Market volatility sparks interest in alternative investments

Market conditions are driving a renewed interest in alternative investments, but a number of practical limitations may be limiting allocations in the retail space. Bela Moore reports.

Complex products, illiquid structures, high fees, stepping into the unknown: there are a number of reasons why sticking with traditional assets – namely equities and bonds – is seen as a safer bet than delving into the world of alternatives – hedge funds, fund of funds, private equity, infrastructure and property – just to name a few. 

As Certitude’s Craig Mowll said, “Alternative investments are marginalised, almost by definition.” 

However, with continued market volatility dulling the shine on equities and low interest rates impacting negatively on bond yields, alternative investments have crept back into the financial planner’s spotlight. 

Although inflows have been slower than before the global financial crisis (GFC), alternative investments stood at a record $6.5 trillion in assets under management at the end of 2011, according to McKinsey and Company. 

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According to Morningstar’s November 2012 alternative investments wrap-up, investors’ interest in alternative investments has increased due to a perceived ‘new normal’ investment landscape. 

“In this environment of low interest rates, low growth, low returns, and increased volatility, the promise of absolute and uncorrelated returns is certainly enticing,” it said. 

Certitude saw increased inflows into virtually every asset class it held as last year’s discussions with planners turned to investments this year, according to Mowll.  

He said the move was driven by the pressure of interest rates on huge allocations to cash. 

Blue Sky Alternative Investments experienced a marked increase in planner interest for alternatives, reflected in ‘click-throughs’ on its investment communications increasing from 3-5 per cent to 10-15 per cent over the last six months, according to national relationship manager Vaughn Henry.  

“When it (interest rates) came below five [per cent], clients started to think ‘we should look for something else – high yielding stocks can’t be the only answer’,” he said. 

A good theory 

Lonsec’s head of investment consulting, Lukasz de Pourbaix said planners could see the investment case for the potential value of alternative investments as diversifiers within a portfolio.  

However, he said in practical terms a number of challenges exist, including the move by planners to a fee-for-advice model coupled with increased market uncertainty. 

De Pourbaix believed only 10-15 per cent of planners in Australia currently recommended alternatives. 

“If you look at the financial planning world, there has certainly been an increased focus on cost and it’s fair to say alternatives isn’t a low-cost sector,” he said. 

Mowll said he wouldn’t be surprised if retail allocations were as low as 5-8 per cent. 

Fund manager fee structures overseas were more appealing, often modelled on a 2 per cent flat fee and 20 per cent performance fee, according to de Pourbaix, which limited Australian investment options.   

van Eyk head of strategic research and consulting Jonathan Ramsay said alternatives make sense to planners, but there are not enough alternative investment options on platforms to implement a diversified portfolio solution.  

“There’s a relatively small subset that are liquid enough for platforms, so sometimes having it in a fund of fund wrapper alleviates some of that,” he said. 

He said limited alternative investment options presented planners with an “out of the frying pan and into the fire” situation.  

Planners struggle to construct well-diversified portfolios, often building up from a limited number of single-strategy funds that could potentially add manager risk, said Ramsay. 

“Then you try and add more options and basically you start going down the quality scale,” he said.  

However, post-GFC, slowed uptake in the use of alternatives by planners could just be because portfolios better reflect client preferences, said de Pourbaix. 

“These products are more complex and there’s a case to be made that clients that were in those products prior to the GFC maybe shouldn’t have been there,” he said. 

Stiff opposition 

Liquidity is not only a major constraint in alternative products’ journey from the institutional world to retail platforms but it still weighs heavy on the minds of advisers, according to Lonsec’s lead alternatives analyst Stewart Gault. 

He said liquidity presented a catch-22 situation where investors need to sacrifice it to gain the upside of alternatives. 

“You may not be earning that illiquidity premium or you may not be getting exposure to some of the alternative strategies that you think you may be,” he said.  

Although investors often want daily liquidity, it was quite rarely used according to Gault. 

Morningstar senior research analyst Julian Robertson said investors needed to maintain their exposure to alternatives because chasing short-term gains would probably see them switching allocations at the wrong time. 

“You have to build it in as part of a long-term portfolio planning process and not use them as a sort of short-term conduit for some sort of tactical or performance enhancement – it’s really about the portfolio construction in the long term rather than the short-term tactical trade,” he said. 

