The State of the Alts Industry | Ep. 1

Show V/O:

This is Alternative Allocations by Franklin Templeton, a monthly podcast where we share practical, relatable advice and discuss new investment ideas with leaders in the field. Please subscribe on Apple, Spotify or wherever you get your podcast to make sure you don’t miss an episode.  Here is your host, Tony Davidow.

Tony:

Welcome to the inaugural Alternative Allocations podcast series. I'm thrilled to be joined today by my good friend John Bowman. John's an executive vice president of the CAIA Association, the preeminent alternative education organization. And I can't think of a better guest to kick off this important series. Welcome, John.

John:

Hey, Tony, good to see you. Thanks so much for having me.

Tony:

Well, thank you. And this is exciting for us as we start to spread the word about what's happening in the alternative investment space. And I couldn't think of a better guest than you to really kind of help frame where the industry is today. You have a very unique vantage point. Industry wide allocations are up across the board from institutions and family offices. And now we have this new dynamic where wealth advisors are more and more starting to embrace alternatives. Where do you think the industry is and how have we have evolved over the last several years?

John:

Yeah, so maybe I'll zoom out to kind of paint the picture, as you've asked Tony, to give a sense of at least CAIA's perspective and view on our math. Now, the caveat I mentioned there or allude to is that everybody's got slightly different math on how they get to these numbers. But I think directionally, this is perhaps maybe the most accurate picture, an objective picture of where we are with the industry. It's harder to do this in an audio only format, but I'll do my best to kind of verbally walk the listeners through this verbal tour. So if you think about total global investable assets, kind of the full pie investable assets, we're about 153 trillion US dollars. That's the entire pie, about 22 trillion of that based upon 2022 end of year 2022 numbers are in alternatives. So if you do the quick math, you're talking approximately 15% of that total investable universe that is invested in what we traditionally call the world of alternatives, and that is private equity, hedge funds, real estate, infrastructure, commodities, and private debt. And the way that roughly splits up Tony, and you've seen significant changes in the composition of that alternative allocation, as you kind of alluded to, is about 9 trillion is in private equity. So over 40% now is dedicated to the stratifications of private equity strategies from the traditional buyout down through growth all the way into the very hot and interesting venture capital early startup phase. About 5 trillion, and this has been fairly steady for five to eight years, is in what we traditionally call hedge funds. About 4 trillion is in real estate. And by the way, I think many of the other studies that you see traditionally underestimate real estate. So we think that we've captured the sizing of this huge real assets bucket, that is real estate, at about 4 trillion. And then the tail here is about a trillion and a half each of infrastructure, as I said, commodities, and then shockingly, private debt, which started as a tiny little appendage for private equity, a financing source on the capital stack, and suddenly has become a massive segment in itself. So I'll just close on this question with a retrospective. CAIA is 21 years old. When we did this study in 2002, when we first started, the total investable assets allocated to alternatives was about 5 trillion US. 5 trillion. So less than one fourth of where it is now, which represented about 6% at the time. And even more strikingly, if you think about the evolution here, Tony, is that that was almost exclusively in what we now call hedge funds. So it's just shocking the evolution and the expansion, the proliferation of what we've seen over the 21 years of our existence.

Tony:

And John, you have a unique vantage point. You have the opportunity to speak to big allocators all over the world. Every time I see you on LinkedIn, you're in a different country moderating a panel with some world leader on how they're allocating and where they see opportunities. Historically, institutions and family offices have been big consumers of alternatives and it's a relatively new thing for, I would say, the wealth management community had some exposure to hedge funds going back maybe 10, 20 years, but very little exposure to private markets. What are you hearing when you're talking to those big institutional allocators as far as where they see the opportunities, what they think about the overall opportunities going forward as so much money has come into this space?

