Leveraging alternative assets as a means to minimise downside investment risks

Benedict Mongalo, Managing Director of Novare Impact Investment Partners

When most people think of investing, the first thing to come to mind is usually your traditional asset classes like stocks and bonds or even interest on cash savings. After all, these make up the bulk of virtually every investment portfolio domestically.

Beyond these, however, more and more investors are shifting the balance of their portfolios into alternatives, in search of new ideas and innovations that diversify their asset mix, lower volatility, and potentially offer better, more predictable returns. This is because alternatives are not positively correlated to traditional asset classes, in that they often move in a different direction, which therefore offers a diversification benefit. They also have a wider range of strategies available to them in order to respond to changing market conditions, making them an essential component of any modern investor’s portfolio. In South Africa, the alternatives’ regulatory limit for pension funds is up to 10% of the overall investment portfolio, although domestic institutional investor appetite appears to be significantly lower, with recent studies suggesting that less than half that regulatory limit is actually invested in alternatives.

What are the differences between alternative assets and traditional assets?

Allocating to alternatives is more complex than traditional investments however, and requires a specialised level of experience and knowledge, along with an operational capacity for ongoing research and due diligence. Alternative investments are a diverse asset class that demands an equally diverse set of skills from fund management teams, because they span both private and public markets, with a wide range of strategies, and consequently, highly specialised functions. The asset class includes private equity investments like growth or venture capital, or even infrastructure, and private credit outside of traditional banking structures, which may include senior debt, hybrid, and mezzanine debt propositions. Additionally, there are real estate investments which seek to make returns via both capital appreciation and ongoing rental. Moreover, there are a wide range of commodities as well as collectibles, such as art, for example. All on the private side. Then there are also other alternatives like hedge funds and structured products which invest predominantly in instruments listed in the public market.

With a range of dynamic classes so different from each other, it seems that there is little in terms of defining characteristics to bind them together besides being labelled as alternative investments. That’s not entirely true. For one, they often lend themselves towards longer investment terms and do not offer the same liquidity as traditional classes. Outside of hedge funds, they are not as easily sold or converted back into cash. For instance, in private equity funds, early redemptions or liquidity events are often done on a best endeavour basis, with exit penalties and other members of the fund having to buy you out if there is appetite.

Another common factor amongst the alternative classes is that they tend to be more expensive, relative to traditional asset classes. This is understandable because of the level of management that is often required to successfully research, set up, and operate these funds, which run on a completely different structure. That being said, fees are also linked to performance in most cases on a risk adjusted basis, so the significant proportion of fees are performance fees or carried interest which only become payable if the fund has met its performance hurdle thresholds. This means that you only really pay for what you get. You can easily justify paying higher fees on a higher performing investment.

Alternatives offer a unique opportunity to deliver impact investments

In addition to financial returns, alternatives also offer a unique opportunity to deliver impact investments, which are investments that are made with the intention to generate positive, measurable, social and environmental impact. Principally, impact investments look towards total value creation for all stakeholders including investors, the communities, and the planet at large. They require an investment approach that integrates all other outcomes beyond just financial investment returns.

Recent studies have also shown significant inflows towards funds with a focus on impact, so it is not only a smart social and environmental move, but a financial one as well. This approach still meets strategic and tactical asset management strategies to achieve the highest possible returns at the lowest level of risk, while also doing a whole lot of good. As such, a good impact fund is well-structured, well-resourced, and well researched, and has the capability to deliver predictable and repeatable outcomes over time.

In South Africa, impact funds can be structured to align with both the National Development Plan domestically, and the UN 2030 Sustainable Development Goals internationally. Such an alignment has the potential to unlock economic growth and employment opportunities, while supporting the establishment of greener, more sustainable, and resilient communities across the country.

A mind-set that creates lasting impact in communities

Impact investment funds are geared towards creating lasting impact in the communities within which investments are made. For example, with real estate investment funds, the underlying premise is that properties are a key driver for socio-economic development, community engagement, and social upliftment. However, an impact mind-set recognises that while many would see a development property fund as just another investment vehicle, the long view is that properties that are developed will become enablers for other businesses to develop, grow, and thrive. This view allows the fund to play a key role in developing various supply chains, building skills and capacity, as well as creating and supporting new businesses which are less susceptible to changing environmental and economic shifts. These initiatives are undergirded by a commitment to safe working conditions and employee wellbeing.

In addition to real estate investments, key sectors that are ripe for domestic impact funds include the high labour absorbing sectors of agriculture and manufacturing, as well as economic infrastructure assets like renewable energy, transport, water, and ICT, amongst others. This mind-set essentially helps to create a lasting impact in the communities where investments are made, while simultaneously allowing fund managers to meet our fiduciary duty to investors and societies.

Therefore, within the investment industry, impact funds provide the rare opportunity for the investor to do good, feel good, and make good on their money, all at the same time. In the midst of the Covid-19 pandemic too, these kinds of investments can play an active role in economic recovery and growth in both the short and long term. Ultimately, the value of alternative investment assets is there not only for the investor who wants to minimise investment downside risks, it can also be there for all whom the investment touches.