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    GSAM Insights

    DRIVERS WANTED: SOURCES OF RETURN IN ALTERNATIVE INVESTMENTS

    August 4, 2022  |  13 Minute Read

    Daniel Murphy

    Head of Portfolio Solutions for Alternatives Capital Markets and Strategy

    Daniel Murphy

    Juliana Hadas

    Portfolio Solutions for Alternatives Capital Markets and Strategy

    Juliana Hadas

    Michael Hillman

    Alternative Investments & Manager Selection

    Michael Hillman

     

    Key Takeaways

    • Alternative investment strategies can provide access to differentiated sources of return, which can be broadly considered in two categories—alternative beta factors and alpha sources from manager skill.
    • These distinct return drivers, rather than a single “illiquidity premium,” may explain the historical performance of private markets strategies.
    • Viewing hedge fund strategies through the lens of their underlying return drivers can help tailor portfolio construction for specific portfolio solutions.

     

    Portfolio construction strategies and techniques are becoming increasingly sophisticated. Asset owners and managers are seeking to better understand the specific return drivers and exposures of their investments, an approach that can help define each investment’s strategic portfolio role and positioning across different market regimes. Alternative investments in particular—private market and hedge fund strategies—can benefit from a more comprehensive understanding of their underlying return drivers. Each of these asset classes encompasses a wide variety of strategies, with exposures to different return drivers. Some of these return drivers can also be accessed in traditional equity and fixed income markets; others may be structurally unique to alternatives. Looking beyond the asset class label, therefore, can enable better differentiation and portfolio positioning. For instance, one portfolio construction approach could be to emphasize alternative strategies that offer exposure to the most diversifying return sources relative to the portfolio’s traditional assets. Another approach might focus on strategies with the greatest potential return impact given the investment organization’s resources and available opportunities. Consideration can also be given to return drivers that may be especially valuable in particular market regimes. 

     

    Private Markets

    A growing body of research has shown that private market strategies have historically outperformed public assets over a variety of time frames—and not simply due to differences in leverage, sector or style composition compared to the most applicable public benchmarks.1 Top-performing managers have generated outperformance meaningfully higher than the industry in aggregate.2

     

    Headlines often attribute this outperformance to an illiquidity premium. We believe, however, that this outperformance is the result of exposure to a set of distinct differentiated return drivers. These can be considered in two categories: alternative beta factors and alpha sources. Alternative beta factors are systematic exposures to compensated risk in areas of the market with low or no correlation with broad market direction. Alphas are skill-based, situation-specific, and highly dependent on the skillset of the investment manager. These exposures can drive returns and provide diversification to traditional public equity and credit return drivers.

     

    Traditional Beta Exposures in Private Markets

    Before delving further into the diversifying sources of return, it is important to acknowledge that private market strategies have beta exposures to traditional market factors as well—corporate and real asset equity and credit. Strategies vary in their degree of sensitivity to these factors, and in the efficiency with which they can gain exposures to them, compared to public market strategies. For instance, both private and public equity strategies offer exposure to corporate equity beta, but this exposure is more efficiently accessible in public markets—deployment is immediate, monitoring costs are generally low, and effective exposure is readily available via low-cost ETFs. On the other hand, real asset equity beta may be targeted more effectively in private assets, as public real asset securities are dominated by broad equity beta. For instance, since U.S. REITs became a component of the S&P 500 Index, they have had a correlation of 0.70 to that index. This is double their pre-inclusion correlation of 0.36,3 suggesting that a meaningful idiosyncratic risk and return component has been subsumed by the market dynamics of managers with broad public equity mandates investing in, and managing, their REIT exposures similarly to other equities in their portfolios, and mindful of tracking error to the broad market index.

     

     

    Private Markets Diversifying Sources of Return—A Framework

     

     

    Accessing Diversifying Sources of Return

    These alternative beta factors and alpha sources are not found uniformly across individual strategies. Some—such as structural supply/demand imbalances that affect the cost and availability of financing—permeate the broad set of private markets strategies, albeit to different degrees. Others are generally limited to a smaller subset of strategies.

     

     

    Private Strategies Have Different Amounts of Exposure to Potential Alternative Beta Factors and Alpha Sources

     

    Source: Goldman Sachs Asset Management. For illustrative purposes only.

