Alternative investments sell out

There is little doubt in the industry that there is a place for alternative investments next to their conservative cousins, however, as the popularity of the market grows, so does a cloud over its status as a non-mainstream option.

Five or so years ago alternative investments as an asset class was in its infancy within the Australian marketplace. From an investor’s perspective, options such as commodities, infrastructure, private equity and, in particular, hedge funds were nothing more than a foreign ideal.

Little interest was shown in the sector by the financial services industry, with many advisers deeming the sector too risky and lacking in strong performance. Others simply dismissed it as nothing more than a fad investment that would raise its head to be seen before quickly disappearing.

Today, alternative investments are still among the pack and continue to spark debate and create divisions.

Earlier this year, the Australian Prudential RegulationAuthority (APRA) created a stir by pointing out issues that superannuation funds may come up against if they put monies into alternative investments. In April this year, APRA deputy chairman Ross Jones said changes to the super industry through choice of fund would likely increase competition between funds and, therefore, increase pressure on trustees to chase performance.

“Trustees seeking high returns may be willing to accept higher risk by investing more of their fund’s assets in alternative asset classes such as private equity and hedge funds, or by investing in different countries and products, perhaps without a full understanding of these assets,” Jones said.

And while he acknowledged it was not up to APRA to determine whether alternative investments such as hedge funds were appropriate investments for fund members, Jones said the regulator would be concerned if its reviews showed trustees took an unnecessary risk based on lack of understanding of the sector. In 2003, APRA expressed similar concerns towards the sector.

Meanwhile, earlier this month the Investment andFinancial Services Association (IFSA) lodged a submission with the Senate Standing Committee on Economics Inquiry into Private Equity Investment. IFSA chief executive Richard Gilbert said the association is supportive of private equity investment and believes it presents its own set of unique risks and opportunities, which investors must appreciate.

“Private equity is an issue for investment managers for a variety of reasons, not least because assets are often acquired via the stock market and asset managers must make a decision whether to sell or not to sell.

“The submission also outlines the current regulations affecting private equity transactions and further puts the case to the Senate that, in IFSA’s view, there would not appear to be any compelling need for additional regulation,” Gilbert added.

Despite what both associations say, how viable does the wider industry perceive the alternatives sector?

“I think it’s certainly viable. It’s small but growing,” said ING head of product and strategy, personal investments, David Kan.

Kan said he looks at alternative investments as structural rather than cyclical, meaning it’s not based on a “flavour of the month”.

“There are actually tangible, significant benefits to alternative assets, which mean that it’s something that will continue to grow in the long run. I suppose alternative assets provide two things, which is, from an adviser or an investor perspective, additional alpha, additional returns and also diversification, especially in terms of providing no market correlative returns. So we certainly believe in alternative investments, and we’ve added an allocation in our diversified funds to alternative investments,” he added.

Taking a broader look at the sector is Select Asset Management’s portfolio manager Robert Graham-Smith. He said alternative investments are a viable sector, with more investors adding the option to their portfolio and, therefore, investing more money into the sector.

“Our view is that alternatives are not an asset class in themselves, but a collection of alternative strategies and asset classes,” Graham-Smith said.

“In terms of the state of play in alternatives investments, obviously there is a lot of press and publicity in terms of alternative investments and alternative investing, and my view is that investment in alternatives is going to continue. Historically, it’s been led by some of the world’s leading institutional investors.”

Hedge funds

Pengana Capital’s institutional business consultant Denis Carroll also believes the sector is viable, stating a hedge fund option may surprise an investor with the amount of risk protection it could offer a portfolio.

“Alternatives are certainly a viable and popular investment strategy among institutional investors. Like any other asset class, a hedge fund strategy may not always work with the current direction of the markets,” Carroll said.

“But generally, hedge funds offer much greater risk protection in a portfolio than many investors may emotionally attach to them. There can be much less volatility than people think while still generating the desired returns,” he added.

And while hedge funds’ viability garnered a unanimous response, the conjecture regarding its definition as alternative rather than mainstream was a little less clear.

“Right now, I’d say they’d be on the alternative side of things. I suppose, strictly speaking, if you look at alternative assets as being based on traditional asset classes and being linked to markets or market indices in the listed environment, then hedge funds … aim not be in that space,” Kan said.

“So, therefore, you consider them to be alternative. The point of a lot of hedge funds is to have performance that’s independent of the market, so to that extent they’d be considered alternative. Having said that, when you say mainstream, again, like a large number of alternative assets, they’re becoming more frequently used, but I wouldn’t call them mainstream right now.”

