Finding a place for alternative investments

Fund managers remain divided regarding the merits of alternatives, with some financial planners ignoring the sector entirely, writes Benjamin Levy.

Defensive assets should be the cornerstone of an investors’ portfolio coming off the back of bear markets.

With an uneven share market recovery and different sectors of the market underperforming, the alternative investments business should be booming. So why are significant numbers of financial planners ignoring it?

And the planners who are trying to access alternatives through the simplest method, a platform, are being caught out by platform requirements, restricted to products with enough liquidity and daily unit pricing – like hedge funds or commodities – to fit on the platform, without any opportunity to gain real, direct exposure to other more illiquid alternatives.

The result is a very low penetration of alternatives among the planner community, a typical portfolio allocation of only 3 per cent or 5 per cent, and substandard products.

Continuing liquidity concerns are also causing a decline in the use of illiquid strategies, despite efforts by fund managers to showcase their benefits.

This is leaving fund managers divided about what alternatives are remaining popular among both retail and institutional investors and how they should plan any future developments.

Platform restrictions

Alternatives should be an important part of investors’ portfolios right now, but instead some financial planners seem to be ignoring the sector.

“We’re just not convinced; we don’t have them on our recommended list; we don’t have any approved products at this point. We don’t have a closed mind to them, but we haven’t been persuaded with a strong enough case to include them in our portfolios,” says Fiducian head of financial planning Alan Hinde.

A number of financial planners contacted by Money Management for this feature declined to be interviewed but nevertheless confirmed that they were not using alternative investments in their portfolios, or that alternatives were not included on their dealer group’s approved product list.

But that may not be the fault of advisers at all. The majority of advisers rely on platforms to provide single-point access to investment products for their clients, meaning that unless alternative products are provided on the platform, advisers would have a hard time getting access to them.

Credit Suisse’s Pension Coverage Group head of third party distribution, Josh Peel, blames the structure of the investment platforms for the slow penetration of alternatives among planners.

“From the experience we’ve had, the planner community largely has had a slow take-up with the quality of alternative products [that] fits within the framework that most planners operate within.

"If they use a platform, or they use a managed discretionary account, it’s very hard to fit a quality alternative product into that platform universe,” he says.

Much of the difficulty comes down to the platforms’ requirements of daily liquidity and daily unit pricing. Because many alternatives on offer are not liquid, the platforms are skewing the availability of alternative investment products towards those that can fit within their requirements.

“Planners who might be selecting alternatives from a platform are restricted to those alternatives that have sufficiently liquid pricing to be on that platform. And so that reduces that alternatives world down quite considerably, to generally liquid alternatives,” says head of alternatives at AMP Capital, Suzanne Tavill.

“There continues to be interest in the spaces of hedge funds and commodities, but that needs to be seen against the fact that it is a restricted interpretation of what alternatives is, more broadly.”

The narrow focus on liquid, platform-friendly strategies is being followed across the industry.

Standard & Poors’ January review of the alternatives sector noted that there were large inflows into commodities, index exposures, and actively managed alternative products, while at the same time liquidity terms for many retail alternative funds had improved, including recently introduced daily unit pricing and increased redemptions.

Credit Suisse has also seen renewed interest in commodities and hedge funds, all strategies that have liquid characteristics or introduced daily liquidity and redemptions, post-GFC.

Platforms requirements could partly explain why hedge funds, commodities, and fixed income funds are so highly favoured among those planners who do use alternative investments.

The result is that aside from a select few alternatives with long traditions of use among financial planners – like fixed income funds, bonds, and private equity – the greater universe of alternatives remains unexplored.

“Everyone would love to be able to offer some of these illiquid alternatives on a platform. But there’s no way of really doing it; you can’t pretend these illiquid strategies are not illiquid,” Tavill says.

AMP Capital got around the problem by creating a suite of multi-manager funds – the Future Directions Funds (FDF) range – that contain within them a more complete range of alternative strategies, and offering the funds themselves on a platform. AMP’s benchmark allocation to illiquid alternatives in the FDF range is 7 per cent. It’s not direct access to illiquid strategies, but it’s better than nothing.

Finding the perfect alternative

Lingering concerns from the GFC are partly responsible for fuelling interest in more liquid alternatives from industry players still using the sector.

