselves, clients
86 per cent of all companies valued over $100 million (USD) are privately held. The average number of IPOs per year has dropped to around 125 over the past 20 years, after more than 300 IPOs per year in the preceding two decades. The total mass of private assets is projected to hit $30 trillion by 2030. Investment opportunity, it would appear, is shifting away from public securities into the broad universe we often just call alternatives or alts. Where opportunity for alpha generation goes, retail money follows, meaning advisors, their clients, and a host of DIY investors are now seeking access to a more sophisticated, less transparent, and less efficient market rife with challenges and risks for the poorly informed.
Tom Johnston is keenly aware of the knowledge gaps that both investors and advisors still have in their alts portfolios. The Managing Director and Canadian Market Head at iCapital works at a firm with the stated mission of bringing alts into wealth channels. His work towards that goal is underpinned by education as his team try to ensure that advisors and their clients know what they’re getting into. That education, in many ways, begins by defining exactly what we mean when we talk about alts.
“There’s a big knowledge gap around what’s included in the alternatives bucket,” Johnston says. “The main food groups are private equity, private credit, private real estate, hedge funds, and other esoteric strategies like music royalties, litigation finance, water rights etc. But the bulk of this category would be in private assets and hedge funds… Now we’re seeing portfolio construction imperatives that include alternatives for the sake of diversification.”
Because privately assets have grown so much in scale, and because some of the negative correlation between stocks and bonds appears to be shifting into a more positive relationship, Johnston believes that investors now need these private assets to achieve adequate diversification. He argues that the common wisdom of a 60/40 equity bond portfolio is reverting back to performance from the early 20th century, when higher resting inflation resulted in positive correlation between stocks and bonds. He also highlights concentration risk on public equity markets, namely in the Untied States where growth-oriented tech names now dominate the major market indices, presenting alts as a diversifier away from that risk.
For all the appeal that investors may now see in the broad alts category Johnston highlights perhaps the most important aspect of alts that he wants all investors to understand: managers matter. Where public markets tend to be more efficient and see minimal outperformance by specific managers over significant time horizons, private markets are far more differentiated. Managers can outperform by up to 20 per cent over the long-term, he says, which makes assessing an alts manager a crucial stage of any investment in this space.
That work is all the more crucial as access to alternative strategies gets easier to obtain. Johnston notes that retail investors and advisors might have normally used closed end funds to gain access to alternative asset classes. Now, however, there is a growing shelf of evergreen funds that may offer greater utility for these investors. As more of these fund models emerge, he stresses the importance of assessing the right evergreen fund based on the quality of its management.
For advisors, learning how to assess alts managers begins with availing themselves of the educational opportunities out there. Johnston highlights iCapital’s own educational efforts, including a dedicated research team publishing on the subject of alts. They’ll offer insights into broad market trends and specific funds that advisors can make use of. Johnston emphasizes the importance of that education because he sees risks for investors and advisors who see the importance of alts but fail to fully grasp the risks in this market.
Beyond the assessment of management quality, Johnston stresses the inherent illiquidity in alternatives. That’s a feature of the space, he explains, and the illiquidity of private assets results in a premium to their price. Still, investors who may assume greater liquidity in these assets than there is could be at some risk. He suggests looking at the underlying construction of an alts fund to assess what tools it uses to maintain required liquidity levels and whether those tools could result in a mismatch with the underlying strategy in the fund. Transparency, he says, is key to assessing these funds and while the broad alternatives category tends to be less transparent than public securities, Johnston says that some of the better managers will offer a great deal of transparency into their funds.
As retail investor interest in this space grows, Johnston sees a place for greater regulation to ensure market efficiency and public protection. He notes that Europe has already implemented certain regulations in the alternatives space that may help investors navigate the difficult process of assessing liquidity. He believes that as this space grows, more regulation will come across jurisdictions, helping advisors and investors navigate the space. In the meanwhile, Johnston drives home advisors’ responsibility to be as diligent and educated as possible.
“Make sure that the utilization is appropriate for the client in the client's risk goals. And that's where we use analytical tools and foundational education to mixing different alts together to create the tapestry of risk return that works for the client,” Johnston says. “Then just also understanding that there's elements of a portfolio that aren't always supposed to be as liquid. And that's a good thing sometimes.”
