Alternative investments have become a standard feature of sophisticated portfolios, but the questions that investors ask before allocating to them are often less rigorous than the complexity of these strategies demands – and Toby Watson’s perspective on what those questions should be is worth considering carefully.
The universe of alternative investments – spanning private equity, hedge funds, private credit, real assets and more – has expanded considerably over the past two decades, attracting growing allocations from both institutional and private investors. But wider access has not always been accompanied by deeper understanding, and the gap between what investors think they are buying and what they actually own can be significant. Toby Watson, whose career in structured finance required rigorous assessment of complex investment structures across multiple asset classes, brings a particularly well-informed perspective to the questions that deserve more attention before capital is committed.
Alternative investments occupy an increasingly prominent place in diversified portfolios, and for reasons that are not difficult to understand. The potential for returns that are less correlated with public markets, access to return premia not available through conventional listed securities, and the diversification benefits of genuine exposure to different economic risk factors all make alternatives an attractive portfolio component. Toby Watson, whose time at Goldman Sachs involved working with sophisticated alternative investment structures across multiple geographies and asset classes, developed a precise understanding of both the genuine merits of alternative strategies and the questions that investors too rarely ask before committing capital to them.
The Gap Between Alternative Investment Marketing and Reality
Alternative investments are, almost by definition, more complex than conventional listed securities. That complexity creates an information asymmetry between the managers who design and market these strategies and the investors who allocate to them – and information asymmetry tends to favour the more informed party.
The questions that Toby Watson considers most important are those that cut through marketing narratives to the underlying investment reality. They are not designed to be sceptical for its own sake – genuine alternative investments can add real value to a portfolio – but to ensure that allocation decisions are made on a clear-eyed understanding of what is actually being bought.
Why Do So Many Investors Allocate to Alternatives Without Asking the Right Questions?
Part of the answer lies in the complexity itself – strategies that are difficult to understand are also difficult to question effectively. Toby Watson’s years at Goldman Sachs gave him the analytical background to engage with that complexity directly, asking precise questions about the sources of return, the structure of risk and the terms of the investment before any capital commitment was considered.
1. What Are the Actual Sources of Return?
The most fundamental question is where, precisely, the return is expected to come from. Is the return genuinely uncorrelated with public markets, or does it simply have a delayed correlation that shows up in stress scenarios? Is it a genuine risk premium, or primarily a liquidity premium that disappears when markets are difficult? Toby Watson’s structured finance background gives him a precise framework for interrogating these questions before any allocation is made.
2. How Does the Strategy Actually Behave in Stress Conditions?
Historical performance data for alternative strategies often looks more attractive than the live experience of investing through difficult market conditions. Toby Watson considers stress scenario analysis an essential component of any alternative investment assessment – asking not how the strategy has performed in normal conditions but how it is likely to behave when financial conditions deteriorate and the assumptions embedded in its structure are genuinely tested.
The Importance of Stress Testing Beyond the Track Record
Track records for alternative strategies often cover periods that have not included the specific stress conditions most relevant to the strategy’s risk profile. Toby Watson applies a disciplined analytical framework to assess how strategies are likely to behave in scenarios not represented in their historical data – a habit developed through years of working with complex structures whose behaviour in extreme conditions was a central consideration in their assessment.
3. What Are the Real Liquidity Terms and Do They Match Your Needs?
Liquidity mismatch – committing capital to strategies with lock-up periods that do not match the investor’s actual liquidity requirements – is one of the most common and most avoidable sources of poor outcomes in alternative investing. Toby Watson considers a precise understanding of the liquidity terms of any alternative investment a prerequisite for allocation, alongside a realistic assessment of the scenarios in which those terms might be tested.
4. How Toby Watson Assesses Fee Structures in Alternative Strategies
The fee structures of alternative investments are often complex, and their impact on net returns is frequently underestimated. Among the fee-related questions worth asking carefully are:
- What is the effective total cost of the strategy across a realistic range of performance scenarios, not just the headline fee rate
- How are performance fees calculated and crystallised, and what are the implications for the timing of fee payments
- Whether the fee structure genuinely aligns the manager’s interests with those of investors, or creates incentives for risk-taking that may not serve investors well
5. What Is the Manager’s Genuine Edge and Is It Sustainable?
Alternative investment managers typically articulate a clear investment edge that justifies their fee premium. Toby Watson considers rigorous assessment of that claimed edge one of the most important elements of manager selection. Is the edge genuinely proprietary, or easily replicated? Is it dependent on market conditions that may not persist? And has the manager demonstrated the ability to sustain it as assets under management have grown?
6. How Transparent Is the Reporting?
The quality of reporting from alternative investment managers varies considerably. Toby Watson’s analytical background gives him a clear sense of what good reporting looks like – genuine transparency about portfolio composition, risk exposures and performance attribution is a reasonable expectation from any manager, regardless of the complexity of the strategy.
7. How Does This Strategy Fit Within the Broader Portfolio?
Alternative investments should be assessed not just on their standalone merits but on their contribution to the overall portfolio. Toby Watson considers portfolio-level analysis essential – asking how the strategy interacts with existing holdings, whether it genuinely adds diversification or simply complexity, and whether the allocation is sized appropriately relative to the role the strategy is expected to play.
8. What Are the Exit Options If Circumstances Change?
The final question that Toby Watson considers consistently underweighted is the exit question. Alternative investments with limited liquidity are easy to enter and potentially very difficult to exit on acceptable terms if circumstances change. Among the considerations worth addressing before commitment are:
- What secondary market options exist if the investor’s circumstances change before the end of the intended holding period
- What the likely bid-offer spread in the secondary market would be under different conditions, including broader market stress
- Whether the investment terms include any provisions that could affect the investor’s ability to exit, including gates or extension options at the manager’s discretion
