Considering the alternative

The alternative asset management space has ballooned over the past decade and, while Australia still stands as a laggard globally, the COVID-19 pandemic and low interest rate environment has created increasing demand from investors.

Within FE Analytics’ Australian Core Strategies universe, the alternatives sector had 117 funds and 16 (13%) had been launched since 2019. This signals there is appetite in the Australian market for alternative investments.

Tribeca portfolio manager, Jun Bei Liu, said the sector had been growing in the country quite meaningfully over the last five to 10 years but was still behind the global pace. Liu said COVID-19 had increased demand from both retail and institutional investors as both were looking for market agility and higher returns. 

Long-short alternative managers, she said, had the opportunity to buy long and short stocks whereas long-only managers were unable to take advantage of their insights of an underperforming company.

“This is a very efficient way to utilise both sides of the argument and benefit from rising and falling prices,” she said.

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“In the falling market it provides strong protection when the market is falling because we are shorting the companies that have a weaker business model and the like. This is really good protection when those businesses fall more than higher-quality businesses when normally there is a lot of investor support.”

Active long-short managers, she said, were able to outperform in both up and down markets and provided more consistent returns. Since the COVID-19 pandemic was declared last year, the market has crashed and risen and long-short managers were able to enhance their returns by shorting during market volatility. 

“If you look across the alternative fund manager space as a group, we have always had higher returns than the rest of the funds management market,” Liu said. 

Regal Funds Management chief executive, Brendan O’Connor, said many investors were a bit despondent given the current low interest rate environment and were looking to diversify and achieve growth by moving into alternative investments. 

The pandemic had exacerbated and prolonged the low interest rate environment and investors were seeking to benefit from returns that were uncorrelated to the market. Long-short managers, he said, were able to harvest alpha from idiosyncratic movements from shares as opposed to the market movement.

Away from long-short managers, investors could also use alternative strategies to access niche beta. These were typically from a specialist investment team that were trying to access different parts of the market such as agriculture, forestry or water assets. 

“They are largely owning the assets (being long) but through their expertise they seek to generate alpha in a manner that is uncorrelated to traditional financial assets,” O’Connor said. 

ADVISER RELUCTANCY

Despite the benefits of producing alpha when rates are low, financial advisers have historically been reluctant to dip their toes into the alternatives world. 

O’Connor pointed to the higher volatility that alternative investments experienced as a barrier for investors. 

“The volatility associated in investing in this market is unfortunately the price you pay for getting exposure to some of these companies you wouldn’t usually have exposure to. We focus on strong risk-adjusted returns over the medium to long term,” he said.

“You will get periods where your portfolio experiences volatility, but when it comes to the overall asset allocation and positions provided, you can size your positions and allocations to a manner where you can tolerate that volatility and that volatility that can turn into opportunities that help tie in your investments.”

Liu attributed the hesitation to the fact that the sector still felt very new to investors and a myth persisted that alternative strategies were highly leveraged and risky. However, she believed that the long-short space helped lower risk in portfolios.

“If you look at the consistency of performance, most long-short managers outperform in a downmarket, but generally a lot of them struggle in a rising market. We have been able to outperform in both up and down markets” Liu said.

“This is because we can short stocks which gives us the ability to buy risky stocks as well. We can buy a very volatile company that have shares that move a lot because we can short similar companies, and that takes out so much risk and makes long-short managers more defensive than long-only managers.”

Liu said if she invested in a high-quality tech company that was exposed to stockmarket risk but also invested in a similar exposure where earnings were not doing so well, when the stockmarket fell her portfolio would be protected as she would have a short position pair traded with the higher-quality stock. 

Apostle Funds Management managing director, Karyn West, said alternative funds were often designed around the institutional market as they had longer lock-up periods and that it was a struggle to create products that suited the retail market.

“The retail market often needs daily pricing and high liquidity needs and that does not fit well with alternative investments.”

Apostle invested in more niche alternative areas including venture capital, private equity, alternative debt, and property.

WHAT TO LOOK FOR IN AN ALTERNATIVE MANAGER

West said advisers looking at the alternatives space should look for quality managers who aligned themselves with clients and were cognisant of the market and regulatory environment. 

“It’s all about quality and the best investments that diversify. Advisers should look for products that are suitable for a particular period or suit a certain environment. At the end of the day it’s about quality teams and quality investments,” she said.

Agreeing, Regal’s O’Connor said the hallmarks of a good alternative investment manager were that they demonstrated they had added alpha over a long period of time over different market cycles. He said advisers needed to look at a period of over 10 years and find out whether the fund had some sort of independent recognition.

“Advisers should look for funds that can demonstrate they have achieved alpha over a number of market cycles and corrections, and they should look at how they have responded, and how their risk management has performed,” he said.

“The funds need to truly be able to demonstrate they’ve added alpha, and they haven’t just ridden the beta of the market. This will be demonstrated through the manager’s individual stockpicking skills which have generated the return as opposed to the rise of the overall market.”

O’Connor noted the Rubicon people needed to cross when considering alternatives was to realise that there were fewer alternative managers than long-only managers, their fees were typically higher as investors were paying for the specific skillset of the manager and that, sometimes, the strategies required a degree of illiquidity to generate alpha.

Liu said before jumping into an alternative sector, advisers needed to understand the strategy itself and what the strategy deliver for their portfolio as there were so many variations of alternative investments in the sector.

Similar to O’Connor, Liu said the track record of alternatives was extremely important and that there were a number of managers who had not been through many market cycles.

“You want to know how the funds have responded to market events and see the funds stress tested during crisis events like the pandemic and the Global Financial Crisis,” she said. “You want to see how they behave and how they deliver returns.”

ALTERNATIVE CHALLENGES

However, Liu noted longevity was a challenge for new managers coming into the space as there were only around seven or eight alternative managers in Australia that were consistently rated.

“Every now and again a new manager pops up but they don’t have longevity. The challenge for funds is having a strong team and building on it, which is another example of why you want to see how managers have responded through different cycles,” she said.

For West, she said the top two issues for the sector were liquidity and fees. Given the Government gave the greenlight for superannuation funds to release members’ funds on grounds of hardship during the COVID-19 pandemic, super funds were now more cognisant of liquidity. 

“They are all looking through their portfolios and they’ve been through a difficult year and now they are turning attention to the new heatmaps and benchmarking arrangements coming into play. They are having to look through a range of issues and liquidity is one and fees another,” she said.

West said there was a disproportionate focus on fees in Australia that was not present overseas. Other markets looked at net returns and assessed the merit of the investment and, while fees came into consideration, it did not have the same focus as Australia.

“I fear that going forward we will need to forego really good investments if fees are higher because the budgets here are going to be stricter. Unfortunately, that’s the landscape we’re going into but we have to deal with it,” she said.

“Typically alternative investments are more expensive as they are more specialised, and often require very specific skillsets, large teams, specialist systems and the operational aspects that run the products are going to be higher for investments such as private equity, venture capital, and hedge funds.”

She said any areas where there was a large supply of managers were more vulnerable such as private equity. 

“If a group wants to enter the Australian market and is prepared to discount their fees to get a foothold it impacts the other private equity managers. This has been happening for about five to 10 years, but it has intensified over the last 12 months. It’s a permanent feature of our system,” West said.

“Funds need to be more creative with things like co-investment, opportunities, and find different ways to reduce fees. They need to work actively with the underlying manager for them to be more creative with finding better value for the clients.

“If they’re not prepared to do those sorts of things, it’s going to be a huge challenge for them.”