Which investment categories drive the highest returns across alternatives?
Alternative assets are generally defined as investments outside of traditional public stocks, bonds or cash. An alternative investment is a financial asset that does not fall into one of the three traditional investment categories. Alternative investments are complex and not heavily regulated. For this reason, most alternative asset investments are held by institutional investors or accredited, high-net-worth individuals.
Assets under management (AUM) for alternatives have more than tripled since 2010 to roughly $13.3 trillion in 2021 and could grow to over $23.2 trillion by 2026 (Exhibit 1). Alternative asset classes may offer the potential for higher returns because they tend to take on more risk and are generally lesser known and understood by investors.
The surge in interest in private market alternative investments was initially driven by the largest institutional asset owners pursuing the “endowment model” or “Yale model,” popularized by legendary investor David Swenson, Chief Investment Officer of Yale’s endowment for over 30 years. Swenson took the helm of Yale’s endowment in 1985 and remained CIO until he died in 2021. During that time, he grew the endowment asset base from $1 Billion to over $30 Billion. Endowments, pensions and large family offices across the globe took note and began to increase their allocations to Alternative Assets. As the number of publicly traded companies declines and private companies remain private longer and achieve much higher valuations before entering the public equity markets, the case for owning private companies has become more compelling.
Some investors pursue alternative asset classes because they seek differentiated sources of return that may be less correlated to traditional asset classes and help diversify a portfolio. Many intergenerational families have compounded their wealth over decades based on the power of alternative assets. No longer the exclusive realm of institutions and billionaire families, alternative assets are becoming an accessible option for mainstream investors seeking to generate meaningful return and lots more.
In recent years, alternative assets have grown in both AUM and allocation, representing a higher percentage of how leading institutions invest their funds.
What exactly are Alternative Assets?
Generally defined as investment vehicles that fall outside of stocks, bonds and cash
Examples of Alternative Assets
- Venture Capital Funds
- Private Equity Funds
- Hedge Funds
- Private Debt
- Natural Resources
- Infrastructure
- Real Estate
The Common Characteristics of Alternative Assets
- Alternatives are Investments that are not easily accessible and usually have stricter qualification requirements for investors unlike public stocks and bonds, they are harder to find, harder to access and sometimes require a large minimum investment
- Generally longer-term investments; many alternative investments need time for their value-creation strategies to play out, often requiring a multi-year investment horizon.
- Private and less regulated; alternative investments are private investments and subject to less regulations compared to public investments.
- While alternatives drive higher returns on average, alternative investments are generally less liquid than traditional asset classes because the funds and many of the underlying assets are not publicly traded.
While Alternative Assets have generated higher returns than stocks, bonds and cash, there are some basic challenges that have to be addressed when evaluating. The biggest challenge for most investors has to do with basic access to the Alternative Assets that consistently drive greater returns. As an asset class that has been limited to large institutions and billion dollar family offices, there is no readily available directory of investment opportunities or managers to peruse.
Most high-performing Venture, PE, and Hedge Funds are oversubscribed and unless you were an investor in the last 2-3 funds, your likelihood of getting access as a new investor is near zero. The more specialized and focused the Alternative Asset is, the harder it is to get access to leading managers in that opportunity.
This closed-off private club-like ecosystem has kept the pool of LP’s in Alternative Assets relatively small over the years. Unlike the stock market where you can sell at any moment, Alternative Assets typically have some level of structured lock-up, requiring longer periods of time to achieve their high-returns. While specialized secondary markets have popped-up in recent years to address this issue, the lack of liquidity is something investors must consider.
Key Question: How do different Alternative Assets compare in terms of returns
Venture Capital returns have dominated the Alternate Assets category for the last 15 years with a reported median IRR of 21.6%. It may seem obvious, but as each of our lives are touched by new innovative technologies that have transformed global industries from finance to travel – the investors behind those companies have been rewarded handsomely with generational returns.
However, don’t assume that Venture Capital doesn’t exhibit the challenging characteristics associated with Alternative Assets described above. For an investor, the path to participating in Venture Capital is not simple.
There are four primary ways to participate and invest in Venture Capital.
- Invest in a large well known venture capital fund
- Invest in a small/emerging manager fund
- Invest in a fund-of-funds made up of multiple funds
- Invest directly into a start-up in return for equity
| Large Established Venture Funds | Small Emerging MGR Funds | Fund-of-Funds | Direct in a Start-up |
| Hard to get in, if your not in last 2 funds Large minimum investment 10-Year Time Horizon | Hard to find Hard to evaluate, diligence Small minimum investment 10-year Time Horizon | Hard to find Extra layer of fees 10-Year Time Horizon | Really hard to find Really hard to vet, evaluate 3-5 year Time Horizon |
| If MGRS are top 20%, returns are good Single fund, portfolio risk | Top fund returns in Venture Capital category (if you’re in top 50% of MGRS) Single fund, portfolio risk | Good returns Creates index of MGRS and verticals Multiple funds and large portfolio hedges risk | Highest Possible Return |
Key considerations when evaluating the path to investing in Venture Capital
- [1] Easy/Hard to Find -Easy/Hard to DD
- Easy/Hard to Access/Get-In
- Minimum Investment Level
- Time horizon to liquidity
- Loss Ratio
- Fees
- Returns Performance
| Large Established Venture Funds | Small Emerging MGR Funds | Fund-of-Funds | Direct in a Start-up | |
| Difficulty to find & Diligence | Low | High | High | High |
| Difficulty to get Access | High | Low | Medium | High |
| Minimum Investment Level | High | Low | High | High |
| Time required to Liquidity | High | High | High | High |
| Loss Ratio | Medium | Medium | Low | High |
| Fees | Average | Average | High | Low |
| Historical Returns | Average | High | Average | Highest |
| Summary | The top 20% of large well known funds perform well, but unless you invested in their last 3 funds and are willing to write a large check, you won’t likely get access | Emerging manager funds have outperformed the market for 15-years. They are hard to find and hard to diligence but allow a low minimum investment entry point. | Funds-of-funds are hard to find, but provide an index-fund like diversification across managers. The loss ratio is quite low but returns are not as high as other options. Typical FoF fees are layered on top of underlying manager fees. | Direct investments into start-ups provide the absolute highest returns, but also have the highest loss-ratio and are most difficult to find and diligence. High risk, high reward. |
The ideal approach to venture capital investing would incorporate the absolute best qualities of each of these channels, while shielding investors from the negative downside potential in each. We call this approach Integrated Venture Investing and is the foundation of the MDSV strategy.
Click HERE to learn more about the Integrated Venture investment strategy.