     

    Exposure to some sources can be obtained in both public and private strategies, but may find different expressions between the two. For instance, all active strategies have the potential to generate alpha from insight, but private equity strategies have an expanded set of opportunities to choose from, as the universe of private companies has expanded while the universe of public companies has contracted over the past two decades.6 Similarly, companies capitalizing on innovation are found in both public and private markets, but those in the earliest, most innovative, highest-growth phases of their trajectory are almost exclusively privately funded.

     

    Other exposures may be structurally particular to, or significantly more effective in, private markets. This is particularly the case among factors that rely on control over the investment—such as tailored capital solutions and operational expertise. Sourcing is also a bigger component to alpha generation in private markets, as by definition private opportunities are not easily visible to all. And the type of complexity undertaken by certain private situations may far exceed the amount that public market investors would be comfortable with. 

     

    "Exposures differ by the magnitude of their potential returns, the size of the opportunity, and the consistency with which they may be available across the market cycle."

     

    The excess return potential for a given strategy is not simply a function of the sum of its factor exposures. Exposures differ by the magnitude of their potential returns, the size of the opportunity, and the consistency with which they may be available across the market cycle. Certain sources of return may be more valuable in specific environments. Some of this may be intuitive. For instance, alternative risk premia become more valuable when correlations between traditional equity and credit exposures rise. Capital flexibility and operational expertise become more critical levers of value creation and potentially a stabilizing force in regimes of greater stress and market volatility. Other dynamics may be under-appreciated. For instance, private capital beta may offer investors a steadier way to navigate an uncertain market environment. Recent research has found that private equity owners’ support of portfolio companies through downturns translates into lower costs of distress.7 If a company does encounter distress, a single lender should be better positioned to work alongside the company’s owners to effect efficient modifications and work-outs, compared to a broader syndicate of lenders with potentially competing interests. In addition, periods of market volatility make the certainty of execution associated with private capital more valuable to companies seeking financing—which can translate into a greater premium in the cost of capital.

     

    The excess return potential of exposures to these return drivers also varies greatly across managers within each strategy. Historical dispersion across funds in a given strategy offers guidance as to the impact these sources may have. A corollary is that manager selection and access to superior managers are critical factors in private markets portfolio construction—and can influence the set of strategies the investor may choose to focus on.

     

     

    Historical Private Markets Strategies Returns Dispersion Can Offer Guidance as to the Impact of Return Drivers

     

    Source: Cambridge Associates, as of Q4 2021. Net of Fee Returns. For each strategy, represents the average of the dispersion across funds of vintage years 2000-2017. 2018-2021 vintage funds are considered too young to have meaningful performance due to the effect of the performance J-curve. Past performance does not guarantee future results, which may vary.

     

    Finally, the impact of some of these sources may vary by the vehicles in which these strategies are accessed. For instance, funds of funds managers can generate returns in excess of those from the median single-fund manager, with the best performing constituent funds bringing up the average across investments. However, funds of funds may not outperform the highest-performing single-fund managers: diversification across multiple underlying funds helps mitigate downside risk at the expense of diluting the upside impact of top-performing portfolio constituents. Secondary vehicles may offer their own exposures to a number of diversifying sources of return, above those offered by the underlying investments, as secondary firms have evolved to become providers not just of liquidity but of bespoke capital solutions to fund managers and investors. Complexity and tailored capital solutions are two such return drivers.

     

    Hedge Funds

    Similar to private markets, a carefully constructed skill-based hedge fund portfolio may introduce particular, uncorrelated sources of return to an asset owner’s portfolio. And like private markets, hedge fund returns can be separated into distinct components: beta exposure to traditional and alternative risk factors, and alpha generated from manager skill. Alpha—skill-based returns—are the returns generated in excess of what is expected given the risks taken to generate them.8 While not associated with any common risk factors, hedge fund alpha can be segmented based on the approaches used to generate it.

     

    This byproduct of manager skill is generally viewed as the most desirable component of a hedge fund manager’s return, and with the recent elevated levels of market volatility and higher correlations of stocks and bonds9—two fundamental building blocks of most allocators’ portfolios—we believe that increasing exposure to idiosyncratic, or skill-based, returns can address some of the biggest challenges hedge fund investors face today.

     

    What Hedge Funds Seek to Capitalize On

    The hedge fund universe encompasses a plethora of investing strategies, focused on a wide range of asset classes and individual securities. Some funds take directional bets in their portfolios, albeit with lower exposure to traditional betas than is the case in traditional equity and credit vehicles. Other funds pursue market-neutral strategies, which focus on pure alpha generation.

