Are alternative investments a missed opportunity?

In the current investment climate, alternative investments can provide valuable diversification. So why are investors still not jumping on the bandwagon? Freya Purnell reports.

Hedge funds. Infrastructure. Commodities. Private equity. Private real estate. Agriculture. Direct assets such as water. Fund of funds. Insurance linked securities. Catastrophe bonds. Depending on who you talk to, all these investments can be lumped in under the alternative banner.

So what do these disparate investments have in common? Using a functional definition, ‘alternative’ refers to any investment that has a low correlation to traditional investments like equities and fixed income.

According to Grant Forster, chief executive of Principal Global Investors, alternative investments also typically use leverage in their structure, often have an absolute return objective, and usually have some restrictions around liquidity.

These criteria give some clues about the current position of alternative investments in the Australian retail market. In a climate where transparency, fees and liquidity are king, alternatives seem to be knocking hopefully at the window, offering valuable diversification benefits, but in a package that investors are unwilling or unable to accept.

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A range of options is not really the issue – Daniel Liptak, head of alternatives research for Zenith Investment Partners, says the company researches around 450 different alternative investment opportunities each year – some from Australia, others from offshore.

But access to a variety of alternative investment options is a challenge for retail investors, given the dominance of platform-based investing in Australia. Another issue is the heterogeneity of the sector – as is the quality of individual investments.

Suzanne Tavill, head of alternatives for AMP Capital Australia says, “In private equity, for example, your span of returns between the top and bottom quartile is over 20 per cent. So it matters who you invest in and when you invest.”

Popular alternatives …

To ask what is currently hot in the alternatives space would be perhaps overstating things – no individual strategy or fund is setting the world on fire at present, for reasons which we’ll come back to.

But in terms of which alternative options are more popular than others, hedge funds – the new breed, at least – are having a resurgence. The ‘hedge fund is dead’ mentality of 2008 and 2009 is no more.

“That’s all gone away, and they’re coming back more strongly. They’re more sophisticated, there is a lot more transparency,” Forster says.

David Griffith, senior investment strategist at Blackrock, says although hedge funds have an “image problem” due to some negative experiences, provided that investors choose an institutional quality hedge fund backed by solid administration oversight and risk management, the rewards are there.

“If you pick the right strategy, they can deliver some very attractive returns – particularly when the returns from equities have been sub-par over the last few years,” Griffith says.

He points to the Credit Suisse Dow Jones Hedge Fund Index as evidence, which shows that the average return for a multi-strategy hedge fund over three years is 13 per cent, annualised with around 5 per cent volatility.

This compares with the ASX 200, for example, which delivered three-year returns of 2.9 per cent with 15 per cent volatility.

Within the hedge fund space, global macro strategies are proving successful.

For example, though it is better known as a fixed income manager, PIMCO has been running a long/short global macro strategy for an Australian client for five years, which has produced returns of 19 per cent with a correlation to the domestic equity market of 0.48 per cent.

Joe Bracken, head of macro strategies at BT Investment Management, says “Global macro is reasonably popular because it’s a very liquid strategy, and it tries to incorporate the big picture.

"For example, if you don’t like Europe, then the global macro fund is a good way to express that view, because we can basically ignore European stocks.”

Market neutral funds have also performed strongly, and Forster believes they can be a powerful weapon in the arsenal.

“The objective of market neutral is to be exactly that. It takes out some of that absolute volatility you get from the equity market,” he says.

Also popular, according to Scott Fletcher, investment specialist for Russell Investments, is listed infrastructure, while Liptak says investors are favouring commodity trading advisers and managed futures as well. However, he believes this is due to their 2008 performance, rather than their role in the portfolio.

“They are good as a diversifier – they are great to provide some stabilisation during market routing, but they should not be seen as a return enhancer,” he says.

… and those that are struggling

Still on the nose after blow-ups during the global financial crisis (GFC) are fund of hedge funds.

John Wilson, head of PIMCO Australia, says the crisis exposed investments with excessive leverage and liquidity.

“I think they were discredited for good reason – in some instances where the structures weren’t terribly investor-friendly,” Wilson says.

