Alternative investments: It’s time to pay attention

How do institutions take advantage of growth?

Given the rise of alternatives, asset managers and owners looking to expand their presence in this space should follow five steps.

First, institutions need to assess their present capabilities. The process starts with baselining key processes - risk, compliance, any retail/institutional market processes, reporting, and client service - as well as documenting strengths and shortcomings. Doing so will let firms make a realistic appraisal of additional capabilities they will need, and will allow them to make decisions on questions like keeping certain operations in-house versus outsourcing or adding additional geographic capabilities. In our experience, a formal study is essential: In the 2014 PwC Alternative Investments survey, the respondents, by a large margin, picked the need for formal processes, procedures, and controls as the top operational priority for alternatives managers.

Second, institutions have to consider whether they will participate in the retail market for alternative investments. Those that plan to do so need to establish the right fund structure and distribution, and provide client support teams with the right training. Regulators are beginning to pay close attention to whether alternatives strategy advisors have detailed knowledge of the complex products sold to retail investors to ensure that FINRA's suitability rule is met. As a result, asset managers are introducing training on alternatives and some are requiring advisors to undergo certification programs such as the newly launched Fundamentals of Alternative Investments Certificate Program by the Chartered Alternative Investment Analyst Association.

Third, they need to understand the tools that deliver effective risk, portfolio monitoring, and data management. This requirement is supported by the 2014 PwC Alternative Investments survey, in which respondents picked greater use of data, analytics, and advanced technologies as the second top operational priority for alternatives managers.

Fourth, they should consider whether they will build capabilities in-house or gain them through external partnerships. In building capabilities, institutions should use leading tools for routine operational activities, mostly in the back office. They should consider building or customizing tools that will let them differentiate their products with analytics, dynamic reporting, and other client-facing activities. Partnerships, on the other hand, allow for quicker market entry and the possibility of forming minority investments with small alternative funds to test strategies. Keep in mind, however, that a smaller portion of the lucrative higher alternatives fees will be captured in-house through this arrangement. The main benefit of partnership is to quickly confirm strategic fit for alternatives. If the scale and usage of alternative offerings turn out to be substantial, the institution can then either fully acquire alternative funds or develop a similar fund in-house.

If this route is chosen, there are major considerations for selecting the right external partner and ensuring that the asset manager/owner maintains a differentiated strategy and stays relevant.

Finally, institutions should recognize that they need time. Any organization expanding into the alternatives space should recognize that it will need some time to gain performance data and understand whether the alternatives strategy is truly working. Furthermore, typical operating costs in alternatives are higher than in other investment spheres. Management fees are notably higher than in traditional asset classes, but so are the costs - if the fees are any indication, then asset managers in the alternatives space should be prepared for costs as much as six times those of fixed income or equities.