     

    However, a common theme across these strategies is capitalizing on changes and inefficiencies in the market environment. If financial markets were perfectly efficient and evolved in an efficient way, divergence in market prices would not lead to the emergence of opportunities with abnormally high risk-adjusted returns. In reality a changing economic environment and the reaction of market participants to these changes can move prices away from efficient levels, creating temporary potential profit opportunities. History has shown this process is not simultaneous and may evolve slowly until prices converge to efficiency.10 Markets display varying degrees of efficiency at different points in time, making for constantly-changing opportunity sets. The more uncertainty and the greater the dispersion of potential outcomes, the greater the potential opportunity to capitalize. When these opportunities do arise, competition for idiosyncratic returns can be fierce.

     

    Role of Hedge Funds in a Portfolio

    We do not view hedge funds as a monolithic asset class with one specific role in every investor’s portfolio. Rather, we consider skill-based returns as components for developing solutions for different portfolio needs. The role for hedge funds will likely vary by asset owner, based on a portfolio’s current exposures, desired outcomes, and changing market conditions. With over 8,00011 different hedge funds in the market today pursuing a wide variety of strategies, identifying the desired mix of funds calls for a systematic approach. The first step could be to identify elevated risk factors, or potential shortcomings in an asset owner’s portfolio. The portfolio’s historical returns can be decomposed to identify major market risks. Then, a range of exposures and sensitivities to fundamental market and hedge fund factors can be assessed including equity prices, implied volatility, interest rates, credit spreads, commodity prices and foreign exchange levels. Understanding changes in return drivers and the portfolio’s risk profile can help assess the evolution of portfolio risk, and what opportunities can be complementary to the portfolio’s profile and objectives.

     

     

    Hedge Funds Diversifying Sources of Return—A Framework

     

     

    There is a multitude of use cases for including a well-designed portfolio of skill-based returns, particular to each investor’s situation. Three use cases below reflect common issues facing investors in today’s environment.

     

    In an environment in which traditional fixed income and equities are positively correlated, where can an investor find attractive sources of uncorrelated returns?

    A diversified portfolio of low correlation strategies with skill-based managers who have little or no direct structural exposure to equity markets can help offset elevated beta risk. Lower direct equity exposures may create a return profile with lower expected correlation to equity returns. These portfolios typically have more exposure to relative value, market neutral and tactical trading strategies.12

     

    If a portfolio’s projected returns are below the stated return objective, can returns be enhanced without increasing equity beta?

    For investors facing a potential return shortfall with limited flexibility with their risk budget, the focus can be on absolute return solutions whose primary goal is generating higher alpha. Such an investor may consider hedge fund managers who invest with a medium-term time horizon and are relatively agnostic to strategy styles or asset classes, allowing for an expansive opportunity set.

     

    Are there ways for an investor with a mid-duration time horizon to be opportunistic?

    An investor can consider opportunistic exposures in portfolios focused on concentrated investments in a single theme undertaken in partnership with an external manager. Often, these opportunities are tied to specific catalysts that will take a 2–5-year investment horizon to fully materialize. They tend to be highest on the risk/return spectrum of hedge fund strategies.

     

     

    Top Asset Owner Challenges and Potential Hedge Fund Solutions in the Current Market Environment

     

    Source: Goldman Sachs Asset Management, June 2022. For discussion purposes only.

     

    Identifying and Accessing Manager Skill

    Hedge funds have many tools to seek to magnify their excess risk-adjusted returns—utilizing shorting and leverage to increase or reduce risk exposures, taking diversified or concentrated positions, and investing in a manner unconstrained by benchmarking considerations. However, these tools also magnify the potential dispersion of returns, making true manager skill all the more critical to find.

     

    While time series analysis provides a historical quantitative assessment of a manager’s ability to generate skill-based returns, it is more critical to assess a manger’s ability to generate persistent alpha in the future. We believe a manager’s forward alpha prospects are more dependent on their analytical capabilities and process, their behavior and incentives, and the organizational and cultural values than on historical performance, making track record an important, but incomplete, input into the evaluation process.

    Since investment risks are multi-faceted, our experience has shown that skill-based active management works best in an environment of fewer constraints, and is best implemented with a diversified set of managers capitalizing on a combination of different sources of skill. Portfolios diversified in this manner tend to demonstrate both more attractive correlation dynamics and better downside mitigation through various market cycles. As such, a well-crafted, diversified portfolio that prioritizes skill-based investment strategies should enhance risk-adjusted returns and may ultimately improve the long-term consistency of an asset owner’s performance.