Mowll agreed and said a lot of alternative investments played out over time, outperforming traditional returns.  

“None of them with the exception of global equity will provide you with that daily liquidity, and so you’re going to miss out on the real value of why you’re investing in hedge funds in the first place,” he said. 

He said the planning industry was caught at a crossroads regarding alternatives and liquidity. 

“In the one breath everyone’s saying we’ve got to have these things daily liquid; and then in the next breath they’re looking for broader opportunities. And the two don’t necessarily correlate well,” he said. 

There was no assurance investments with daily liquidity would not be locked up in the case of another financial crisis, he said, while a highly liquid profile may not align to the client’s risk profile. 

Cash allocations, which were below 5 per cent pre-GFC, should be higher to provide immediate funds, according to Mowll. 

Ramsay said there was danger in investing in illiquid assets with a skinny risk premium, because people were not getting paid for it. 

“That was the situation five years ago,” he said.  

“Looking forward, I would say there’s potential that some illiquid investments probably offer a risk premium that compensates.” 

Cost considerations 

 “If fees are the constant focus, we’re going to see hedge funds with less prominence because they (planners) have to meet the fee budget,” Mowll said. 

Zenith head of alternatives Daniel Liptak said the management expense ratio (MER) fee argument was flawed as it failed to cut across different strategies.  

“It’s very good if you’re building a car,” he said.  

“You know that the fueling price of the car is a certain amount and your profit is driven by the cost of inputs, so an MER type measure for widgets is perfect – but unfortunately for portfolios, it’s not necessarily the case.” 

He said for every dollar paid, an investor would receive approximately $1.96 back from a market neutral fund, compared to paying 7c extra on a long-only fund.  

“When there is an alpha subtraction, you actually end up in deficit with a long-only manager,” Liptak said. 

Ramsay said the 2/20 fee structure would not cut it in a MySuper low-cost world. He had started to see cut-off bands for a total MER on a diversified portfolio of under 1 per cent. 

“If they are happy that this particular product or asset class is going to pay its way, then they’ll accept  slightly higher fees but not that much,” he said.  

“You’re getting to the point where 2/20 is just not going to happen but 1/10 is if it’s something they’ve got conviction in – it’s a little bit more feasible.” 

But he said investors needed to be picky to avoid being ripped off. They should target the area where they have the best probability of finding managers with the highest information ratio. 

Gault said the danger in the trend towards low-cost and passive strategies was in the lack of active risk management. 

He said investors got what they paid for. 

“They just copy an index – there’s no downside protection,” he said. 

“I would just say buyer-beware because I would prefer to pay a higher fee for someone who can protect my downside so I have got capital for tomorrow.” 

De Pourbaix said regulations including MySuper were encouraging the move to passive, low-cost investment options which had far-reaching impacts on the industry. 

International hedge funds would be shut out of the Australian market.  

“You’re probably going to spend a good three years getting your message out and a lot of money – to be told your product is too expensive,” he said. 

A new risk? 

Post-GFC, product issuers have adapted to fit with what planners want, according to Stewart Gault. 

He said some managers had moved into hedge fund replication strategies which aimed to be liquid and kept costs down through replicating active hedge fund strategies. 

“What these funds seek to provide is daily liquidity and diversified exposure across multiple hedge fund-like strategies – be it directional or non-directional strategies in equities, fixed income, in commodities – but the underlying principles being that these things, if needed, can be liquid,” he said. 

But although they deployed liquid instruments like futures, options and swaps, Gault said they could not really guarantee liquidity. 

“They’re liquid when everything is good but if there’s a rush to the doors, they can’t guarantee it,” he said. 

Replication strategies could also reduce the potential for generating true alternative alpha, de Pourbaix said.  

“They are liquid but they tend to sit in the growth part of the portfolio and they’re not conservative,” he said.  

“They’re single-strategy hedge funds so you are exposed to those risks.”  

Ramsay said diversified alternatives, which often included replication strategies, were a bit more liquid and less esoteric than traditional hedge funds. 

Although there were better alternative opportunities, they were an investment that planners could articulate to clients because they reduced underlying investments from about 60 in the old fund of hedge funds to 10-20. 