John:

Yeah, and you kind of mentioned it. There's been a sequence of interests from first movers to laggards. All the way to the now overused word that is a big part of your motivation for starting this podcast, which is the democratization of alts into the wealth management space. But if we go back kind of to the origination of the endowment model, which your listeners probably know, but basically that means just a much wider diversification of their capital pool or their retirement nest egg across multiple different types of asset classes, what we now call alternatives. It really started with university endowments that have a much longer term period of investing. So your time horizon is very long. Sovereign wealth funds that have almost a perpetual timeline in kind of serving their citizens over multiple generations. Pensions were later and are just still in, I would say, the upward momentum of building out particularly their private equity and maybe even more so, their venture capital. Private debt is very new, to I think, most of the pension world. And so I think we often lump, quote, institutional altogether. But there's actually been very different journeys and narratives and stories based upon the governance structure, the risk appetite, and ultimately who's sitting in the CIO seat of those individuals. We're at a stage now where we are approaching and perhaps already started another inflection point where now this is coming downstream to high net worth, single family offices and even the upper end of the mass affluent in pursuing these diverse sources of cash flows and risk structures and return expectations that I think will ultimately serve them well over a full cycle.

Tony:

And maybe just to put a little finer point on that, I think based on data that I've seen from the CAIA Association or some family office reporting, I see numbers where endowments and foundations, certainly Yale being famous for it, are allocating 70% to 80% to alternatives and again, pretty granular sort of allocations across the spectrum. I think some data that I saw from Prequin suggested that maybe public pension plans are somewhere around 30%. Based on the last data that I had looked at from Cerulli & Associates, I think the wealth management community is roughly a 5% allocation. And it seems like it's stubbornly been on that 5% allocation number. I'd say ten years ago that was almost all liquid alternatives or hedge fund type strategies. And now we're starting to see a lot more interest in the private markets. I wonder, you and I have spent a lot of time talking about this over the years just on the structural evolution and how some of the structures are a little bit more conducive for high net worth investors. So maybe if we can just kind of take that journey a little further and talk about the democratization of alternatives and how we think that's going and what we think some of the challenges are.

John:

Sure. And I think like you said, Tony, you're absolutely right. When we talk about 15% allocated to alternatives of the total pie, that is somewhat deceptive because the endowments are well over 60% and wealth managers are typically 5% in the low single digits. So 50% of that total pie, 153 trillion, is coming from the retail world, but just a fraction of it is in the 22 trillion of alts. So you can imagine the multiplier effect if there's only a small movement, a small migration of that 75 trillion of the pie that is in wealth management towards alts, this thing could move very, very rapidly. There's no doubt there's been massive product innovation that has been married to this newly found or voracious appetite from wealth managers. Again, I think we're in an environment, I don't have my crystal ball out. We're not prognosticators. But I think the consensus is that after the last 40 years, particularly after the last ten years of risk on 60/40 returns that are probably above 10% on average, that we're likely in a more normal lower return environment. And so there is a lot of appetite to find other sources of alpha, other sources of diversification. And so you've had this proliferation from asset managers of what I would call semi liquid vehicles. Traditionally, the reason that institutional investors would be really the only ones that could play on the field of institutional alternatives is because these drawdown funds, the traditional private fund vehicles, were only really available to qualified persons, very wealthy individuals. And now we're seeing these semi liquid vehicles. Your listeners might have heard of Interval funds or tender funds that are ‘40 Act regulated, that limit the asset manager in some ways, but still allow for access to private companies or private loans depending on the type of asset class they're pursuing. And that gives them, as you know, Tony, quarterly access to at least a small portion of the fund of redemptions or liquidity in the case of cash being needed. And I think that's been a huge movement on private debt and private equity to a degree. The other huge innovation that I find very interesting is our friends at places like ICapital and Cais, these aggregators that have created gateways for much smaller allocations. So if you're the Davidow estate and you're trying to get access to a private equity interval fund or a private equity drawdown fund, even at a higher level, it's very difficult for you to allocate enough to meet the minimums. And then you have to deal with all the difficulty of the legal and tax implications and the pooling of all these individual allocations. And these aggregators kind of do the due diligence for you. So they know the asset managers and the GP’s to pursue and they also do all the backend kind of operational and administrative elements. So it is hugely advantageous that I think ultimately is going to create a tailwind for even more interest on alternatives.

