Institutional investors are increasing their exposure to alternative asset classes in a bid to diversify their portfolios, generate higher returns and minimise risks.

Demand for alternative asset classes such as private equity, hedge funds, infrastructure, private debt, real estate and natural resources has been on the rise and is expected to further increase in the years to come.

Assets under management (AUM) across all alternative asset classes are set to reach $23trn in 2026, up from $11.32trn in 2021, according to data provider Preqin. This shows steady growth since 2015, when the AUM amounted to only $7.23trn.

Losing a taste for plain vanilla

The move towards alternative investments comes as institutional investors are walking away from plain vanilla assets such as fixed income in search of higher yields. Some investors may opt to invest across the entire spectrum of alternative asset classes, while others may pick and choose the classes that match better with their risk profile and level of sophistication.

Smaller investors tend to allocate less to alternatives, while more sophisticated investors will typically dedicate more than 10% of their portfolio to such asset classes.

Research by Manulife Investment Management shows that the largest Canadian pension funds allocated between 34.7% and 54.3% of their portfolio to alternative assets in 2020. This is approximately 10% higher compared with 2015 when the allocation to alternatives ranged between 24.6% and 44.1%.

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The data shows that the Ontario Teachers’ Pension Plan had the highest allocation to alternatives in 2020, followed by the Canada Pension Plan Investment Board, the Public Sector Pension Investment Board, the British Columbia Investment Management Corporation, and Caisse de Depot et Placement de Quebec.

Inflation pushes investors to allocate more to alternatives

Macroeconomic indicators such as inflation are also playing a key role in pushing institutional investors towards alternatives.

In fact, a snap poll by consultancy Bfinance shows that macroeconomic conditions are boosting allocations to illiquid strategies, with real assets leading the way. More specifically, 46% of investors expect to increase their exposure to infrastructure as inflationary conditions provide an additional spur for infrastructure investors.

The poll also reveals that there is a strong momentum behind investments in private debt and real estate as institutional investors are planning to increase their exposure to such asset classes in the next 12 months, much more so than they did over the past 12 months.

In addition, the poll shows that institutional investors are planning to reduce their exposure to total public equities and inflation-linked bonds during the next 12 months.

Most attractive sectors in private markets

'The hunt for yield leads to alternatives' was seen as one of the key themes that would shape strategies among institutional teams looking to position their portfolios to manage any unknowns ahead in 2022, according to a report published by Natixis Investment Managers.

The 2022 Institutional Outlook, which features the results of a survey conducted among 500 institutional investors, reveals that information tech, healthcare, infrastructure, energy, real estate and financials were seen as the most attractive sectors for private markets ahead of 2022.

The report also states that inflation was ranked as the top concern, with the majority believing that it is transitory. Other top risks include interest rates, valuation, volatility and environmental, social, and governance (ESG) issues.

Indeed, ESG has been a key topic among the institutional investor community, with all types of investors looking to embrace it. However, it is important that investors avoid approaching ESG as an opportunistic short-term commitment and instead see it as a long-term strategy.

The same applies to the alternatives, as it is key to have a longer investment time frame when allocating to such assets. In short, investing in alternatives can provide institutional investors with opportunities to generate higher returns, navigate inflation and volatility, and minimise risks by diversifying their portfolio. There are also challenges, as alternatives are seen as riskier assets compared with the plain vanilla variety. However, investors are willing to go beyond their risk curve as a way to generate higher yields and beat the rising inflation rates.