Myths of Alternative Investments

Text on screen: PIMCO

Text on screen: TITLE – Myths of Alternative Investments; SUBTITLE – with Devin Ekberg

Text on screen: Devin Ekberg, SENIOR CONSULTANT, ADVISOR EDUCATION

Image on screen: Devin speaking to camera in PIMCO offices

Devin Ekberg: My name is Devin Ekberg from the PIMCO Advisor Education Team. I'm here to talk about a very important topic of alternative investments. Now there's a lot of interest, and innovation, and opportunities for advisors to add significant value to their client's portfolio in this investment space. There are also a lot of misperceptions about alternatives. And I'm here to address two in particular.  

Text on screen: TITLE – Agenda

Image on screen: Two boxes side-by-side highlight two myths of alternative investing. The box on the left, representing Myth 1, says alternatives are only available to institutions and the top 1%. On the right, Myth 2 is that alternatives are too risky.

The first misperception is that alternative investments are only for institutions or only the top 1 percent. We're also going to address whether or not alternatives are just too risky.

So let's talk about institutions.

Devin Ekberg: Now it's actually true that institutions have been investing in alternative investments for the last several decades. Institutions like endowments, and foundations, and pension funds.

Text on screen: TITLE – Why do individuals want access to alternatives? SUBTITLE – For the same reasons institutions do

Image on screen: A pie chart shows the asset allocation of Yale University’s endowment. The chart notes that about 70% of the assets are in alternatives, with the following breakdown: 24% in hedge funds, 24% in venture capital, 18% in private equity, 9% in real estate, 12% in foreign equities, 7% in bonds and cash, 4% in natural resources, and 2% in U.S. equities.

The most famous example is the Yale endowment model. Now Yale has allocated almost 70 percent of their portfolios to some form of alternative investments over the years.

And when you ask them why, they give you a lot of reasons. One of the biggest reasons is that their expectations for future returns in the traditional markets like stocks and bonds are a little bit less optimistic.

Text on screen: TITLE – Projected lower equity returns; SUBTITLE – Long-term capital market assumptions below historical averages

Image on screen: A table shows average expected returns and volatility for five different asset classes. The table divides the asset classes in two groups: public markets in two columns on the left, and private markets in three columns on the right. The numbers in the table show that public markets have lower expected volatility, but also lower expected returns compared with their private market counterparts. Global equities have an expected return of 7.3%, with volatility of 14.7%, while fixed income has an expected return of 4.3% and volatility of 4.4%. By contrast, private equity has an average expected return of 11%, with a volatility of 29.4%. Private credit has an expected return of 7.7%, and volatility of 13.1%. Real estate has an expected return of 8.5%, with volatility of 13.9%. 

They think that the opportunities maybe lie in some of the alternative investments like private equity, private credit, and real assets. And they've certainly allocated to those investments over the year in anticipation of potentially higher returns.

Also what they've noticed is that the correlations between traditional asset classes like stocks and bonds have largely started to become more positive. Now that for diversification purposes is a little bit challenging when you're seeing correlations rise amongst traditional asset classes.

Text on screen: TITLE – Elevated correlations between asset classes; SUBTITLE – Difficult to find uncorrelated assets

Image on screen: A bar chart shows historical 10-year rolling correlation between stocks and bonds for each year from 1937 to 2021. Correlation is shown on the Y-axis, and the time span on the X-axis. Over the last three years, the correlation has been slightly positive, increasing from about 0.05 in 2019 to almost 0.1 in 2021. From 2005 to 2018, the correlation was negative, ranging between negative 0.2 and negative 0.6. This is the only period of negative correlations other than from 1962 to 1968. The chart also notes a period of inflation between 1965 and 1982, when correlations ranged between about 0.1 to 0.8.

In this particular chart you can see 10 year rolling correlations increasing over the last several decades, and might continue to increase as well. I also want to point out that in the periods during the '60s and '70s when we were experiencing high inflation, those correlations tended to be highly positive as well between stocks and bonds. And that may be a situation that we may be headed for in the future, at least to some degree institutions are predicting.