According to Ramsay, the overarching risk with hedge fund replication strategies was the inherent conflict between the replication model and the aim of hedge fund investing. Hedge funds were a group of investments that resisted being quantified and replicated he said. 

“The whole point of hedge funds is they’re exploiting inefficiencies or risk premiums that the rest of the market have not caught on to or are not good at valuing,” he said. 

“By the time it becomes a hedge fund replication strategy, by definition the market has got its mind around it because you can replicate it.” 

Hedge fund replication strategies would remain popular, according to Ramsay, because they were cheap and liquid. 

Henry said investors were forgoing manager skill in trying to replicate liquidity with replication strategies and exchange-traded funds (ETFs). He compared them to the balanced fund 10 years ago. 

“What you had was a jack of all trades and master of none,” he said.  

“I think if you’re going to allocate a portfolio, give it to an expert in each area and rely on your researchers and experience to identify the people that are actually masters of their universe,” he said. 

Fit for purpose 

Allocations to alternatives need to change depending on the client’s risk profile, but on average the industry seems at odds about how much planners should designate to alternatives. 

Mowll warned that an alternatives allocation that was too small would not allow the asset class to act in the way it was designed to. 

“If you only put a tiny amount in, it doesn’t change the dials on what it’s meant to do in the portfolio,” he said 

Robertson said alternatives could be difficult to position within a portfolio as they were more complex – for example, cross-boundaries between equities and bonds and equities and cash. 

“It gets a bit murky and gets confusing as to where they should be placed,” he said. 

“The overall exposure should be limited to 10 percent of the portfolio so that you don’t get too much exposure to the idiosyncrasies of these things.” 

Robertson added that these included specific manager or strategy risk. 

Henry said 30 per cent of a portfolio should be invested across alternative asset classes. 

Some research houses have allocations of up to 30 per cent where even conservative clients have 20 per cent of their portfolio invested in alternatives, he said. 

“I think if you can find quality solutions, there’s no reason why you wouldn’t be at 30 and 40 per cent,” Henry said.  

Most clients had between 10-20 per cent allocated to alternatives, according to Ramsey. 

Mowll said alternative allocations needed to be blended according to the investor’s risk profile, but often hedge funds were misjudged as risky. 

“It’s actually there to reduce the overall risk of the portfolio to begin with,” he said. 

“Where the market gets it wrong is saying a really high risk appetite should be aligned to hedge funds. It’s actually an incorrect assumption because it’s meant to reduce volatility, it’s meant to be an allocation that doesn’t correlate to equities and fixed income, it’s mean to be something in your portfolio that compliments and balances out your portfolio,” he said.  

Henry said the independent planner community is ahead of the curve on portfolio construction. Planners were much more active with risk allocation profiles and talked about allocating to sectors they would have shied away from 12 months ago. 

“Risk used to be an academic concept – now it’s real,” he said. 

Alternatives didn’t fit into the cookie-cutter advice model, which meant independent planners were looking more meaningfully at portfolio construction as a way to differentiate their business model, according to Henry. 

“When you strip everything else away, the risk to a client now is drawing down on their capital and they’re really looking for an alternative to that and they want to see the evidence of it,” he said. 

Lifting the lid on hedge funds 

According to Henry, investors are demanding more information and want to know exactly what they are invested in. 

When the Australian Securities and Investments Commission’s (ASIC’s) Regulatory Guide 240 comes into play this June, disclosure of hedge funds will increase and investors will gain access to hedge funds’ underlying investments.  

“If anything my sense is that there will be less use of alternatives and not more,” Gault said. 

“But if the outcome is that advisers know the product and know their clients better, that’s great and we can leverage the pain of having to adjust our processes and everything else.”

Mowll said the regulations would help investors understand what they could invest into, but too much information could be overwhelming. 

It was important to strike a balance between information that could be used to make a decision and information that was too onerous to form a conclusion from. 

Liptak agreed. He said in 2006 and 2007, transparency was something investors longed for but rarely got, however now hedge fund disclosure could be “so good”, it was too much data to properly assess.  

Henry said there would be some fund managers that resisted the changes, some that were unprepared and some that struggled to implement changes because they could not afford to. 

“I think undoubtedly you’ll see some competitors disappear,” he said. 