“There is an increased focus, post-GFC, on transparency, liquidity, risk management, governance and fees, so that has led to certain sectors or products becoming more popular than others,” says Credit Suisse’s head of the Pension Coverage Group Matthew Perrignon.

Rob Graham-Smith head of portfolio management at Select Asset Management, says there is a strong desire for very liquid alternative products among retail investors, while interest in illiquid alternatives has been on the decline since 2008.

The trend is the same even among institutional investors like super funds where they can afford to hold more illiquid investments for longer periods of time. Despite alternative allocations of 5 per cent to higher than 20 per cent in the institutional space, most of that is directed towards liquid alternatives.

Direct infrastructure and private equity have been the ones to suffer from that trend, Graham-Smith says.

Fund managers believe advisers shouldn’t be too quick to dismiss illiquid alternatives.

“Illiquidity is not necessarily a dirty word. There is definitely still room in portfolios for longer-term illiquid assets, like in closed-end funds,” Perrignon says.

AMP Capital divides their alternatives portfolio into liquid and illiquid assets and combines them to get the best mix of their different risks and returns.

“It’s ‘the sum is more than the cost’ type of effect. We think you can do quite well in that space,” Tavill says.

Infrastructure, timber, agriculture and aircraft leasing are some of the more illiquid assets that AMP Capital include in their portfolios.

Tavill believes the inflows they are receiving indicate that financial planners are investing in direct liquid alternatives as well as investing in their diversified fund approach to gain access to illiquid alternatives.

“They like using the diversified fund approach where the diversified portfolio manager makes allocations to alternatives and manages the liquidity, and you continue to have planners who have interest in wanting to pick specific, more liquid exposures,” she says.

Peel believes that investor focus on the ability to get daily liquidity is making it difficult for advisers to match their clients’ requirements for long-term assets.

“We should be focusing on the real horizon, which should be well into retirement – 20 to 40 years from when they invest,” he says.

But many in the planning industry need to be convinced that they should invest in the alternatives space at all. Hinde warns that many advisers, including Fiducian, believe alternative investments are hyped-up solutions to periods of uncertainty, leading them to treat the products cautiously.

“Often, when things go wrong, people cast around for silver bullet solutions; they cast around for some ‘magic’ that they’ve overlooked previously, but alternatives aren’t delivering proven benefits to portfolios, in Fiducian’s view,” Hinde says.

“Do the potential rewards give a benefit that will overall deliver something to client’s portfolios, given the unknown and unproven nature of many of these areas?” he asks.

The association between the alternatives asset class and hedge funds may be behind planners’ reluctance to rely on some of the more ‘out-there’ alternative products.

Many financial planners still see certain hedge funds as opaque and not easily understood, and it appears that they are readily transferring those blemishes to include the wider alternatives asset class.

“People think of alternative investments as different to the normal asset class ranges, whether it’s water futures, or things that are really not classified in the normal asset class boxes,” Hinde says.

Advisers’ experiences with hedge funds do make things difficult, Peel acknowledges.

“They haven’t been exposed to them. Alternatives tend to be a very big universe, and if you mention hedge funds you may be frowned upon for even mentioning it,” he says.

Financial planners have to be educated on the use of alternatives and their benefits before they will take them on more broadly in their portfolios, Peel says.

Investors also need to be educated on how alternatives work.

Because returns from alternatives come from products that are not correlated to the share market, it necessitates moving away from what investors themselves know about investing, leading to even less enthusiasm for the sector.

Graham-Smith warns that investors shouldn’t invest in fund managers that have high levels of tail risk involved.

“They have an incremental sort of gain, gain, gain – and then they fall off a cliff! That’s something we’re not interested in,” he says.

Where is the alternatives space headed?

The continuing interest from planners and investors in liquid and transparent alternatives is splitting the funds management industry, with several industry players mapping out different future trends and their response.

Investors would do well to remember that the broader alternatives asset class are much like hedge funds in at least one respect: investors have to know when in the market cycle to hold them.

Russell Investments’ multi-manager portfolios started rotating back into alternatives in late 2009 as concerns over possible inflationary pressures in commodity prices mounted.