Devin Ekberg: Now there is a case for continued outperformance in some of these areas like private equity, private credit, and real assets.

Text on screen: TITLE – The case for potential outperformance

Image on screen: A diagram highlights the case for potential outperformance with three reasons, represented as columns left to right. Reason one is to seek active alpha, shown on the left, with bulleted points underneath, noting position-level intervention, control, and long-term horizons. Reason two, information, is in the middle column, noting different rules for material non-public information, information asymmetry, and operational intelligence. Reason three, on the right, is opportunity, noting there are larger opportunity sets than public markets, illiquidity premium and lower multiples, and a complexity premium.

One is that asset managers actually have an opportunity to add what I would call active alpha at a security level. In other words, they have an opportunity to construct an investment with the issuers to give it the best chance of success, aligning their objectives with the asset managers, and maybe providing some expertise and knowledge in some of those areas to produce the best result.

Secondly, there is an information asymmetry involved in some of these private markets and alternatives. Some of that information can actually be helpful to make the case for outperformance. And then thirdly, the opportunity set for alternative investments is typically broader and deeper. You simply have access to other types of investments that are not available in the traditional markets and traditional public markets.

Now individual investors are starting to see some of the benefits of this type of investing.

Text on screen: TITLE – Individual investors are increasingly allocating to alternative investments; SUBTITLE – What do HNW and affluent investors want?

Image on screen: The figure is a bar chart showing the intention to allocate to alternatives by high-net-worth and affluent investors. Bars from left to right show the percent of respondents who either own or intend to allocate to five different alternative asset classes. On the left, a bar shows 22% of respondents either own or intend to own private credit. Moving to the right, the percentage increases for each asset class: 32% for hedge funds, 34% for venture capital, 41% for private equity and 48% for real assets. Each bar also shows the amounts respondents actually own, which are about half or slightly less than half of the percentage totals.

And they're intending and indicating that they intend to allocate more to these types of investments. So in areas again of private equity, private credit, real estate, and others, these individual investors, high net worth and other affluent investors, are indicating their interest in this area.

Also some of the barriers and friction that individual investors have experienced in these areas are starting to be removed.   

Text on screen: TITLE – Barriers are being removed

Image on screen: A table shows three columns, showing how structural problems of alternatives led to practical problems, which can be addressed by technology and products. The first column, on the left, lists seven structural problems of alternatives: capital calls, cash drag, large minimums, no liquidity, K1s versus 1099s, no IRA or ERISA eligibility, and no investor protections. This leads to practical problems, listed in the middle column: limited to QPs, un-investable by IRAs and DCs, limited interest and education, sporadic availability, and difficulty of assembling portfolios. A third column on the right shows how the problems can be addressed by technology and products, such as advisor platforms, next generation structures with liquidity, 1099 tax treatment, smaller minimums, and availability to accredited investors.

Traditionally in alternative investments and especially private markets, you had to deal with things like capital calls, dealing with situations of cash drag and illiquidity. There may have been complicated tax forms like K1s that they had to deal with.

Often times they weren't eligible to be inside their IRA or other ERISA covered accounts. And really, regulatorily speaking, they really didn't have as many investor protections for these types of investments. Now this led to a lot of practical problems for individual investors to involve. But as the market has evolved, we've seen these practical problems being removed. And we've seen the adoption of other technology and products, things like advisor platforms and next generation structures with liquidity.

We're seeing 1099 tax treatment, which is a little bit more favorable. And we're ultimately seeing some of the minimums come down to a smaller degree. All of those things are increasing the interest of these high net worth investors to alternative investments in their portfolio.

Text on screen: TITLE – Agenda

Image on screen: Two boxes side-by-side display two myths. The box on the left shows Myth 1, which is that alternatives are only available to institutions and the top 1%. On the right, Myth 2 – highlighted for discussion – is that alternatives are too risky.