“Fund of hedge funds have been seen as having too many layers of cost in relation to the realised alpha for the underlying investor.

"In many respects, single strategy hedge funds managed by a reputable manager with scale, breadth and research capacity are more appropriate for the environment we’re in now.”

Similarly, leveraged beta funds are very unpopular, primarily because of the amounts of leverage they utilise – as are overly complicated strategies like statistical arbitrage and convertible bond arbitrage, because of the difficulty investors face in understanding these types of investments and “an unfortunate history of locking up”, Bracken says.

Delivering the goods

When it comes to performance, Australian market neutral funds have been the best performers – in fact, outperforming every other strategy in the world over the past five and 10 years, according to Liptak.

Over the past five years, Australian market neutral funds didn’t have a negative year as a collective index, and produced average returns of 12 per cent per annum – and that includes the period of the short selling ban in 2008 and 2009.

This translates to investors receiving $2.54 for every dollar spent on fees in an Australian equity market neutral strategy, while for every dollar paid on fees to an average Australian long-only manager, they received 5 cents.

“The participation in excess returns is definitely there in the alternative space,” Liptak says.

“From a capital preservation, long-term wealth creation perspective, it’s a much better space to be.”

Although traditionally difficult for retail investors to access, private equity has delivered positive returns.

For example, the Cambridge Associates Australia Private Equity and Venture Capital Index – which pools data from 52 Australian private equity and 19 venture capital funds – reported that as at 30 September 2011 the one-year average return net of fees was 4.79 per cent, 3.92 per cent over five years and 7.41 per cent over 10 years.

Unlisted infrastructure – another difficult-to-access asset class – has also showed decent returns.

According to Russell Investments, as at 31 December 2011, Australian unlisted infrastructure managers delivered net returns of 12 per cent over one year, 7 per cent over five years, and 10 per cent over 10 years.

Are financial planners jumping back in?

Historically, alternative investments have primarily been the province of high net worth and institutional investors.

Bracken says on the institutional side, larger super funds like Sunsuper and the Future Fund have moved quite heavily into alternatives in recent years, with the latter now having more than 16 per cent of assets, or around $11.9 billion in assets, allocated to this asset class.

However, in the retail space, some financial advisers are still wary about alternative investments, having been burnt during the GFC by structures which had a lack of liquidity and resulted in significant capital loss.

While Fletcher believes that investor appetite is beginning to increase, it is still hampered by the tough market conditions and a focus on basic exposures at a lower cost.

There’s no doubt alternatives can typically be more expensive, and investors’ focus on reducing fees may mean they are shunning some alternative options.

“The appetite has been very strongly impacted by the focus on return. Alternatives are expensive. If there was a focus on return post-fees, then alternatives would fare much better in this debate,” Tavill says.

Liptak believes that when it comes to options like market neutral funds, Australian investors are too focused on management expense ratios rather than looking at the net-of-fee returns.

This may be short-sighted, given investors are now looking for alternative sources of return and diversified risk in their portfolio because of the low returns and high volatility equities are contributing.

“Financial planners are all trying to solve the same problem – how do I generate good returns for my investors without this massive volatility? Alternatives appear to be the way that they’re looking to pursue that,” Bracken says.

He has seen a vast improvement in the options available to financial planners, particularly over the past two years, and large dealer groups incorporating more and different types of alternative strategies into their approved product lists and model portfolios.

Even so, there are indications that investor interest might be exceeding the access to alternative investments planners have – particularly via platforms.

Liptak says for the first time, individual investors have contacted him asking how they could access hedge funds – particularly single strategy hedge funds.

“There is a disconnect between what they are being offered, and what they know is available,” Liptak says.

Tavill is seeing a similar level of interest in alternatives.

“We do have a lot of queries from advisers who have read about interesting things in private equity or infrastructure, and want to know how they can get exposure.”

But while financial advisers might have a small allocation to alternatives as part of a model portfolio, or even through a multi-manager fund, accessing alternative opportunities directly is much more of a challenge – as is choosing the right alternative – without the benefit of a large research capability.

“The issue is if an adviser wants to plug and play independently, then it does become more difficult – it has to be off-platform and the extent of opportunities is much smaller,” Tavill says.

