The old saying that “diversification is the only free lunch when it comes to investing” is mostly alive but, like so many things in our world, its meaning has evolved rapidly in the last few decades.

The initial reference was meant to get investors to think about a larger equity allocation and then further cuts across region, market cap and style.  In essence, this was the origin of the basic 60/40 model and the concept of the Modern Portfolio Theory, where investors sought to be on that so-called “efficient frontier,” earning the maximum return for every unit of risk taken. 

The basics of this theory have not changed, but there is now a lot more choice across broadly defined asset classes such as hedge funds, private equity, and private debt. To give the investor even more options, there are even sector mimicking exchange-traded funds and daily liquidity funds. These, at least in theory, can offer an investor their desired exposure in line with their risk tolerance, absent the illiquidity burden.  

But are these alternative asset classes as fungible as, say, value equity products?  Let’s look at the facts.

Hedge funds are not at all a new concept, but the industry really took off over the last decade. There are now about 15,000 funds from which to choose.  Similarly, private equity was the exclusive domain of the most sophisticated institutional and family office investors in the 1980s, when the world had a clubby group of just 24 general partners. Today almost 7,000 exist; sitting on a war chest of over $1 trillion of unlevered limited partner capital yet to be invested.  

Finally there is the world of private debt, which was barely visible prior to the global financial crisis. Toss in a bunch of central banks easing until they can’t ease any more, coupled with reams of regulation that has forced banks out of the lending business, and the private debt market looks set to eclipse $1 trillion by the end of this decade. 

Choice vs. returns

Take a step back, and it’s possible to make a few educated observations about these asset areas. 

Choice, as measured by numbers of funds and offerings, is up. So is performance dispersion and the fees of average plans. On top of that, investors see average returns as being less attractive, and the uncorrelated risk premia that they sought in alternative assets in the first place look increasingly linked to some of the very cheap beta they already own in their portfolios. 

Alternative asset classes have morphed into industries where product offerings are anything but fungible and the concept of compensation for an illiquidity premium is almost nonexistent.

In this very crowded space, all investors should remain on the hunt for alpha solutions.  The prime breeding grounds for alpha are usually the less liquid and efficient corners of the market, where mispriced opportunities can be found ahead of the herd. This has not changed, but it has become a lot harder to find such niches with so many players on the field.  

Operational and investment due diligence has become even more important. As a result, the most sophisticated general partners spend hundreds of thousands of dollars on single opportunities to make sure that their investment thesis is correct before a decision is even made.

Access and choice are no longer barriers to entry for the investor, but true diversification will only be found through the prism of education, diligence and patience. There are no longer any shortcuts.