Which leads me to the second misperception, which is alternatives are just simply too risky.

Now it's true that some alternatives may have a higher risk profile than some of the traditional investments. And it's also true that the manager dispersion of returns is much wider in the alternative space compared to traditional investments.

Text on screen: TITLE – Alternatives and manager selection; SUBTITLE – Public and private

Image on screen: A bar charts shows manager dispersion for the 10-year period ended Nov. 30, 2021, for traditional and alternative asset classes. Alternatives show much wider ranges of dispersion. The first three bars of the chart on the left-hand side show tight ranges for traditional asset classes. Global equities show an actual range of 11% to 12%, for bonds it’s 1.8% to 2.4%, and U.S. core real estate, 9.6% to 10%. Alternatives, represented by the next four bars to the right, show much wider ranges. The ranges are about 8.1% to 14% for U.S. non-core real estate, 7.3% to 19% for global private equity, 8.4% to 24% for U.S. venture capital, and 1.9% to 9.3% for hedge funds.

So it's that much more important to find a top quartile, a manager, or an effective manager. If you find a bottom quartile manager, you're simply going to have a worse experience. So it's important to do your due diligence and align yourself with a good manager, much more so than it is in traditional markets.

But it's always important to analyze risk not just at an individual security level, but in the context of an entire portfolio.

Text on screen: TITLE – Improved portfolio efficiency

Image on screen: A graph plots annualized returns versus annualized standard deviation for six different portfolio allocations. The plots show portfolios with alternatives have higher returns and lower volatility. Returns are expressed on the Y-axis, and standard deviation on the X-axis. A table below the graph includes the data for the plots in the graph above. For a portfolio of 40% stocks and 60% bonds, whose plot is shown on the bottom left-hand side of the graph as a pie chart, has a return about 6.85% and standard deviation of 7.98%. Yet when the allocation shifts to 30% stocks, 40% bonds, and 30% alternatives, the return is 8.09%, and standard deviation is 7.18%, represented by a pie chart higher up and to the left. It’s a similar result for adding a 30% allocation to portfolios with higher amounts of stock, with the pie charts shifting upwards and to the left. For example, on the bottom far right, the graph shows a plot of a portfolio of 80% stocks and 20% bonds. When the mix is changed to 50% stocks, 20% bonds, and 30% alternatives, return rises to 8.44%, up from 7.45%, while standard deviation falls to 10.13%, from 13.74%. The result is the plot moving upwards to the left.

And some of the historical data has suggested that an allocation to alternative investments, along with other traditional investments in a portfolio, can cause the portfolio to achieve potentially higher returns at a lower potential risk. That causes an upward left shift in the efficient frontier, which is what a lot of portfolio managers are looking for.

So it's always important to analyze the risk of a security or an investment in the context of an overall portfolio. Now it's also true that alternative investments may come with additional risks on top of traditional investments,

Text on screen: TITLE – Beyond investment risk

Image on screen: The figure displays six risks, in two rows of three, with diagrams representing each one. The top row is represented by regulatory, liquidity and information risks. The bottom row includes counterparty, operational and manager risks.

things like regulatory risk. These markets are simply not as regulated and don't offer as many investor protections as some of the traditional markets. There may be significant liquidity risk. There may be, as we mentioned, information risk which can be an opportunity, but can also certainly be a risk as well.

We may end up with additional operational risks if an asset manager is not set up properly to deal with some of the operational issues in investing in these types of securities. And also manager risks among others as well.

Devin Ekberg: Now we hope we've cleared up some of the misperceptions about these types of investments. And we hope that it's clear that we can potentially add value by meeting other multiple investment needs within the portfolio.

Text on screen: TITLE – Adding value by meeting multiple investment needs

Image on screen: A diagram shows how alternative investments meet five investment needs, which are listed in a column on the right, and include the following: income potential, lower correlations, downside risk management, expanded opportunity set, and better liquidity matching. Each of these items, color-coded, are represented as clockwise-pointing arrows as part of a circle on the left-hand side of the diagram. 