Also singling out hedge funds, Graham-Smith believes the investment option is still classed as alternative, though he does admit as its popularity increases there is a blur surrounding its definition.

“More investors are using hedge funds in their portfolios and, from that perspective, they’re considered a more normal investment now than they historically may have been. But I think the underlying strategies used by hedge fund managers in most cases … are definitely still alternative.

“There are some hedge fund strategies that have become more mainstream, and we’ve seen a lot of capital go into hedge funds globally and the funds under management in the hedge fund space has grown hugely in the last few years. I think what that leads to is that the older style hedge fund strategies and investments are getting quite crowded.”

But, he said, as the sector experiences overcrowding there has been an emergence of “second generation hedge fund strategies”, which are seeing a lot more managers get involved with fund of hedge funds investing in some of the emerging hedge fund strategies.

Graham-Smith said the so-called second-generation hedge fund strategies are part of the sector’s natural evolution. He said the hedge fund industry has attracted some “incredibly smart investment talent” over the years, who are awake and alert to the fact that change needs to occur when it appears returns are being eroded. It’s at this point that Graham-Smith said they have to either do things differently or look for different sources of alpha or performance.

“I think to an extent that has been driven by the weight of money as well. I mean, long- short equity is an interesting one. That is becoming more mainstream and more readily accepted in the general investment community. So there’s a real blurring, particularly in the equities space of hedge fund and traditional investment. And likewise, you’re seeing a blurring of the alternative investment areas such as private equity and hedge funds.

“I think strategies employed by hedge funds historically have relied more on market traded securities, and I think some of the newer hedge fund strategies particularly are focusing on non market related securities, so essentially less liquid, longer lock-up type strategies, and I think to a degree that has encroached on the private equity stakes as well. And I think that’s really what’s driving it,” Graham-Smith added.

While agreeing with Graham-Smith, Carroll offered a more direct response.

“Some types of hedge funds are indeed becoming mainstream,” he said.

“Most [institutional funds] list hedge fund as alternatives, though long-short equity funds are more often becoming seen as mainstream equity investments.”

So if the lines separating alternative investments from the mainstream starts to blur, what then for the sector?

“The challenge for us and for other people that invest in alternative investments generally is to come up with other alternatives that truly diversify portfolios,” Graham-Smith said.

“Some other areas we consider alternative are managed futures and trading funds, commodities (pure commodities exposure rather than resource stock), agribusiness is an area that we’re interested in (pure agribusiness rather than tax-driven managed investment schemes rated investment), alternative debt, and infrastructure, although infrastructure has become more mainstream, particularly in Australia.”

Graham-Smith said there’s a whole raft of options that could be considered “alternative alternatives”.

“We’ve got a big universe of things that we look at, everything from investing in water, electricity futures, carbon trading to weather derivatives. We don’t necessarily invest in these things, but they are potential [investments]. [Others include] trade finance and shipping, catastrophe bonds and reinsurance; so everything from things like that to vintage cars and art. I guess in that basket you could put anything in there that doesn’t necessarily rely on traded equity or bond markets or performance,” he said.

Meanwhile, Kan’s attitude towards the alternative investment sector is to grab it with both hands, with ING launching a number of capital protected products in the past six months.

“We certainly believe in alternative investments and we’ve added an allocation in our diversified funds to alternative investments. And we’ve also recently launched a capital protected product that has underlying alternative investments as the underlying funds.

“We [also] launched in December last year our first capital protected fund, which was based on the managed growth fund, which is basically a diversified fund of conventional asset classes. And that’s been quite successful,” he said.

Kan said the group’s next step is to add a second capital protected fund that is based on alternative funds. He said investors are now more familiar with the capital protection structure, as ING has put it on its platform.

“So this is a fund that investors can enter and exit on a daily basis and which capital protection can apply from day one. And I think this is an easy way for investors to get into alternative investments with a level of capital protection.

“I think advisers are becoming more familiar with them. And as they become more familiar with them, usage will grow. I wouldn’t say there’s reluctance, but rather an increasing familiarity.”

While it’s all too easy to theorise on ways to maintain alternative investments within the alternative space through expanding existing options such as hedge funds, the practical aspects surrounding such a suggestion easily comes up trumps.

“A lot of these areas sound very interesting and compelling, but there may be fundamental reasons why they’re not commercially viable or they’ve got other risks, such as credit risk,” Graham-Smith said.

“The challenge there is that there isn’t something that is a hard and fast definition as to what is an alternative. You could put in anything that doesn’t rely on performance and equity. It’s not something that can be hard and fast.”