By Renan Rego, senior partner at G5 Partners*
The global economic scenario has been undergoing a different dynamic since 2008. Following the Subprime Crisis, some Central Banks, such as the American Federal Reserve System (FED), the European Central Bank (ECB) and the Bank of Japan (BOJ) have promoted global liquidity measures in response to the economic crises over the last decade. In this context, we saw debt securities with negative rates reach a total of US$16 trillion and due to these recurring economic stimuli, the volume of securities with negative returns increased by 40% in 2020 alone.
In Brazil, which benefited from this dynamic, among other factors, the Central Bank reduced the country’s reference interest rate (Selic) to its lowest level in history (2% p.a.), with negative short-term real rates.
During long periods, Brazilian investors experienced extremely favorable conditions. Just four years ago, simple products, such as government bonds, generated returns of 14.25% p.a. and monthly yields above 1%, offering investors an environment with high returns, high liquidity, and low risks. The challenges of investing resources in the current scenario have become much more difficult.
However, if we analyze how main investors in developed markets, which have maintained a low interest rate environment for a long time, allocate their capital, we can see that a significant portion of equity is invested in alternative assets.
Brazilian investors are familiarized with the most liquid part of this asset class, the Hedge Fund investments which are locally known as Multimarket Funds. However, illiquid alternatives, which is preferred by many long-term investors, are still under-explored here. Exposure to this asset class is important for a diversified portfolio in any interest rate environment, but an overweight allocation in illiquid assets is even more justifiable in the current scenario.
Among the strategies that make up this illiquid asset class, I would like to highlight the following: private equity funds, venture capital funds, legal claims, real estate development funds (FII – perhaps the most popular), direct corporate lending, and distressed assets, among others.
Perhaps the most emblematic examples of successful long-term investments are the Yale and Harvard Endowment Funds, known as “Super Endowments”, with assets above US$ 25 billion. When compared to smaller peers, or even to portfolios in general, these endowments have offered higher returns. The main reason is their significant allocation to alternative investments, which is around 45%, on average.
In 2018, Yale stated in its annual letter to shareholders the dramatic migration of equity to non-traditional assets due to their high potential return and diversification power. According to Yale, alternative investments naturally offer better possibilities to explore price inefficiencies when actively managed with long-term investment horizons, therefore tactical short-term allocations are less relevant in a portfolio.
Yale also stated they pledged to invest approximately 50% of their equity in illiquid alternatives, of which 21.5% in venture capital, mainly due to their high return potential as these assets are generally poorly priced, and the enormous diversification and de-correlation power this subclass offers.
It is also worth highlighting that, for the most part, illiquid assets directly benefit from low interest rates as they use more sophisticated leverage structures to create arbitrages between real economy and financial assets.
Due to this, the current interest rate environment encourages investors to structure their portfolios and investment in these types of assets, creating asymmetries and a good relationship between risk and return, consequently, improving portfolio profitability in the long term.
Obviously, there is no free lunch. Despite this investment class offering higher expected returns, they often considerably increase leverage risk. Thus, due to the greater sophistication of these products, they are commonly distributed exclusively to professional investors with long-term portfolios. However, the current favorable interest rate environment has stimulated an increasing offering of these assets to qualified investors.
It is important to point out that, although these assets offer higher return potential, they have inherent risks, which makes it even more essential to carefully select the right managers to explore these strategies and determine the chances of success of the investment thesis. Alternative illiquid investments can sometimes take up to a decade to maximize in value, and only at such time will investors gain access to their invested capital.
The final attention point to be highlighted is that these assets must fit into an investor’s risk profile. Despite being very interesting, and the asymmetric return they offer, illiquid investments, as the name already suggests, are not recommended for investors who require immediate liquidity or have a short-term investment horizon.
Therefore, investors should seek professionals who are able to translate their real needs and risk appetite into tailored and appropriate investment portfolios. Two different investors will rarely have the exact same portfolio as they have their own individualities, preferences, and inclinations to take on different risks.
An advice to investors: Have a long-term focus, do not rush when building your portfolio and always be honest and loyal to your investment needs and goals. Taking on higher risks is not just about longer asset duration or increasing exposure to stock markets and, above all, it does not necessarily guarantee higher returns.
Choose qualified professionals who understand the increasingly varied and sophisticated investment options. It is important to have your individual needs and goals met, but also be sure to look at illiquid assets. Yes, they increase risk, but if carefully selected a differentiated portfolio return can be achieved. Harvard and Yale can sure say so!
* This article was originally published in Exame magazine.