Tony:

Yeah, so there's a couple things there, and John, we completely agree with you. We think there's a confluence of events that make this a very appealing environment for alternatives broadly in private markets specifically. And I think part of that is the market environment is demanding a different playbook. We're likely in a low return environment, yield has been challenging to source over the years. We now have increased volatility and of course, this new phenomena inflation that we need to solve for. So to me it argues for a more expanded playbook beyond the 60/40 portfolio I'd also offer this product innovation has been huge because again, there's nothing wrong with their first generation of products. They were perfect products for institutions and family offices, but for individual investors they often didn't qualify. The minimums were very high. You had capital calls and all sorts of things that were troubling for individual investors. And now we've got these registered funds, interval and tender offer in particular, which are more conducive for it. But I think at the end of the day, none of that actually matters unless you get access to world-class institutional managers. Because if you get a watered-down version, you can't afford to dabble in the private markets. We want managers with defects for T's and managers who've been doing this for a long time and can source the opportunities appropriately. So in our view, it's an incredible time. It's part of the reason that Franklin Templeton has committed so much time and resources to developing education and thought leadership around it because we want advisors to have better experiences. And I think it's a perfect segue to you, John, and the CAIA Association, who I think has been the industry leader for, as you point out, 21 years, in helping to inform institutional investors and big allocators. And more recently, your focus, I think, has shifted more to the wealth management community. If I can, I'll give you the opportunity to maybe describe a little bit of your focused effort here and why education is so important for advisors.

John:

I think you've hit on a couple of points that we find just critical and both opportunistic and concerning at the same time. Those are always two sides of the same coin when you think about investor expectations and education is that we are certainly proponents and supporters of investing a capital pool of any size, flavor, and style, whether you're an individual at the very low end of the retail size all the way to the largest sovereign wealth fund in the world. We are proponents of diversification across all of these asset classes, full stop. That said, this is not for the faint of heart. These can be opaque, very idiosyncratic, and they have elements that are very different that you need to understand that public market investing does not entail, and they come with higher fees. Now, often we get tied up in what the right fees should be, but certainly you need to understand that you need to get paid for the higher fees in some form. And so managing expectations and client education is why we exist, is to protect and help and serve and steward metaphorically hold the hand of the client. Whether an institutional client, beneficiary on a big capital pool, or whether an individual, they need to understand the liquidity constraints. You're locking up capital in most of these situations. Now, liquidity, unfortunately, is one of the most misunderstood elements of investing. This is not inherently good or inherently bad. It's a feature that you need to understand alongside of every other feature. Do you need access to this capital? What are your client goals? What is your expectation as far as time in needing this cash? What are your return expectations based upon your retirement goals and your dreams? And what are the potential risk profiles of liquidity needs in the next five to ten years based upon your lifestyle, your career, your spending habits, et cetera? Often, I would say not in every case, but I will make a generalist statement. But often the average retail investor is way too liquid. I think we've been conditioned to be way more liquid than we really think. And it's funny, Tim Draper of the somewhat royal venture capital family, the Drapers, who are multiple generations in VC, interestingly, told me when I was talking to him on a stage one day that if you're 25 and starting your 401K, for example, you don't need any liquidity. And now, yes, Tim is talking his book a little bit, but I think the point stands for your listeners, Tony, is that if you're just starting off, I tell my kids this, you shouldn't be worried about these dollars at all for the next 40 years. So the idea that you want to make sure that some of it is accessible, I think, already starts to create flaws in thinking and behavioral challenges that inhibit your long term thinking. So those are just a couple of examples, and I think the latest case study of BREIT at Blackstone, where as soon as the market turned south, this is what we do as humans, don't we? As soon as the market turned south, I'm sure there was proper discussion and education with each of these clients going in, but they all wanted their money back right away, and obviously this is a gating feature with a 5% liquidity cap, and they obviously can't give the money back to everybody, nor should they want it back. And so, it's just an example of how behaviors and conditioning and biases go wrong when the markets turn against you.

