Institutional investors have faced a challenging investment environment over the last few years. Many have contended with lower returns from traditional investments as the low interest rate environment continues at a time of slow growth in Canada and globally. Amid continued volatility in oil prices and stock markets, institutions are looking for alternative investment opportunities. Generating returns in this environment can be challenging and consequently, alternative asset classes are gaining ground in institutional portfolio allocations, often at the expense of traditional asset classes.
BNY Mellon recently released the results of a survey it conducted in collaboration with the research service FT Remark, which looks at alternative asset managment trends from the perspective of 450 investors and managers in the Americas, Europe, the Middle East and Africa, and the Asia-Pacific region. The objective of the survey of institutional investors was to determine how they are investing their allocations to the alternatives spaces, what their future plans are, and how their needs are shaping the products managers offer.
BNY Mellon’s report, Split Decisions, Institutional Investments in Alternative Assets, notes that private equity is the most popular alternative investment strategy, followed by allocations in infrastructure and real estate. Survey respondents indicated that on average they allocated 37.3 percent of their alternative portfolio to private equity, 24.9 percent to infrastructure, funds and direct investments, 23.6 percent to real estate, and lastly, 14.2 percent to hedge funds.
In terms of expectations, BNY Mellon’s findings across all asset classes show that institutional investors are generally satisfied with returns from their alternative exposures, with the majority reporting that their investments across all alternative asset classes have met or exceeded their expectations over the last 12 months, with strong returns, both on an absolute and relative basis.
While the findings are fairly consistent for each asset class, there was an exception for real estate. It is worth noting that 14 percent of respondents found that returns generated by real estate underperformed their expectations for this asset class, delivering lower returns on average. However, within the subset of Canadian respondents that took part in BNY Mellon’s survey, none found that real estate performed worse than expectations. In fact, 56 percent thought this asset class performed at expectations and 44 percent thought real estate performed better than expectations.
Real estate remains one of the top four allocation segments for Canadian institutional investors. For the Canadian market, respondents listed their alternative portfolio allocation as the following: 44 percent in private equity, 22.7 percent in infrastructure, 20.7 percent in real estate and 12.6 percent in hedge funds. While Canadian companies appear to allocate more of their alternative portfolios to private equity, the country seems fairly in line with the other three asset classes, just slightly below BNY Mellon’s overall international allocation data.
Looking ahead at real estate over the next 12 months, over a third of international respondents, 36 percent, are looking to increase their exposure to this asset class. In comparison, over half of institutional investors surveyed are planning to increase their allocation to private equity. As for decreases, 10 percent of respondents say they will allocate less to real estate. The report reasoned that this perhaps reflects “concerns that the cycle is starting to turn in this area of the alternatives spaces, particularly in markets such as China”. As for overall exposure to alternatives, the report confirms that the majority of respondents are looking to increase or maintain their alternative asset allocations over the next 12 months; only a very low amount of institutional investors are seeking to reduce their allocations to alternatives.
Canada is known for having a number of large, sophisticated asset owners, which in many cases have engaged in direct real estate investment over many years. BNY Mellon’s survey suggests that the country’s institutional investors will continue to have an appetitive for real estate over the next 12 months. The Canadian market has a higher-than-average allocation planned in the next year for real estate, with 50 percent of respondents indicating a moderate increase in this asset class versus 36 percent internationally. A further 45 percent of Canadian companies plan on keeping their real estate allocation the same. Only 5 percent of respondents indicated they would make a moderate decrease in their allocation to real estate, compared to 10 percent in the international aggregate.
BNY Mellon’s report reminds us that overall, in some areas of alternatives there is a challenge of greater demand among institutional investors than there is supply of opportunities. This issue affects managers’ ability to sustain performance over the long term, and their ability to source the assets that can reach the required return. Therefore, it is suggested in the report, investors should make sure that their due diligence looks very closely at what is driving current performance to evaluate whether it is sustainable.
Another international study, the Preqin Investor Outlook: Alternative Assets, H2 2016, affirms that institutional investors are mostly satisfied with the role real estate plays in their portfolios. According to Prequin, 89 percent of respondents indicated that the performance of this asset class met or exceeded their expectations over the past year. However, similar to BNY Mellon’s findings, Prequin’s report demonstrates that investors are not all expecting the strong performance of real estate to continue; 39 percent of investors interviewed by Prequin believe this asset class will perform worse in the next 12 months.
One key issue facing the real estate market, and cited by the institutional community in this survey, was asset pricing—valuations for assets are increasing due to higher demand and competition for institutional-quality real estate. Another challenge is the rise in direct participation from institutional investors, while over half of respondents said they believe it is more challenging to find attractive investment opportunities in the current market than it was 12 months ago.
Despite these challenges, Prequin notes that investors remain confident in real estate’s ability to deliver returns for the long-term, citing that 35 percent of respondents are planning to increase their private real estate allocations over the long run and 51 percent plan to maintain their allocations in real estate versus 14 percent who plan to decrease their allocations in the longer term.
Overall, the research shows that alternative investments are now part of the mainstream landscape of investment options for institutional investors, and alternatives are here to stay. BNY Mellon’s study suggests that the trend of institutional investors building out their alternative asset portfolios is likely to continue, given that the large majority of institutional investors are satisfied with the performance of their alternative assets and that a large proportion plans to increase their allocation.
Having said that, this steady trend does not imply it is a time for the industry to be complacent. According to BNY Mellon’s report, institutional investors are simultaneously becoming more sophisticated and demanding. Furthermore, BNY Mellon’s report indicates that institutional investors have built up the knowledge and expertise that is needed to manage alternative asset portfolios, with many striving to fine-tune and hone their exposure with the goal of meeting their investment goals and return expectations.
For investment servicing providers like CIBC Mellon, changing attitudes towards alternative investments such as real estate create new opportunities for client service and feed innovative solutions to support private real estate funds, real estate investment trusts and other investment vehicles across a range of fund types.
Alternative investment classes like real estate are no longer a small niche, but are an increasingly integral part of the institutional investment landscape. As such, market participants can continue to look forward to new solutions to support their needs.