Ramsay said incoming hedge fund regulations could also impact other areas of the investment world. Mainstream managers that adopted hedge fund-like strategies to manage risk could be snared by legislation that targeted speculative investments.  

“A relatively well-managed risk constrained portfolio can quickly end up with that 35 per cent in what is deemed to be hedge fund,” he said. 

“It does create a barrier and will ultimately stop people managing risk as they might have otherwise done.” 

Institutional investment leads the way 

Although Austrade found that high net worth individuals and retail accounted for 64 per cent of hedge fund assets in August 2011 and institutional 19 per cent, it may be that institutional investors will have to take the first plunge into unchartered territories as international product issuers struggle to jump through the hoops onto retail platforms, according to Gault. 

He said retail investors may gain access to more alternative investment options as international managers looked to tap into the trillion-dollar Australian superannuation market via big mandates. 

According to Russell Investments’ 2012 global survey on alternative investments, institutional investors allocate 22 per cent to alternative investments on average. The majority said they would keep current allocations steady while 12-32 per cent were considering increasing allocations over one to three years. 

Russell found over 63 per cent of super funds obtained customised hedge fund strategies, showing they are also able to leverage scale to bring down manager fees and negotiate mandate terms. 

Towers Watson said its institutional clients had increased alternative allocations by 70 per cent since 2010, and had reached $12 billion in alternative assets under management by the end of 2012. 

Its 2012 global alternatives survey found that funds’ allocation to alternatives had increased from 5 per cent to 20 per cent over the last 15 years, Towers Watson said. 

With only a comparable handful of managers to select from, institutional investors were more likely to award global alternatives mandates, according to de Pourbaix. 

Towers Watson found that globally North America was the largest destination for alternative capital at 48 per cent, while one third of assets were invested in Europe, one tenth in the Asia-Pacific and 5 per cent in the rest of the world. Although North America attracted the most capital overall, Europe topped the list for infrastructure, it said. 

Alternatives on the horizon 

In preparation for a hike in interest rates, some product developers are testing the waters in the fixed income space,  according to Gault. 

“Some of those traditional funds may face more difficult times in the future, but having a more flexible alternative strategy in fixed income allows some managers to take advantage of what everyone believes – that interest rates will go up again,” he said.

Robertson agreed.

“I think the whole thing about mitigating interest rate risk going forward – with more flexible fixed interest offerings where they can manage out the duration risk and so on – is certainly an area that’s been gaining traction,” he said.

According to Robertson, the diversified multi-sector funds where the manager had flexibility to move in and out of asset classes and incorporate alternative assets were also gaining traction – because they were a solution for advisers that provided an element of tactical allocation that was delegated to fund managers. 

Mowll said he believed event-driven investments would produce good results in the coming year. 

Distressed credit was a good opportunity, according to Mowll, who cited the good performance coming out of the Lehman Brothers liquidation of assets. 

He said merger and acquisition (M&A) activity would increase, which could lead a manager to gain performance out of the abitrage. 

Herbert Smith Freehills earlier this month said that emerging market M&A activity had performed well in the first quarter, which Liptak agreed with and said would increase in coming years. 

Emerging markets would outperform due to their relative economic growth, according to Liptak, who said investors could gain opportunities in less risky markets than equities.  

“There are opportunities just to take advantage of emerging markets’ currencies and debt and basically trade the capital flows in and out of emerging markets,” he said. 

Investors that had an illiquidity budget would do well to take a contrarian viewpoint, for example in private equity as opposed to cash, Liptak advised.

Although he believed the industry was somewhere in the midst of a credit bubble, it was not over yet and good opportunities existed in the asset backed security space.  

“There must be a lot of opportunities if you’re willing to provide cash for less liquid opportunities and something which generates good cash flow,” he said. 

Ramsay agreed that contrarian strategies would do well. 

“You’ve gone through a period where momentum hasn’t worked so if you have a break-out on either side then you could have a period where momentum-style strategies start working again,” he said. 

He said global macro was at an advantage because it did not go along the top; it did not matter whether markets broke on the upside or the downside.  

Henry said global macro and other thematic investment funds were popular with advisers as they could be explained to clients. They would continue to produce good results in 2013, he said. 

Hedge funds had an advantage in that the global economy was fragile and not suitable for long-only managers, according to Henry.