Why is innovation into new asset classes important for alpha generation?
Hedge funds seek outsize returns, leading to high reward for specialists and those who add value through innovating. Success attracts more capital, not just deployed through the successful hedge funds but through others seeking to exploit the same opportunity.
In alternative lending markets, though the returns payable to lenders are high, this is tolerable because new capital is made available in markets where capital is scarce. The increased competition alluded to above increases capital available and thus eventually reduces the cost of borrowing. As the borrowing rate reduces it attracts new borrowers into markets, and the market evolves to establish institutional standards to ensure the increase in borrowing does not push borrowing costs back-up.
This institutional capital is deployed when key risks are effectively mitigated by originators, justifying a reduction in returns. The returns on offer still beat traditional lending markets thus offering yield enhancement, something which is increasingly sought as we remain in a return constrained environment.
Despite the reduction in average returns, return expectations at hedge funds and other principal risk-taking businesses remain consistent. This pushes these businesses down the risk spectrum, achievable by entering new markets, taking more lending risk in existing markets, or introducing leverage.
Those who borrow to enhance returns quickly focus on optimising borrowing cost and reducing borrowing risk. This leads to structured products such as asset-backed securities (ABS) which use structured borrowing to match risk appetite and the duration requirements of underlying investor-types. Through financial engineering, principal risk-takers are thus able to maintain a relatively consistent expected return for a time, but all opportunities have a finite life as institutional capital (a huge pool of money greater than $100 trillion) becomes more sophisticated and increasingly chases the same opportunities.
Thus, a new cycle begins in a new lending market. This pattern has been repeated many times over in fixed income, where outsized returns are available for the earliest entrants only for those opportunities to diminish as the opportunity matures and institutional capital is employed more intelligently into the space. This cycle means that there will always be strong churn in appetite for private, structured, and / or alternative fixed income products, and there will always be innovators looking for new markets to deploy capital and generate outsized returns.
Institutional interest in alternative markets is growing exponentially as investment businesses face a perfect storm: increased regulation, greater competition, increased investment options for consumers, and a return-constrained environment where traditional assets classes are offering historically low returns.
In subsequent blogs, we’ll highlight a few examples of this cycle and will offer some thoughts on which opportunities offer the greatest potential for institutional adoption. At present, we are seeing innovation cycles ongoing in markets from private credit and direct lending to digital assets, where the cycle of investment has already begun and where early movers are already enjoying outsized returns. Inevitably, successful early investors will lead, and will eventually draw increasing interest from institutional investors. Though the cycle is inevitable, the timescales are uncertain.