As interest rates remain at historic lows, Family Office Managers need to discover new ways to produce consistent returns that are uncorrelated to the broader equity market.
Managers are finding new ways to grow capital with investments in alternative investments in general and alternative credit in particular. This often ignored, but valuable, asset class represents “an overall investable universe of over $4 trillion in size today” according to research from Ares Market Insights.
US consumer credit represents part of this asset class. These investments are sourced from Market Lending Platforms (MLPs). An MLP is a non-bank entity that serves as a platform for joining lenders and borrowers. In the last five years, more than $23 billion in loans have been issued from MLPs globally. More than 50% of this total is concentrated in the US. More importantly, it is a notably resilient asset class. So much so that even in the hight of the financial crisis, Charge-Off Rates remained below Interest Rates (meaning, on average, consumer loans were profitable for lenders).
Here, we look at three reasons why the US consumer credit and the wider alternative credit asset class can offer value to plan managers. We show how alternative credit:
1. Can Boost Growth in Tomorrow’s Low Return Environment
2. Can Offer Diversification that is Difficult to Find Today
3. Can Leverage the Power of AI to Source Value
Strategizing for Tomorrow’s Low Return Environment
In the wake of the financial crisis, central banks employed extreme strategies to get their economy’s economic engines running. Most notably, banks lowered their lending rates to 0 and in some cases, even below. Despite these drastic measures, in Japan and most of Europe, there are little signs of the robust growth needed to warrant a hike in interest rates. This means that investors cannot rely on government bonds as a reliable source of returns.
Family Offices- who manage nearly $6tr in assets- typically used hedge funds to navigate the market. But research from UBS and Campden Wealth shows that just 5.7% of family offices sit in hedge funds, down sharply from recent years. Meanwhile, the allocation to public markets is also falling, with just 28% in equities and 16% in bonds.
Conversely, investment in alternatives is on the rise, with private equity allocations rising to 22% and real estate investment increasing to 17%. This growing trend reflects family office’s appetite for high yield, uncorrelated investments they can no longer achieve with hedge funds. Naturally, alternative credit should be part of their mix.
Finding Diversification That’s Elusive Today
Since the fall of the Iron Curtain, the global economy became more and more connected, integrating supply chains, lowering labor costs, and spreading technologies at record speeds.
As a consequence of the global economy becoming increasingly connected, investment returns became more correlated. Therefore, factors like tariffs, civil unrest, and geopolitics all influence the returns of investments across different classes. Today, investors need a more sophisticated diversification plan. For many, this plan includes alternative credit.
By accessing alternative credit as an asset class, family offices can construct a portfolio that may be less anchored to traditional equity/bond risk factors like economic growth, inflation, and liquidity. Additionally, alternative credit gives managers the possibility to explore ways to drive asset growth that is not dependent on the few companies driving the broad equity market performance. In one quarter of 2019, just five companies in the S&P 500 represented more than 30% of the index gains.
In contrast, alternative credit assets, characterized by short-duration and high-yields, have a low correlation to the broader market.
Leveraging the Power of AI Technology to Make Smarter Moves
The data which moves today’s market is vast and nearly limitless. Distilling insights from the data to find the signal in the noise means forming a robust strategy designed to handle the influx of information driving the markets. That strategy is artificial intelligence (AI).
AI is up to the task for three key reasons:
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AI offers speed. AI technologies can process, and distill “bottom-line” information from terabytes of data in a fraction of the time needed for traditional computing methods. Quant-based strategies outpace traditional asset allocation and credit risk models.
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AI helps avoid the biases that creep into human-only investment strategies and serve as a risk mitigation tool that circumvents the unseen leanings.
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AI can offer the predictive power needed to identify the relationship, and level of influence across the countless factors at work in the investment market.
Embracing a 21st Century Approach to Family Office Management
As the investment market matures, family office managers need new tools to grow assets in a way that satisfies their fiduciary obligations. For many, the alternative credit asset class is that new tool because it offers the possibility of accelerated returns and improved diversification, which could be magnified with AI-powered strategies
(such as Pagaya’s) that seek to provide scalable benefits.
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