We hope that we can achieve more income potential through things like private credit and real assets.

We also hope to overcome maybe some of the higher correlations in the traditional markets by adding a lower correlated asset as a diversifying benefit to the portfolio. We hope that we can manage some of the downside risk associated with some of these securities and the portfolio in general. We hope to take advantage of an expanded opportunity set just beyond the traditional public markets. And we hope that we can create better liquidity matching to different time horizons within an investor's portfolio.

Devin Ekberg: If you'd like more information on this and other topics, please check out PIMCO's website or reach out to your account manager for more information. And look for more opportunities to receive PIMCO's advisor education.

Text on screen: To learn more visit pimco.com/advisoreducation or speak with your account manager

Text on screen: PIMCO

Disclosure

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

Bloomberg Global Aggregate (USD Hedged) Index  provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. 

The MSCI All Country World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The Index consists of 47 country indices comprising 23 developed and 24 emerging market country indices.

The HFRI Fund Weighted Composite Index is comprised of over 2000 domestic and offshore constituent funds. All funds report assets in USD and report net of fees returns on a monthly basis. There is no Fund of Funds included in the index and each has at least $50 million under management or have been actively trading for at least twelve months.

The NCREIF (National Council of Real Estate Investment Fiduciaries) Property Index is a quarterly time series composite total rate of return measure of performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes only.

The Cambridge Associates U.S. Private Equity Index is based on returns data representing nearly two-thirds of leveraged buyout, subordinated debt, and special-situations partnerships since 1986.

S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market.

Bloomberg Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax-exempt bond market. The index is made up of all investment grade municipal bonds issued after 12/31/90 having a remaining maturity of at least one year.

The Bloomberg High Yield Municipal Bond Index measures the non-investment grade and non-rated U.S. tax-exempt bond market. It is an unmanaged index made up of dollar-denominated, fixed-rate municipal securities that are rated Ba1/BB+/BB+ or below or non-rated and that meet specified maturity, liquidity, and quality requirements.

It is not possible to invest directly in an unmanaged index.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. Outlook and strategies are subject to change without notice.

All investments contain risk and may lose value.

Alternative investments involve a high degree of risk and can be illiquid due to restrictions on transfer and lack of a secondary trading market. They can be highly leveraged, speculative and volatile, and an investor could lose all or a substantial amount of an investment. Alternative investments may lack transparency as to share price, valuation and portfolio holdings. Complex tax structures often result in delayed tax reporting. Compared to mutual funds, private funds are subject to less regulation and often charge higher fees. Alternative investment managers typically exercise broad investment discretion and may apply similar strategies across multiple investment vehicles, resulting in less diversification. Trading may occur outside the United States which may pose greater risks than trading on U.S. exchanges and in U.S. markets. Private credit involves an investment in non-publically traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing a strategy.

PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Investments LLC, U.S. distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.] | PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch  (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. 2604517) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institutions Act (WpIG).  The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and  203  to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2). The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. PIMCO Asia Limited is registered as a cross-border discretionary investment manager with the Financial Supervisory Commission of Korea (Registration No. 08-02-307). The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Investment Management (Shanghai) Limited Unit 3638-39, Phase II Shanghai IFC, 8 Century Avenue, Pilot Free Trade Zone, Shanghai, 200120, China (Unified social credit code: 91310115MA1K41MU72) is registered with Asset Management Association of China as Private Fund Manager (Registration No. P1071502, Type: Other) | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association, The Investment Trusts Association, Japan and Type II Financial Instruments Firms Association. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is managed and operated independently. The reference number of business license of the company approved by the competent authority is (110) Jin Guan Tou Gu Xin Zi No. 020. 40F., No.68, Sec. 5, Zhongxiao E. Rd., Xinyi Dist., Taipei City 110, Taiwan (R.O.C.). Tel: +886 2 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2023, PIMCO.

CMR2022-1013- 2464909