In response to this demand, AMP is looking to develop some off-platform alternative solutions for financial advisers, composed of illiquid investments – but they will have quite a specific investor target market for these products.

“Some of these alternatives naturally suit advisers with clients that have a higher account balance, because they introduce very different return driver spins into their portfolio, which should diversify all their existing holdings.

"If done appropriately, it should help them to have a much more stable return stream over time,” she says.

Mark Sowerby, managing director of Blue Sky Alternative Investments, says that most financial advisers are reluctant to talk their clients through individual off-platform alternative investment options such as a private equity or real estate deal. But this may change.

“What most groups are trying to do is get more discretion over the capital they are deploying so they wouldn’t have to go through that process,” Sowerby says.

“As a general rule, it needs to come out of a bucket. We are seeing that the allocation is increasing through vehicles like separately managed accounts and managed discretionary accounts first.”

Blue Sky recently completed a private equity fund raising of $30 million, and Sowerby says a proportion of those funds came from the financial planning and private wealth space as off-platform investment.

It’s not just access that is the problem with alternatives – both perceived and actual risk can also be an issue. Sowerby says that while equities investors face market risk, with alternative investment comes manager risk.

Understanding the strategies used in alternatives is another hurdle for financial advisers to overcome.

“One of the major barriers to investing in alternatives is simply one of education. The problem in a lot of alternative strategies is that they do tend to be a little opaque and obscure, and that worries investors. Planners in particular need to be educated as to how they can use these alternatives in their portfolio,” Bracken says.

Why alternative investments?

So why should investors consider alternatives? To achieve three main objectives, according to Fletcher – to enhance returns, reduce risk, or gain yield from income-type exposure.

“One thing we did learn through the GFC is that a diversified alternative exposure did exactly what it was supposed to do, and that was diversify risk,” he says.

“The risk in the market at the moment is that as people run to low-cost core exposures, they miss out on this alternative allocation.”

Bracken also believes that the appeal of alternatives lies in their focus on positive and relatively stable returns, not being linked to the massive volatility in the equity markets.

“Investors are looking for that stability of return over time,” he says.

In line with this appeal, Fletcher is seeing higher weightings and more diversity in the type of alternatives institutional and high net worth investors are investing in.

“At one point, it just used to be the straightforward liquid side, but you’re seeing more and more into unlisted exposures – such as tollways, ports, airports and infrastructure,” Fletcher says.

Zenith has observed a trend to include long/short and equity market neutral funds in traditional equity portfolios, with allocations being taken from both the passive and active equity pools.

“This is to reduce equity risk in the portfolio without having to take on extra risk in the fixed income space, and we are seeing increases in the use of single strategy funds in that space,” Liptak says.

Is a focus on liquidity blinding investors to alternative opportunities?

Alternative investments – particularly unlisted varieties – are typically less liquid than equities and fixed income.

With investors and financial advisers focused on daily liquidity, some fund managers are arguing that retail investors are missing out on valuable opportunities in the alternatives space – particularly if they are investing superannuation assets with a longtime horizon.

“A lot of platforms won’t have a product that doesn’t have daily liquidity. It seems to me that’s a naïve position,” Wilson says.

“Every investor has really got to think hard about their own situation and work out whether that liquidity structure is appropriate for them. If these are genuine long-term asset pools, then why does anyone need daily liquidity?”

Tavill agrees that as a long-term investment, alternatives make a natural fit for a longtime horizon.

“It’s a big pity that the focus on fees and liquidity is detracting from how people are able to actually invest in this space. Ultimately, what that means is that it’s a distortion,” she says.

“From a global perspective, private equity is one of the best returning asset classes over longer time periods. I do fear that without having some exposure to that in a portfolio over the long-term, you have got to hope that your other asset classes are working very, very hard.”

Griffith says there is definitely a trade-off with more complex strategies between the quality of returns you can expect from a monthly or quarterly liquid fund.

“If investors are looking at the long-term, why limit yourself and insist on daily liquidity when you can actually get better returns by investing in a monthly fund which perfectly satisfies your long-term horizon and you can still access your funds on a monthly basis?,” he says.

