Asset classes and product types: considering the alternatives

PortfolioConstruction Forum, in association with Money Management, asked the research houses the following questions: What asset classes/product types does your firm include under the ‘alternatives’ label? Why? How many strategies/funds do you rate in each? 

Lonsec

Lonsec considers the alternative asset area to include the following three distinct groups:

• Hedge Funds Single Manager – Managed futures, global macro, event drive, multi-strategy and commodities funds. These funds are typically uncorrelated or have low correlations to traditional asset classes. They offer asymmetrical returns and downside protection, employ a flexible investment tool set (eg, can use short selling, leverage, derivatives, etc), and are relatively unconstrained;
• Hedge Funds Long/Short – Australian equities and global equities funds. These managers employ a flexible investment tool set and the funds offer asymmetrical returns and downside protection; and
• Hedge Funds Multi-Asset/Multi-manager – Fund of hedge funds and diversified alternatives. Like the single manager group, these funds are typically uncorrelated or have low correlations to traditional asset classes. They offer asymmetrical returns and downside protection, employ a flexible investment tool set (eg, can use short selling, leverage, derivatives, etc), and are relatively unconstrained.

Standard & Poor’s

Standard & Poor’s Fund Services (S&P) has three main categories for alternatives – Alternative Equity, Alternative Futures, and Multi-Asset – and each has sub-peer groups.

Alternative Equity Strategies includes funds that vary from those that may use simple derivative strategies to preserve income, to absolute-return funds that may use large amounts of leverage.

S&P considers these types of funds to be using alternative strategies around the traditional equity assets. All of the strategies are actively managed.

There are three peer groups:

Beta variable including:

• Diversified – Absolute-return equity strategies with a global focus.
• Regional – Absolute-return equity strategies with a specific regional focus.
• Sectoral – Absolute-return equity strategies with a specific industry focus.
• Income – Equity income-focused strategies, usually incorporating buy-write option strategies.
• Market Exposure – Market extension strategies, also referred to as 130/30, with an overall market beta exposure target of one; and,
• Market Neutral – Equity strategies that aim to minimise overall market beta exposure – ie, have an overall market beta exposure target of zero. S&P currently rates two special events funds that aim for broader market neutrality in this way.

Alternative Futures funds are specialist products that use non-traditional investment strategies, most notably within commodity and financial futures markets. Offerings can be either index-enhanced products or absolute return strategies.

These funds should not be grouped as hedge funds or even absolute-return funds, but should be viewed as investments that offer explicit access to alternative strategies not included in the average retail portfolio.

There are four peer groups:

• Commodity;
• Commodity trading advisers;
• Global Macro; and
• Fixed income trading strategies.

Alternatives Multi-Asset funds use multiple alternative investments strategies across one or more asset classes. This can be through the fund of hedge fund format that invests in multiple managers or through a single manager using a multi-strategy approach. There are two peer groups:

• Multiple-manager – fund of fund and multiple manager funds; and,
• Single-manager – use more than one asset class and use of alternative strategies including shorting, derivatives, commodities and/or options.

Zenith Investment Partners

Zenith considers alternative assets to include all investments that cannot be easily benchmarked to traditional assets and therefore the alternatives area includes:

• Direct assets including water (wet) and shipping – Demonstrate a very low correlation to traditional asset classes;
• Commodities – Provide a pure method to capture growing emerging market demand for essential commodities (food, energies and metal) without exposure to management, gearing, franchise benefits or detractions that are contained within equities;
• Currencies – Capture flows of capital in and out of emerging markets, providing the opportunity of capturing elements of emerging market growth and simultaneously capturing some returns when the inevitable cyclical capital flows capitulate, or concentrates on capturing returns when movements become extreme;
• Agriculture – Provides an opportunity to capture emerging market growth without the associated geo-political risks of investing directly;
• Private equity and secondaries;
• Fund of private equity;
• Insurance and CAT bonds – Provide strong returns with bond like returns from assuming insurance risk on catastrophes, life insurance and automobile insurance.;
• Hedge funds – Can be combined to reduce risk inside portfolios, while enhancing returns. Importantly, it is the risk constraint that they bring to a portfolio that allows the investor to better match future liabilities with assets. Trend-following strategies, commodity trading advisers are included in this broad hedge fund group as they provide a positive carry while buying portfolio insurance and are attractive for defensive purposes. Domestic market neutral and long short equity managers are among the world’s most consistent generators of risk-adjusted alpha. Some fixed income strategies, including inflation-linked funds, provide low inflation risks while having some exposure to emerging markets; and
• Fund of hedge funds.

