Private investments were just taking off 40 years ago. Now they are ubiquitous in allocator’s portfolios, with many eager to put even more capital to work. But today’s market conditions are now significantly different: yields are flat, inflation is on the rise, and geopolitical risk is back in the market.
The CAIA Association, a 20-year old professional body for alternative investments, isn’t leaving the future to chance. Instead, the organization is releasing a new guide, called the Portfolio for the Future, to capital allocation on Thursday.
“While we’ve had hiccups or mini-cycles over the past 40 years, we’ve largely had a tailwind in which the 60-40 portfolio performs well,” said John Bowman, executive vice president at CAIA, speaking from Los Angeles on Wednesday. In addition, Bowman argues that investors are returning to a “more normal environment.” In other words, allocators can’t expect their performance this year to match 2021’s record highs.
Marcus Frampton, chief investment officer of the Alaska Permanent Fund, agreed. “I think that all the markets have had a wind at their back going back to the early ’80s,” he said by phone. “We're at this inflection point where it will start going into a different direction.”
With a brand new set of market dynamics, CAIA recognized that investors like Frampton might be disappointed by alternative investments if they used the same playbook.
“The good times rolled, and outsize returns (absolute and risk-adjusted) persisted, and still do to some extent, in the rarified air of the top decile of the respective alternative investment performance universes,” wrote Bill Kelly, president and CEO of CAIA, in the guide. “That party is not over but has gotten much more complicated. Efficiencies and scale are the hallmarks of beta, and the legendary Jack Bogle built an entire investment discipline around the concept of getting (and taking) what the broad market has to offer. Perhaps alpha is not truly dead within the alts space, but it has certainly moved to an altered state of a new reality.”
The guide highlights five features of effective investing, including diversification, with a heavy focus on private, illiquid assets. Investors also want managers who are actively engaged in socially-centered outcomes, rooted in a fiduciary mindset, and focused on generating what it calls operational alpha, according to CAIA.
For investors, the central question is how to find alpha in the future. It starts, according to CAIA, with diversification. While “owning the market portfolio” has long been a widely accepted strategy, CAIA suggests that diversification is more complicated for truly long-term investors.
“Long-term investors define diversification differently, looking across asset classes and paying close attention to the interactions of investments in different parts of the portfolio,” wrote Ariel Fromer Babcock, head of research at FCLT Global, in the guide.
Mark Anson, CEO, president, and CIO at Communfund, told Institutional Investor that there is a beta continuum — passive exchange-traded funds of all flavors, including those exposed to cryptocurrencies and return streams from convertible arbitrage — exist on it. The beta universe is no longer a simple passive approach to capturing equity risk premiums, argues Anson. There’s real diversification benefits in it.
As a result, investors can start with beta and layer on more private assets, like credit, equity, and other alternatives. It works, but only when investors outperform. The guide makes it clear that investors need to select the right manager for the job. According to data included in the guide, the dispersion between global private equity’s median manager performance and the top fifth percentile is 32.7 percent. For venture, that dispersion is 40 percent. “Unfortunately, aggregated private capital fund performance data remains misleading and doesn’t provide a look into what an average investor might experience with a top, bottom, or average performing fund manager,” according to Portfolio for the Future. “The skill required to select good managers is just as, if not more, important as having access to them in the first place.”
“If you do alts well, it can really be a bigger return driver,” Frampton said. “That data reinforced my view.” He added that commodities and macro hedge funds appear poised to do well in the next decade, and that’s where he plans to focus some of his private investing.
To implement these investments, CAIA argues that culture is also critical for both the limited and general partners.
“The more CIOs that I talk to, the more I hear about the power of healthy culture,” Bowman said.
According to Roger Urwin, head of investment content at Wilis Towers Watson, this can show up in explicit values like “a focus on outcomes and experiences over relevant time horizons, fair fees and rewards, and substantially transparent, accurate, and authentic communications.”
Some allocators express these values within their own operational frameworks. The California State Teachers’ Retirement System has its collaborative strategy, for instance, while the Yale Investment Office has its endowment model. “What you can’t do is just import the model,” Bowman said. “These have great lessons for us though.”
What makes these successful, according to researcher Ashby Monk, is not simply that these funds are able to express a certain investment style and set of values. It’s that they play to their operational strengths — their edge, if you will.
These advantages are both structural (at Yale University’s endowment, it’s the strong pipeline of alumni, for instance), and cultivated, which can look like a family office pursuing the micro venture opportunities a sovereign wealth fund is too large to access.
“True investment outperformance among allocators tends to come from an investor correctly identifying its structural advantages, and then allocating resources to cultivate them further in unique ways,” Monk wrote.