     

    Implications for Portfolio Construction

    Alternatives—private market and hedge fund investments—comprise myriad strategies that can play different roles in portfolios. But these strategies have two features in common. First, they offer diversification to traditional public equity and fixed income instruments, complementing traditional investments via differentiated sources of return. Second, their nature and structure make them ill-suited to traditional mean-variance optimization approaches. As such, considering these strategies through the lens of underlying return drivers can be informative. Admittedly, not all of the return drivers noted in this paper can be quantified. As such, this framework is not a replacement for a more robust optimization approach. Rather, it can be an additional lens through which to view these asset classes, a tool to complement the investor’s existing portfolio construction process for creating diversified portfolios of traditional and alternative investments.

     

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    1 See, for instance, Robert S Harris, Tim Jenkinson and Steven N. Kaplan, “How Do Private Equity Investments Perform Compared to Public Equity?” (Journal of Investment Management, 2016), and “Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds” (SSRN, March 2022); and “Performance Analysis and Attribution with Alternative Investments” Matteo Binfare, Gregory Brown, Andra Ghent, Wendy Hu, Christian Lundblad, Richard Maxwell, Shawn Munday, and Lu Yi—January 2022.

    2 Cambridge Associates. Based on inception-to-date performance of funds across vintage years 2000-2017.

    3 S&P, NAREIT. Computed using monthly total returns on the S&P 500 and FTSE NAREIT All-REIT indices, from 2/1988 to 9/2001 and 10/2001 (the first month of REIT inclusion in the S&P 500) to 4/2022.

    4 Based on average age of company at IPO; source: Professor Jay Ritter, as of December 21, 2021.

    5 Binfare, Brown et al, “Performance Analysis and Attribution with Alternative Investments,” January 2022.

    6 PitchBook, World Bank, McKinsey as of 6/30/2021.

    7 See, for instance, Haque, Sharjil, “Does Private Equity Systematically Over-Lever Portfolio Companies?”, July 30, 2021; and Belyakov, Alexander, “Economics of Leveraged Buyouts: Theory and Evidence from the U.K. Private Equity Industry”, March 19, 2020.

    8 Defining Alpha…It’s Skill, Not Excess Return, 361 Capital, June 2017.

    9 Goldman Sachs Global Investment Research.

    10 Alternative Investments, Market Divergence, Dislocation, and Momentum, 2016.

    11 Bloomberg, 2021.

    12 Goldman Sachs Asset Management, XIG Hedge Funds Team, May 30, 2022.

    Glossary

    Alpha refers to returns in excess of the benchmark return.

    Beta refers to the tendency of a security’s returns to respond to swings in the markets

    Beta Agnostic describes funds that are not managed to a particular beta level

    Co-investment portfolios comprise direct investment positions made alongside a General Partner

    Correlation is a statistic that measures the degree to which two securities move in relation to each other.

    Dislocation Trading describes market activity in securities where the price is disconnected from the fundamentals

    Directional managers pursue a strategy that has net long or short exposure

    Distressed managers seek opportunities arising from corporate stress 

    Event Driven Managers trade around major corporate events, including mergers, regulations, and earnings announcements

    IRR is the discount rate that makes the net present value of all future cash flows zero

    Macro managers trade in a range of markets base their strategy on top-down macroeconomic analyses

    Market-neutral strategies maintain zero net exposure to the market, seeking to achieve gains regardless of market conditions

    Merger arbitrage is a strategy predicated on capturing mispricing around merger activity

    Opportunistic Financings typically include bespoke terms to meet specific needs occur during times of corporate or economic stress

    Private credit refers to non-bank lending that is not issued or traded in public markets.

    Private equity (PE) refers to investments in the equity or debt of companies that are either not listed on public exchanges or are taken private shortly after they are acquired

    Real Assets describes investments into physical structures and commodities, including infrastructure and energy

    Relative value managers seek to exploit temporary differences in the prices of related securities

    Secondary vehicles acquire stakes in existing private equity funds

    Strategy Agnostic describes managers or funds that to not pursue a specific strategy

    Risk Considerations

    All investing involves risk. Equity securities are more volatile than bonds and subject to greater risks. Dividends are not guaranteed and a company’s future ability to pay dividends may be limited.