They bought in global-listed infrastructure, commodities, and opportunistic exposures like high yield emerging markets debt. Each of these asset classes delivered returns in excess of 20 per cent in 2010. Those three exposures will still play key roles for Russell Investments in 2011, but commodities are beginning to be pared back.

“We’re happy to hold alternatives, we just want to hold them at the right point in the cycle,” says Russell portfolio manager Andrew Sneddon.

Select Asset Management is continuing to see ‘decent interest’ in the alternatives space as a result of concerns surrounding the bailout of Greece and other European markets last year, according to Graham-Smith.

“We have seen a big turnaround in investor attitudes towards alternatives,” he says.

Graham-Smith expects investor interest in soft commodities like oil and energy, as well as rising food prices, to continue to expand off the back of unrest in Egypt and Libya.

Select Asset has been working overtime to get more exposure to agricultural commodities in their portfolios to take advantage of that thematic.

“Food is particularly large component of emerging market consumer price indexes, particularly in Asia,” Graham-Smith says.

Agricultural commodities is an under-appreciated area, considering there have been very strong rises in the sector, he adds.

AMP Capital has seen some hesitancy among the large superannuation funds towards the alternatives space, with liquidity and types of returns being chief among their concerns.

“There is concern about the liquidity necessary within a [super] fund, plus considering the types of returns that are coming out of the space, I think there is a fair bit of evaluation of the alternative sector going on,” Tavill says.

Investors are also evaluating whether the method they adopted to gain exposure to alternative investments in the past is the best approach to take in the coming year, Tavill says.

Russell has taken the opposite approach with institutional investors. Their global alternatives team is exploding with growth. They spent most of last year shifting experts internally into the alternative investments space, and announced plans to hire more than 25 new specialists.

The move was then part of a strategy to provide investors with opportunities to increase exposure to illiquid alternative investments. The company forecast in the middle of last year that institutional investors would increase their alternative investments from 14 to 19 per cent exposure over the next two or three years.

Russell’s director of alternative investments for the Asia Pacific region Nicole Connolly was very optimistic in her assessment of the sector during last year.

“Alternatives have proved their role as portfolio diversifiers and risk-mitigators during volatile markets, and we expect continued demand from institutional investors, even if the global recovery were to falter,” she said.

Insurance-linked strategies have seen big growth among institutional investors in Credit Suisse’s Pension Coverage Group, thanks to their non-correlation benefits, as well as capital starvation strategies, Perrignon says.

Credit Suisse expects investors to try to exploit the effects of increasing costs of capital of regulatory requirements from Basel III which will be implemented in the next couple of years.

Those alternative providers of capital are emerging as a direct result of the GFC. The after-effects of the GFC are causing many changes in the way the industry works, including driving the development of new, different sectors – like capital providers – so that institutional investors can cast a fresh eye over for new investment opportunities.

“The increase in regulatory requirements and increasing costs of capital are going to mean that it’s harder for banks to keep loans on their balance sheets, and as a result, alternative providers of capital are stepping in to take the place of banks – and that is creating opportunities,” Perrignon says.

Some fund managers openly disagree over future trends of particular alternative products. While Russell’s Global Survey on alternative investing last year found private equity, real estate and hedge funds were the big three preferred alternative types among investors, Graham-Smith believes private equity is struggling.

“Private equity has struggled from a capital-raising perspective in the last few years,” he says.

Graham-Smith also questioned whether real estate should be placed in the alternative asset space.

“In terms of real estate, we tend to carve out real estate as a non-alternative in Australia.

"I know it’s regarded as an alternative in the United States, but Aussies have a particularly high exposure to property and for that reason we regard it as a mainstream investment,” he says.

Some financial planners are also bemused by the choice of label.

“I wouldn’t put the real estate sector into alternatives, unless it was structured in some particular way that was unusual. We see them as mainstream,” Hinde says.

Simon Wu, chairman of Premium Wealth, believes the label ‘alternative’ is itself ill-defined, and warns that terminology can be ‘contagious’.

“There are a lot of misnomers in this industry. Is China an alternative or not? If not, then why is there so little money put into it when it’s growing much faster than the rest of the world?

"In this country, 30 per cent to 40 per cent of every portfolio is put into Australian equities and that’s considered orthodox. Who defines orthodox?” he asks.

The whole investment industry’s approach to defining certain categories and pigeonholing them is wrong, Wu says.