Goldman Sachs: Building institutional-calibre portfolios

It’s imperative for retail investors to truly understand the risks associated with illiquidity when investing in private assets, say Goldman Sachs’ Adam Lane and Greg Olafson.

This article is sponsored by Goldman Sachs.

What have been the most notable changes in the alternative investments investor base that you have seen in recent years?

Adam Lane, Goldman Sachs

Adam Lane: The growth of the semi-liquid market has created more opportunities for individual investors to access alternative investment strategies. 

Meanwhile, high-calibre alternative asset managers, who were historically only available to institutional clients, have also entered the market, which has legitimised it in many ways. 

Today, individuals have more choice and more opportunity to invest in alternative investment strategies than ever.

Over the last couple of years, many high-net-worth clients have used alternatives to generate income through business development companies and non-traded REITs. This has been a significant driver of retail alternative flows. But I think as you look forward, while that will always be a meaningful part of portfolios, individual investors will expand their use of alts to other strategies. 

What are the drivers behind the recent spike in interest in the democratisation of alternatives?

Greg Olafson, Goldman Sachs

Greg Olafson: This is a change that has been driven by a number of factors. I think it would have been a natural occurrence anyway, irrespective of the fact that it was largely catalysed by a low-rate, low-volatility environment. Because why shouldn’t less-institutional investors have exposure to what I certainly believe is an approach to investing that has real edge to it? 

There are two reasons why I think the alternatives approach should at least have the opportunity to generate excess returns: illiquidity and the ability to influence outcomes. Why shouldn’t retail investors be able to avail themselves of that? 

AL: I think the increase in demand is being driven by individual investors themselves, who are looking at what institutions and endowments have invested in to generate returns and diversify asset allocations historically. Alternatives have been a big driver of both of those things. 

As alternative investment structures have become more democratised, individual investors can build what would have previously been deemed institutional portfolios, because they now have the ability to access investment strategies that were previously limited strategies.

What are the risks for individual investors when accessing private equity for the first time?

GO: Individuals need to understand that illiquidity is real, and it only gets worse in times when liquidity is really needed. And then there’s transparency – will the asset class’s fee structures, regulations and terminology be understood? In public markets, there are plenty of things that I think can be misunderstood – it just so happens private markets are, by definition, more bespoke. 

As an industry, we want to be very sure that what is offered to less-institutional investors is appropriate and understood. When something says ‘semi-liquid’, you shouldn’t just read ‘liquid’. If you want to exit something that is inherently less liquid, there will be more friction costs associated with that. 

What should individuals be looking for in an alternative investment manager?

AL: Manager selection is a key part of any investment decision. The strength of the investment team, track record, liquidity and risk management framework are all key elements of the evaluation process. Individuals should also be aware of the reporting cycles and transparency that the managers provides.  

It’s also important to make sure you truly understand what you’re investing in, and how it benefits your overall asset allocation. 

Depending on the fund structure, liquidity is more limited, so investing with a long-term horizon is important. 

GO: In this industry, the traditional providers of capital do a lot of diligence to evaluate who is managing their money – exactly as they should. If you’re going to give somebody money for 10 years, or even longer, understanding the people behind the strategy, in addition to track record, culture, approach and business model, is really important. And that is harder to do for the individual investor.

Naturally, that is why they will gravitate towards the bigger, more established players – those that really have an institutional make-up. If I just think about Goldman Sachs, the standards to which we operate are extremely high, because we have so much scrutiny. When you have a reputation that is very positive, you have so much to gain, but also so much to lose. You’re always focused on maintaining that reputation.

As more and more investors approach the market, are you confident private assets will still be able to deliver strong returns? 

AL: Private markets are growing. When you think about the private credit market, as an example, it has grown significantly over the last five years, so it’s not like all this incoming capital will be directed towards the same opportunities. The funnel is as wide as it’s ever been, which creates a lot of opportunity for investment selection and for managers to deliver alpha. At the end of the day, that’s why investors should be interested in these strategies, in addition to finding opportunties not available in public markets. You can invest in the S&P, or you can invest in an active manager: the reason you’re choosing the latter is because you believe there is opportunity to outperform.

GO: Even if the whole market was actively investing, you’ve still got to pick the best opportunity for your specific needs. And if you think about the big themes out there – for instance, a focus on the energy transition and energy security – the duration for which capital will be required and the scale of that opportunity will keep us busy for a while, which makes it very suited to private markets. So, while it is true that, as there are more participants and more capital, there should be a compression in returns, in the 22 years I’ve been doing this, it’s never felt easy. It always comes back to that sweat, that hard work – having some advantages and then making the most of them.

This industry is pretty sophisticated. Compensation models align interests very strongly: you do well when your client does well. The carried interest, the participation and the profit are really important for both your teams and your business, as they reward people. That’s a strong incentive. 

How do you expect the alternative assets landscape to evolve in its goal to meet the needs of a changing investor base?

AL: I believe we are at the early stages, and client adoption will continue to increase. As an example, the non-US semi-liquid market is still developing and catching up to that of the US market. New participants will enter the market, increasing the available investment strategies and leading to larger allocations. 

The evolution of the industry in terms of democratisation is in something of a nascent stage. Education will be a key part of future success.

GO: The public markets have experienced several phenomena over the last few decades: the compression in fees, the need to extract efficiencies, the need to leverage scale, and the development of technology and data-processing power. These forces are just beginning to meaningfully impact the alts space and will fundamentally change the client experience – how we communicate, access, distribute and service the client base. In addition, on the investing side, we’re also seeing some developments in terms of using data, quantitative techniques and processing power. This is an exciting opportunity for platforms with the right capabilities.

In private markets, relevant information is inherently less available. But if you build your library – if you’re scaled enough that you can have a data set that helps you make better decisions – that’s real edge. The smaller firms are not going to have that. Public information is available to everybody but, by definition, private information is only available to those who own it.

How much of Goldman Sachs’ role is an educational one?

Adam Lane: Education is one of the most important aspects of what we do. Our goal is to be a solutions provider to our clients, and the first way it starts is with education – having people truly understand the asset classes, the pros, the cons and the risks associated with investing in them. 

We want to educate investors on the advantages of the asset class, but also make sure they have the information required to really understand the investment strategy, structure, liquidity, reporting and transparency. Understanding the liquidity of the assets, and the liquidity of the fund structure is a key part of the educational process. If we can do that upfront, it will lead to a better client experience. 

Greg Olafson: You don’t want somebody to come in and have a bad experience. You try to make sure you distil it down and say, ‘This is the underlying exposure you’re taking, and in scenario X this may happen, or Y may happen’. On balance, if people invest with the right managers and construct their exposure in the right way, they’re going to have an experience that is more aligned with their objectives over the long run. But if you’re trying to day-trade your alts account, you’re going to have a very bad time.