    Hedge funds and other private investment funds (collectively, “Alternative Investments”) are subject to less regulation than other types of pooled investment vehicles such as mutual funds. Alternative Investments may impose significant fees, including incentive fees that are based upon a percentage of the realized and unrealized gains and an individual’s net returns may differ significantly from actual returns. Such fees may offset all or a significant portion of such Alternative Investment’s trading profits. Alternative Investments are not required to provide periodic pricing or valuation information. Investors may have limited rights with respect to their investments, including limited voting rights and participation in the management of such Alternative Investments.

    Alternative Investments often engage in leverage and other investment practices that are extremely speculative and involve a high degree of risk. Such practices may increase the volatility of performance and the risk of investment loss, including the loss of the entire amount that is invested. There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. Similarly, interests in an Alternative Investment are highly illiquid and generally are not transferable without the consent of the sponsor, and applicable securities and tax laws will limit transfers.

    Disclosures

    This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities or to make any investment decision.

    The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk.

    Diversification does not protect an investor from market risk and does not ensure a profit.

    There is no guarantee that objectives will be met.

    This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. This material is not financial research nor a product of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed may differ from those of Goldman Sachs Global Investment Research or other departments or divisions of Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors before buying or selling any securities. This information may not be current and Goldman Sachs has no obligation to provide any updates or changes.

    This material represents the views of Goldman Sachs Asset Management. It is not financial research or a product of Goldman Sachs Global Investment Research (GIR). It was not a product nor financial research of Goldman Sachs Global Investment Research (GIR). It was not prepared in compliance with applicable provisions of law designed to promote the independence of financial analysis and is not subject to a prohibition on trading following the distribution of financial research. The views and opinions expressed herein may vary significantly from those expressed by GIR or any other groups at Goldman Sachs. Investors are urged to consult with their financial advisers before buying or selling any securities. The information contained herein should not be relied upon in making an investment decision or be construed as investment advice. Goldman Sachs Asset Management has no obligation to provide any updates or changes.

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    Index Benchmarks

    Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

    The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of “failed” or closed hedge funds may mean that each index overstates the performance of hedge funds generally.

    Prospective investors should inform themselves as to any applicable legal requirements and taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant.

    This material is provided for informational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. This material is not intended to be used as a general guide to investing, or as a source of any specific investment recommendations, and makes no implied or express recommendations concerning the manner in which any client’s account should or would be handled, as appropriate investment strategies depend upon the client’s investment objectives.

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    Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

    Although certain information has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness. We have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources.

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    Colombia: Esta presentación no tiene el propósito o el efecto de iniciar, directa o indirectamente, la adquisición de un producto a prestación de un servicio por parte de Goldman Sachs Asset Management a residentes colombianos. Los productos y/o servicios de Goldman Sachs Asset Management no podrán ser ofrecidos ni promocionados en Colombia o a residentes Colombianos a menos que dicha oferta y promoción se lleve a cabo en cumplimiento del Decreto 2555 de 2010 y las otras reglas y regulaciones aplicables en materia de promoción de productos y/o servicios financieros y /o del mercado de valores en

    Colombia o a residentes colombianos.  Al recibir esta presentación, y en caso que se decida contactar a Goldman Sachs Asset Management, cada destinatario residente en Colombia reconoce y acepta que ha contactado a Goldman Sachs Asset Management por su propia iniciativa y no como resultado de cualquier promoción o publicidad por parte de Goldman Sachs Asset Management o cualquiera de sus agentes o representantes. Los residentes colombianos reconocen que (1) la recepción de esta presentación no constituye una solicitud de los productos y/o servicios de Goldman Sachs Asset Management, y (2) que no están recibiendo ninguna oferta o promoción directa o indirecta de productos y/o servicios financieros y/o del mercado de valores por parte de Goldman Sachs Asset Management.

    Esta presentación es estrictamente privada y confidencial, y no podrá ser reproducida o utilizada para cualquier propósito diferente a la evaluación de una inversión potencial en los productos de Goldman Sachs Asset Management o la contratación de sus servicios por parte del destinatario de esta presentación, no podrá ser proporcionada a una persona diferente del destinatario de esta presentación.

    Conflicts of Interest

    There may be conflicts of interest relating to the Alternative Investment and its service providers, including Goldman Sachs and its affiliates. These activities and interests include potential multiple advisory, transactional and other interests in securities and instruments that may be purchased or sold by the Alternative Investment. These are considerations of which investors should be aware and additional information relating to these conflicts is set forth in the offering materials for the Alternative Investment.

    Date of First Use: August 4, 2022. 282941-OTU-1634881

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