The Alternative Investment Sector

The alternative investment sector has progressed over three decades to become a critical part of the financial system and the international economy.

Its growth could be traced to an array of external factors, with regulatory fluctuations, technological development, and economic cycles, all playing vital roles. Within this macro scenario, entrepreneurs initiated a range of firms using a varied mix of value sources to create returns for investors.

At present, the sector is extremely relevant for the international economy. The dot-com crash and the global financial meltdown led several experts to question the significance of alternatives, but they proved resilient and emerged stronger following both events.

The demand for alternatives has been strong. Total assets under management increased from $1 trillion in 1999 to more than $7 trillion in 2014.

Its impact on the economy, the wider financial system, and society, has extended drastically. Analysts have been able to determine how asset classes like private equity buyouts, hedge funds, and venture capital influence a variety of factors (positively as well as negatively).

Emerging economies would play a vital role in the international economy. Changes in demographics and economic policy are restructuring the economic scenario. The alternative investment sector is already impacted by some of the consequences.

Advances in global health have led to a drastic increase in life expectancy in emerging economies, with the total and working population growing in absolute terms and relative to developed countries.

Several nations have implemented very liberal economic policies, like a notable reduction of tariffs in emerging economies, with the total freedom of trade continuing to rise following the financial crisis.

The outcome has been a substantial increase in trade and GDP. Emerging economies are projected to account for 50% of global GDP by 2016.

Driving this is the development of a strong middle class in emerging economies. With large-scale economic reforms underway in nations like China, the rebalancing of the international economy is expected to continue for some time. The change has created new prospects for alternative investors.

Emerging economies are also an increasingly vital source of capital for alternative investment firms, as robust economic development leads to a corresponding growth in financial markets and national wealth.

The share of global financial assets held by emerging nations is continuing to rise. Assets under management by sovereign wealth funds have grown substantially.

The majority of the sovereign wealth fund assets is based in emerging economies, strengthening the demographic trends, and driving transformations to the business model of alternative investment firms and their relationship with institutional investors.

The retirement of the baby boom generation in developed countries is straining pension systems across the world. The funding gaps are leading public pension funds to assign larger shares of capital to alternative investments.

The extraordinary monetary policies executed by the UK, the US, European Union and Japan in the wake of the global financial crisis are having an enormous influence on capital markets and the investment system. It is expected to continue in the future.

The introduction of quantitative easing has significantly increased the size of balance sheets at important central banks.

Institutional investors with outstanding liabilities are severely affected, as quantitative easing decreases the expected returns from fixed income products and increases the probability of funding gaps developing or growing.

This is leading to a significant increase in the demand for assets that provide higher expected returns, predominantly by retirement systems in developed nations.

A huge flow of capital has enabled the US stock market hit record highs. The search for yield is also increasing demand for high yield bond in the United States and Europe. The impact could be seen in alternative investments.

Faced with difficult decisions, stakeholders have decided to increase the risk profile of investments in pursuit of higher returns. This is resulting in increased demand for alternatives. Historically, alternatives have been regarded as adding value through diversification.

Institutional investors seek assets reducing portfolio volatility, a role that alternatives continue to play.

The magnitude of investment moving further out along the risk/return curve would drive the twin industry trends of retailization and institutionalization, restructuring the role of both investors and alternative investment firms within the alternative investment ecosystem.

The alternatives sector is also experiencing tremendous change. Three specific trends are expected to shape the structure of the sector:

Regulation

It affects alternative investment firms directly or transforms the way they engage with the wider financial sector.

The wave of new banking and investment regulations announced by governments globally in response to the financial crisis would shape the sector for years to come.

Institutionalization

It structurally alters the number of capital providers investing in alternatives. A significant growth in the scale of investing by institutional investors along with the experience they have accumulated in alternative asset classes, has led some institutions to build up their internal proficiencies.

Retailization

It has the potential to redefine and extend the pool of investors in alternatives. The rise of retail investors as a key source of capital will shape the alternative investment landscape over the coming decade.

Retailization is expected to lead to large inflows of capital into alternative investments over the next decade, significantly affecting the competitive landscape.

The forces likely to shape the magnitude of the alternative investment sector in the future include fundamental macro trends, financial services regulation among others. The sector would reach a completely new scale in terms of assets under management, create new business models and establish new relationships.

The future of the alternative investment industry appears likely to be one of both growth and substantial structural change, accompanied by an increasing maturity of the sector’s infrastructure, regulation, and investment relationships.

Growth is also reasonably assured due to the ongoing demand for the above-average returns related with the sector, increasing distributions from several large institutions, additional capital flows from emerging economies, and the developing process of retailization, as well as the quest for yield pushed by pension funds.

The challenge for the sector would be in delivering above-average returns continuously to all the constituents.

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