However, with some recent failures still fresh in their minds, it seems investors are just reluctant to lock up their money for longer periods of three months or more.

“That’s just not useful. Pre-GFC, that might have been acceptable, but not any more,” Bracken says.

While this liquidity focus does restrict the investible universe for clients, Griffith says there are still good opportunities – for example, equity long/short strategies which can offer daily liquidity and satisfy the needs of platforms.

For this reason, hedge funds are typically the recipient of a higher proportion of the alternatives allocation bucket for retail investors.

“The only reason for that is the focus on liquidity – not necessarily because it’s any better, but because it’s easier to sell and explain,” Sowerby says.

Hedge fund haven

The Australian hedge fund industry is one of the largest in the Asia-Pacific, according to an Austrade report released in August 2011, with $32.6 billion in hedge fund strategies managed by more than 85 Australian investment managers.

Sixty-four per cent of investment in this sector comes from Australian retail and high net worth investors, with 19 per cent from Australian institutional investors and 17 per cent from offshore institutional investors.

Over the next five years, Sowerby believes hedge funds will see the largest amount of growth in the alternative space.

“Hedge funds have the characteristics that the financial planning and private wealth space needs. It’s a nice entry point for them to get started in alternatives, and it is relatively low risk and transparent,” Sowerby says.

According to a paper by Towers Watson, ‘Hedge fund investing: Opportunities and challenges’, released in May 2012, moving forward, the structure and vehicle associated with a hedge fund investment will be as important as the investment strategy itself.

Towers Watson warns that while investing in hedge funds via managed accounts can provide control, ownership, liquidity, transparency and customisation for a portfolio, it’s not an ideal solution – there can be a lack of willingness on the part of hedge funds to run these accounts, control may not be as complete as expected, and costs can be high.

Towers Watson therefore recommends the industry find some middle ground for hedge fund investment between going direct and managed accounts.

Forster points to the UCITS Alternatives regime in Europe as a “halfway house” for investors in terms of providing light touch regulation on characteristics such as leverage.

The UCITS (Undertakings for Collective Investment in Transferable Securities) investment fund regime imposes standardised cross-border regulations and a higher level of consumer protection.

Though UCITS funds traditionally used long-only models, hedge fund-like strategies can also be implemented within the framework, provided specific risk limits are met.

As at June 2011, around 5.6 trillion euros were held in UCITS funds, with total assets under management for alternative UCITS standing at approximately US$115 billion.

“There are now over 1,000 of those funds. It’s a way that retail investors who may not be comfortable with a lack of transparency or fixed monthly pricing can invest. They usually have weekly pricing, and I think it’s a good halfway house which we don’t have here,” Forster says.

With the repeal of the Foreign Investment Fund rules last year, Australian investors are also able to access these UCITS funds far more easily than previously.

Towers Watson also notes the growth of these funds because of their apparent transparency and liquidity, but says that the restrictions on UCITS funds means that some of the best-performing managers are still not available outside the traditional offshore hedge fund sector.

From a regulatory perspective, the Australian Securities and Investments Commission's (ASIC’s) attention as far as hedge funds are concerned is focused on disclosure for retail investors.

The release of Consultation Paper 174 Hedge funds: Improving disclosure – Further consultation in February this year represented the second stage of consultation on this issue.

The paper outlines a range of proposed principles and benchmarks covering disclosures on the responsible entity, the individuals making the investment decisions for the fund, service providers, fund strategies and fund assets, and reflects ASIC’s view that greater disclosure provides retail investors with protection through an opportunity to better assess the risks present in a product.

However, some in the industry have raised concerns that because this guidance (when implemented as regulation) will only apply to investments marketed as hedge funds – other strategies may not be captured.

Growth of alternative investments

So what would give rise to growth in the alternative sector? According to Fletcher, it’s a combination of factors – stable markets over a period of time, and compliance and regulatory safeguards.

“There also needs to be more confidence in the transparency or visibility into the actual strategies and approaches used to manage those alternative investment programs, and education on the part of adviser so they know and understand the risks inherent in the investments they’re recommending for clients.”