Mercer

Mercer’s definition of alternatives covers alternative approaches to traditional assets (eg, long/short equity) and traditional approaches to alternative assets (eg, infrastructure).

Thus alternatives would include everything other than equities, fixed income and real estate/property.

Mercer broadly classify alternatives into Alpha (hedge funds) and Beta (private equity, commodities, infrastructure, timberland and ‘other’).

Each of these falls into the alternatives category for one of two reasons:

• The asset class is an alternative approach to traditional assets (eg, long/short equity); and
• They are a traditional approach to non-traditional assets. (eg, infrastructure).

While this question does not ask about the characteristics of alternative investments, alternatives typically show different risk/return profiles than traditional asset classes and also have different correlations with traditional asset classes that can serve to increase the diversification of a multi-sector portfolio.

Morningstar

Morningstar is generally hesitant to use the term alternatives with clients, since it is often interpreted differently by different people.

Morningstar considers investments with genuinely non-traditional market exposures as alternative.

Broadly, this includes hedge fund of funds, long/short (market neutral or variable beta), global macro, managed futures, commodity trading advisers, multistrategy, and pure commodities.

Morningstar does not include infrastructure, private equity or commodity shares as alternatives as we view these as merely derivations of some form of traditional market exposure.

Morningstar is currently in the middle of a review where it is looking at more than a dozen unique investment strategies.

Currently, Morningstar rates 11 alternative strategies equating to 36 funds.

Van Eyk

Van Eyk believes that, by definition, alternatives should deliver uncorrelated return streams compared to traditional risk assets such as equities.

When added to a diversified portfolio, alternatives should help lower return volatility and maintain or increase the expected return of the portfolio.

Van Eyk divides the alternatives asset class into two groups – absolute return strategies (multi-strategy and single strategy hedge funds) and real assets.

Absolute return strategies are designed to deliver value add in a range of market conditions while controlling the risk exposures of the strategy.

Multi-strategy hedge funds are highly diversified strategies seek to exploit a broad range of sources of return (risk premium) while controlling the risk exposures to individual managers.

The single strategy hedge fund area includes:

• Global macro – Seek to exploit market inefficiencies created by uneconomic market participants as well as the formation of global imbalances;
• Fixed income macro – Target asset mispricing in a range of fixed income markets (eg, government bonds, high-grade and high-yield corporate bonds, loans, structured securities) as well as global currencies markets;
• Event driven – Seek to profit from arbitrage opportunities related to specific corporate or market events. Examples include mergers, acquisitions, restructurings, asset sales, recapitalisations, spinoffs, periods of regulatory and legislative change, and litigation;
• Equity market neutral – Target a market beta of zero, usually by assuming a combination of long and short positions in share markets designed to eliminate systematic risk. These strategies attempt to mitigate risk by neutralising exposure to broad groupings (sector, industry, market capitalisation, country, or region, for example), which then permits the flexibility to exploit specific investment opportunities as they arise; and,
• Insurance-linked investments – Returns are dependent on the performance of a pool or index of insurance risks. The most common form is catastrophe bonds, used by insurance companies to hedge risks in a similar way to reinsurance contracts. Insurance-linked investments offer good diversification benefits as returns are not correlated to market or economic factors.

Real asset strategies generally offer a good hedge against future inflation and are usually backed by physical or tangible goods.

There is an intrinsic value to real assets due to their utility or commercial application. The return of real assets is expected to be a combination of capital appreciation, income return and illiquidity risk premium.

• Commodities (long only, long/short, shares) – Raw materials extracted through mining activities. The changes in commodity prices are expected to be heavily linked to the well being of the global economy (expected demand), investment demand, output from mining and agricultural activities (expected supply) as well as seasonal or political factors. Investments through exchange-traded contracts may earn a roll yield;
• Precious metals (shares and commodities) – Precious metals, such as gold, differ to other broader commodities in that they are frequently viewed as a safe haven assets or as an alternative store of value to financial assets against future inflation. User consumption is driven by a combination of industrial or investment demand. Traditionally, supply is sourced from mining production, metal recycling and selling by central banks; and
• Direct property – Rental income from property investments are usually indexed to inflation (CPI), making property investments a more effective hedge against inflation.