The growth of alternative investment strategies for hedge funds

As alternative investment strategies become more popular - we explore how to invest in alternative funds and the most beneficial strategies in returns for hedge funds.

Trading floor in a stock exchange Source: Bloomberg

What is alternative investment?

Alternative investment is focused on investments or strategies outside of traditional long-only investments in stocks, bonds, or cash.

For many years, the conventional wisdom was that a portfolio should be 60% in equities and 40% in bonds. However, this attitude has shifted and as the stigma surrounding alternative investments has diminished institutions and investors increasingly look to alternative investment opportunities to further diversify their portfolios.

Some of the more well-known alternative investment strategies include hedge funds, private equity and venture capital, infrastructure, private real estate, private credit and debt, commodities, and natural resources. There are also alternative investment opportunities in tangible assets including collectibles like art and vintage cars, and increasingly in cryptocurrencies.

Alternative investment strategies

Amid the tumult following the outbreak of Covid-19 , and following the end of a 10-year bull market, investors looked to and alternative investment strategies and invested in alternative investment funds in the hope of protecting capital and generating returns in uncertain times .

In 2022, interest in alternative investment strategies continued as investors looked to future proof their returns and mitigate against risk in the face of geopolitical unrest, inflation pressure, continued supply chain issues and public market uncertainty.

The attraction of alternative investment strategies in this climate is due to some strengths, including:

  • Exhibiting low correlation to public markets
  • Offering defensive capability or return potential during increased
  • Providing diversified exposure to risk without necessarily diminishing returns
  • The potential to generate returns that are less sensitive to interest rates

There are some considerations to be made when utilising alternative investment strategies. They have unique risk profiles, are less regulated than stock and bond markets, are generally less transparent and often have complex and unique legal and tax implications.

Alternative investment opportunities may also be less liquid than public assets and present different liquidity risks. Private equity, for example, requires long lock-up periods, while certain alternative investment strategies, like in real estate and infrastructure, have considerably longer investment horizons than traditional investments .

Further, the cost of entry is high, and only certain investors will be able to access these investments (see how to invest in alternative investments, below).

How to invest in alternative investments

Many alternative investments require individuals to be accredited investors - that is, to have $1million of assets, or an annual income above $200,000 (or $300,000 if combined with a spouse's income), and to hold a series 7, 65, or 82 licence, among other requirements - as do entities, which involves separate requirements.

In 2020, the Securities and Exchange Commission (SEC) revised some restrictions in 2020, which could mean more alternative investment opportunities or a wider range of investors in the future.

Investing through alternative investment funds

Many of the largest asset managers offer a suite of alternatives that can be built into portfolios for investors wanting exposure to these investments.

Huge alternative investment managers, such as Blackstone and Man Group, and well-known hedge fund giants, including Bridgewater Associates and Citadel, offer alternative investment opportunities. A range of boutique firms and what the Economist terms “artisanal” funds are differentiating themselves from large funds by offering investors exposure to specialist alternative investment strategies .

EY’s 2021 Global Alternative Fund Survey showed that 43% of alternative investment fund managers surveyed said they planned to increase the amount of capital sourced through retail channels and wealth management channels, while almost a fifth suggested they would look to list their funds on fintech platforms that aggregate retail investments.

High-return alternative investments

While some alternative investments offer risk mitigation, others provide the potential for greater returns. Examples of high-return alternative investments historically include private equity and venture capital, as well as private credit.

Advocates point to the ability of many alternative investment strategies under the hedge fund umbrella to offer investors the potential to produce solid performance over that of some other traditional and alternative investments , especially when markets are shaken.

What alternative investment opportunities do hedge funds offer?

As one of the most well-known alternative investment strategies, investors have looked to hedge funds for help in navigating volatility and defensive capital preservation in down markets.

In 2021, the hedge fund industry was able to reverse the downtrend in allocations experienced in the past few years, and in Q1 2022 institutional investors allocated the largest amount of new capital to hedge funds since 2015, HFR analysis showed. The research group also highlighted that the global hedge fund industry began 2022 by surpassing $4trn in capital, an estimated $400bn increase from the start of 2021.

The number of new hedge fund launches also rose in 2021, with an estimated 614 new hedge funds created, according to HFR . This was the highest number of new launches since 2017 and coincided with the lowest number of liquidations among hedge funds (527) since 2004, suggesting a good operating climate for hedge funds.

A survey in February 2022 of over 200 US allocators by the Alternative Investment Management Association (AIMA) and With intelligence, reported by Forbes, found that more than half of respondents planned to increase their allocations to hedge funds in the following 12 months, citing high equity valuations and reaching target allocation as the top reasons, alongside hedge funds presenting “exciting new opportunities”.

Another potential factor in hedge funds’ favour is historically low estimated fees. Recent research from HFR found that the average management fee in Q1 2022 was level at 1.36% and the average incentive fee had decreased by four basis points to 16.03% — the lowest since the research group began recording such figures in 2008, and considerably below the historic 2-and-20 model that the industry has long been known for.

How do hedge funds hope to keep providing returns?

Ever on the hunt for returns, hedge funds were heavily involved in the huge uptick in special purpose acquisition company (SPAC) activity in 2021 , and although this may have peaked in 2021, the consensus among many alternative investment fund managers is that they expect a recovery, according to EY.

The consultancy also found that a quarter of hedge fund managers surveyed expected to increase their exposure to cryptocurrencies - increasing interest in the assets and the related digital infrastructure has been an ongoing trend within the hedge fund industry in recent years.

Hedge funds have also been looking to boost returns and capital generation through increasing activity in private markets through commingled funds. Hedge fund managers have been investing in private equity and venture capital as a way to increase returns, although the vast proportion of investments in these funds remains below 10%, EY found.

Publication date: 2023-01-17T15:46:35+0000

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