Tony:

I love what you said there. Illiquidity is a feature, and, you know, as an industry, I think we have done a disservice by conditioning both advisors and investors to fear it. Rather, we just need to understand it. And the reality is, as you point out, if you're younger and you have the wherewithal, you're probably okay having a 10-20% illiquidity bucket. And I actually wrote a white paper on it because I think it is one of the most fundamental challenges that we hear from advisors, and I think they need to understand it's just a feature. Understand it. But by instilling that discipline of having a 20% illiquidity bucket, you're actually teaching investors to be long term in nature, where you don't have that emotional stimuli that says, I need to exit the market anytime there's any volatility in it. So I think it's such an important discussion to have. It kinds of leads us to…

John:

And Tony, somewhat tongue in cheek, just to end that part of the conversation. In a twisted sense of irony and logic, you could argue that we should have a illiquidity discount. Meaning they pay you to stay or you pay to lock up your capital, in that it protects you from yourself, from the worst elements of our stupidity. There's a sense in which an advisor exists to keep clients, I heard the very crude version of an advisor's job description one day. We exist to keep clients from making dumb decisions, and those temptations toward dumb decisions are always at those inflection points, typically at the bottom. And what do they want to do? They want more liquidity. They want to cash out. They want to sell. This is what we all do. This is common. And I think illiquidity actually in the greatest of ironies can be a real benefit in times of volatility, where the very schizophrenic public markets are telling you you're wrong every day. And if you listen to that emotional roller coaster, you're going to make big mistakes. And private markets can actually save you from yourself in some cases.

Tony:

Yeah, I 100% agree. It's a message that we're trying to reinforce over and over again. I think you need to understand illiquidity is there for a reason. It gives the manager the ability to execute the strategy, and all the historical data suggests you're rewarded with an illiquidity premium. But it is something that protects clients from making that emotional decision at the wrong time for the wrong reason. And as we all know that all the behavioral finance studies have suggested, we all act on impulses at the wrong time for the wrong reason. And the problem that you end up having is they get out at the wrong time, they also get back in at the wrong time. So it's kind of a double whammy there. John, I did want to give you the opportunity, just as we think about for many of our listeners on this call, the question I always get when I'm speaking at conferences, I suspect the same thing with you as you're traveling the country is where do I get more information? Obviously at Franklin Templeton, my sole focus is writing thought leadership, no product. Really designed to help advisors think through these complex decisions. But I know you guys have a wealth of resources at the disposal of the wealth management community. Where can people get more information? And we could probably put a link up at the end of this podcast.

John:

Sure. Well, let me just do 30 seconds quickly on who CAIA is, which will give more context to the answering your question, Tony, if you don't mind. So, CAIA, I've kind of danced around this, but we are the professional body for the alternative investment industry. As I said earlier, we are 21 years old now. We started in 2002, and it was really a response to this explosion or birthing of these unconstrained equity strategies that were coming out of the investment banks at the time. We now, of course, call them hedge funds. And Allocators and CIOs were asking, what do I do with this weird stuff? How do I integrate it within a 60/40 portfolio, which most of them were? So we exist to provide education, to advocate and provide thought leadership for the betterment of the industry and the client. That's who we are. So we manifest that most prominently, most publicly, through our CAIA Credential. This is the high stakes examination in which you see the four letters after people's names. There's 14,000 members around the world that have gone through that program, 105+ different countries. But as you've mentioned twice, Tony, we have recently realized that we have an opportunity, and I would even say an obligation giving our mission and our purpose to really get in the middle and mediate this concern and opportunity that I described earlier for wealth managers to participate and pursue better diversification, better long term portfolios through access to alternatives. But with the proper warnings and labels that are ensuring that they're pursuing this for the right reasons and in the right way. So we've launched a sister online ecosystem called Unify. Unify by CAIA, which is think of your Netflix library. It is an online library of resources, self-paced online courses and certificates, micro credentials that allow you to dive deep at a more elementary level. We're not trying to create a private equity analyst as we are with the CAIA program. We're trying to create a conversational competent advisor that can actually facilitate these discussions and answer questions when their client comes to them and says, what is this blockchain stuff? Can I get access to crypto? Or, why can't you get me a little bit of venture from Sequoia? I hear that that's doing really well. Is there ESG elements to what I'm doing? And why can't my values play a more important role in which managers you're choosing? These are questions we want to answer and equip the advisor to have the conversations, to have the answers, to be equipped with as they go forward in their relationships. So we're really excited to have stood this ecosystem up, and we'd encourage listeners, if that's helpful, to check that out.

