Alternative investments blend talent and technique

Stocks, bonds, and cash—the foundation of most portfolios—might typically serve you well. But the downturn in both stocks and bonds in 2022 was a reminder that sometimes the unexpected happens.

It was a rare event. Investors who had alternative investments in their portfolio mix, however, might have had different results. The high inflation of 2022 hurt many types of investment assets, but some categories of hedge funds had a positive return.^{Disclosure 1}

The term “alternative investments” covers not only hedge funds but also private equity, private credit, the so-called secondaries market, and other asset classes that aren’t traditional portfolio vehicles. “These typically include strategies that are not broadly available or at least easily implemented in more traditional active management structures,” says Spencer Boggess, managing director of alternative investments at Truist Advisory Services, Inc.

Focus on four asset classes

Truist Wealth’s efforts for clients in the alternative space center on hedge funds, private equity, private credit, and secondaries.

Hedge funds. These employ many investment strategies and are less regulated than mutual funds. Managers are free to follow whatever strategy, as well as any asset classes, they choose. Hedge fund performance objectives also vary widely.^{Disclosure 2}

Private equity. Private equity firms typically invest in businesses that aren’t listed on public stock exchanges. To invest in these businesses, the firms create funds comprising pooled investments with set durations, typically 10 years.

Private credit. Companies can borrow from a private credit firm as an alternative to borrowing from banks or issuing bonds. Although companies might pay higher rates for these loans or debt financing, they benefit from receiving the funding quickly and with certainty. Investors in private credit funds receive income based on the interest payments from this financing.

Secondaries. This market comprises investments in a private equity firm’s ownership of companies. In this case, a private equity firm acquires ownership of companies, then offers to sell a percentage of the businesses in the secondary market.

Alternative investments once were only accessible to large institutional investors and some wealthy clients. “But there’s been a considerable convergence between alternatives and traditional assets in making alternatives more broadly available, democratizing them in a way,” Boggess says.

As a result, investors today have more opportunities to participate in these large asset categories. For example, global hedge fund capital currently exceeds $4 trillion.^{Disclosure 3}

“The private market universe is massive,” says Will Repath, director of private equity and credit strategies at Truist Advisory Services. “Not investing in private markets means you’re missing out on a lot of opportunity. Since 2000, we’ve seen a significant increase in private equity-owned companies in the U.S. Today, you have more than 10,000 private equity-owned companies versus, say, 4,000 publicly traded companies.”

Investing alongside talented managers

Perhaps the most compelling reason to consider alternative investments is the opportunity to have your funds overseen by top talent.

“Many of the most talented managers running money today choose to operate in the hedge fund or private equity structure because of the latitude and breadth of opportunities posed by those strategies,” Boggess says. By comparison, managers of mutual funds might be talented, but they face constraints on how they’re allowed to invest.

For hedge funds, the Truist team’s process of identifying the best managers for their clients involves a lot of word of mouth, says Len Lebov, senior alternative investments analyst at Truist Advisory Services. Lebov and his colleagues rely on a network of sources who provide information about talented managers.

For example, our team might learn of an analyst who recently left a well-regarded hedge fund to start their own firm. But that’s just the beginning of the process. “Then it’s a matter of pattern recognition,” Lebov says. “Doing this over and over, sitting down with hundreds of managers over two decades and getting a sense that this is a very talented person.

“You know they’re answering the questions the right way. They have the right respect for risk, they understand their strategy, they’re hiring the right people, they’ve built the firm correctly.”

Lebov and his team continue their due diligence by poring over the fund’s performance and collecting as much background information as they can before deciding whether the fund is appropriate for their clients.

An evolution in approaches

The market for hedge funds, private equity funds, and other alternative investments over the years has matured, with managers broadening their approaches to include many techniques that work in a variety of markets.

Hedge funds, for example, have evolved beyond the “long/short” strategy the industry was once known for. This approach involves combining long-term investing in stocks managers believe are underpriced with short-term trading techniques.

Via hedge funds, investors today can gain access to markets, strategies, and techniques they normally wouldn’t be able to. “For example, if you wanted to get involved in the sovereign bonds of a Latin American country or an Eastern European country, or you wanted to get involved in different global commodities, it’s not that easy to do,” Lebov says. “But hedge funds allow you that access and that richness of strategies.”

Also, not all hedge fund strategies are intended to earn higher returns at a higher risk. “You can go all the way on the other end of the spectrum and have hedge funds that offer very steady or modest returns with very little risk,” he says. “They can offer a lot of diversification in a portfolio.”

Private equity funds have adopted more sophisticated techniques for making the businesses they acquire profitable, Repath says. Where firms once relied on slashing costs, today they try to transform companies by making operational improvements and expanding their business. “It’s also important to identify managers who have been able to execute across multiple cycles by creating value via other levers,” he says.

Opportunities in private credit and secondaries

The private credit and secondaries markets provide opportunities for additional portfolio diversification. Businesses are turning to private credit sources because of changes in the operating environment.

“Traditional lenders, including banks, have retreated from the space because of regulatory changes,” Repath says. The global financial crisis of 2007–2008 created tighter lending standards for banks. To make riskier loans, they’re required to hold more capital than they did before the crisis. Problems at some regional banks in 2023 led some banks to further retreat from lending.

As a result, direct lending from private sources has stepped into the void. For an investor, private credit funds offer a variety of strategies and return profiles. “The private credit spectrum is quite broad,” Repath says. “Many factors drive return.”

The secondaries market is also rich and diverse. Investors might favor putting funds into a secondaries offering instead of a private equity fund because of a concept called blind-pool risk. “When a private equity manager raises funds, it takes some time to deploy that capital, build out a portfolio of companies, add value, and start exiting these investments,” he explains. Meanwhile, the investor’s money is locked up in the fund for perhaps 10 years.

But sometimes a private equity fund wants to sell part of its investments after several years. From the standpoint of a potential secondary buyer, the companies in the fund have matured and the investment is locked up for fewer years. As a result, investors have a chance to benefit from a private equity investment with a risk profile to meet their needs.

Alternatives and your portfolio

Alternative investments might provide diversification benefits for your portfolio, including a wide range of return and risk profiles. But whether an investment is right for you depends on your situation. Investment fees for alternatives might be higher, for example, and you’ll need to determine whether you believe the higher fees are worth the additional potential return compared to traditional assets.

The reduced liquidity of alternative investments might be another issue. Many hedge funds have limited opportunities for redemptions, while investments in private capital are often locked up for 10 years, or maybe more.

But if you and your advisory team determine that alternative investments are a suitable way to meet your financial goals and wealth objectives, you’ll have an opportunity to step into a wider world of investments.