(August 1, 2012) — Alternative investments, including private equity, real estate and hedge funds, have natural advantages in risk and return, and most institutional investors are insufficiently allocating to the sector, according to a recently published whitepaper by Mike Sebastian of Hewitt EnnisKnupp.
His general rule of thumb: an allocation of at least a third of assets for a typical institutional portfolio.
Clients who can tolerate the cost, complexity, and illiquidity should consider opportunity-type allocations of 40% of their return-seeking assets to private equity, non-core real estate, and hedge funds, Sebastian told aiCIO. “For endowments and foundations, they’re already there, but for public pensions, this could be a significant change,” he said, referring to one of his latest papers titled “Go Big or Go Home: The Case for an Evolution in Risk Taking.”
So what’s the reason for the outperformance of alternatives? According to Sebastian, the success of the asset class comes from its greater breadth and flexibility. “Hedge funds and private equity managers are less constrained and restricted so they have a better ability to add value,” he said.
Furthermore, Sebastian highlighted his perceived connection between compensation and value added. “If you’re a smart individual and choose to go into investment management, you can earn a lot more by going to a hedge fund with its two and 20 structure,” Sebastian concluded, referring to hedge fund managers charging a flat 2% of total asset value as a management fee and an additional 20% of any profits earned. “So we’ve seen a drain of talent from mutual funds and stocks and bonds toward hedge funds and other types of alternative investments because the fees are higher.”
Download Mike Sebastian’s full paper here.
This is surely not the first voice championing the success of alternatives as an asset class. A survey of consultants released earlier this year found that alternatives will be the most sought after by institutional investors in the United States this year, knocking traditional asset classes out of the top five most wanted for the first time.
More specifically, private equity, emerging market debt, hedge funds, real estate and commodities are to be the asset classes seeing the most investor searches in 2012, according to the survey of consultants by Casey Quirk and eVestment Alliance. In total, these alternatives are to make up 20% of all fund manager searches, the firm noted.