Tony:

Yeah, I applaud your efforts on Unify. I'm a big fan of what you're doing, and I think it's consumable for advisors in the way that they want to take it. They can take an individual micro credential, or they could take a larger suite of it. And I think that's very smart and it's something that I think folks should take advantage of. John, you kind of joked earlier that you don't have a crystal ball, but if you did, what do you think the industry looks like? You kind of painted this picture of extraordinary growth and clearly bigger adoptions to alternative broadly. What do you think the industry looks like in five to ten years?

John:

It's interesting. We think about this a lot at our executive team and even with the board, because this is how do we position ourselves to take advantage of riding that wave? And I think this wave will continue. So let me just say, very obviously, we think it'll be a whole lot larger. So I mentioned all those numbers at the beginning of the show. I also mentioned that while retail was the source of 50% of those total investable assets, it was still very allocated at a very low level. 5% was the number you threw out, which is similar to our numbers. You can do the math on if that 5% went to 6%, you take 75 trillion and shift 1%. That's a lot of money. What if it doubled to only 10%? You're talking about potentially an increase from 22 trillion to 30 trillion of alts allocations. So when I think about the next 10 trillion of alts assets under management, I think the large majority is going to come from exactly who we're talking to on this podcast, which is wealth managers. I also hope that this, what we typically call the power law, meaning it's really difficult to get access to these set of strategies. The outsized performance is typically coming from very few managers. And therefore, if you don't get into that top decile, at least top quartile, you're going to get kind of median level public equity returns, which after fees is going to be a pretty bad proposition. And I hope that the fairness and the democratization of that also continues. You shouldn't have to have kind of premium loyalty card to get access to these return sources. And then finally, we haven't talked about it much, but I think we need some wind at the sail, some help from the regulators around the world to open this up smartly and carefully. But the 1940 act is pretty old. It's older than both of us and it is outdated. And I think they tried their best when they stated this proxy for access to alts, which was essentially just wealth and income. But I think we realize that wealth is not always the best proxy for sophistication or education. So we have been advocating hard to open up another source of qualification which is effectively based upon an educational route. We don't pretend that CAIA is the only potential pathway to that, but we should be one of them. So there is a bit of a self-serving approach there, but we think education is a much more important marker of whether you should be participating in this than wealth or income should be. So I'm hoping that there will be liberalization, smart, liberalization, careful liberalization of accredited investor regulatory structures around the world as well.

Tony:

Thank you, John. This has been terrific. We've covered so much ground. You kind of framed this huge opportunity in front of us. This is the democratization, but it needs to be done smartly and wisely. I like the focus on education because I think that is the real value of the advisor is leading with education, helping to manage expectations with the individual investors. And I think at the end of the day, this is good for the advisors, this is good for the clients, and this is good for the overall industry because we've seen this growing private market opportunity and a shrinking public market opportunity. So, we'll need to come back and revisit this in the not too distant future. But John Bowman, thank you so much for joining me and kicking off our inaugural Alternative Allocations podcast series.

John:

It's been my honor and my pleasure. Tony, always good to see you.

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