Why alternative investments could be a hot ticket option in 2014

Retail advisers have traditionally shied away from alternative investments, but an upswing in the market could see them become a hot ticket option in 2014, particularly for HNW investors, Janine Mace reports.  

What do the Perth Airport, equity long-short funds, gold and management buy-outs all have in common? 

Very little, but that doesn’t stop them all falling under the broad heading of alternative investments.  

In Australia, it’s an asset class that continues to generate limited interest among retail investors and advisers. But if you take a look at the portfolio of big institutional investors around the globe, it’s a very different story.   

Large pension and superannuation funds have been big investors for years.

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According to Industry Super Australia, 21 per cent of industry super fund assets are invested in ports, roads, electricity generation, unlisted property and other alternative assets.  

Despite this enthusiasm, retail investors remain keener on managed funds based on more traditional assets. 

According to Morningstar’s December 2013 Australian Asset Flows publication, only 3.1 per cent of assets in the managed funds industry were invested outside the main asset classes of equity, fixed interest, property and cash. This was down from 3.6 per cent six months earlier. 

As Lonsec Research senior investment analyst, Stewart Gault, explains: “Alternatives remain a small market as they are still only a couple of per cent of the total investment market.” 

Despite their larger asset base, self-managed superannuation fund (SMSF) investors also remain unenthusiastic about allocating to alternatives.

According to the February 2014 study by SPAA and Russell Investments, ‘Intimate with Self-Managed Superannuation’, only 3 per cent of SMSF portfolios are allocated to alternative assets. 

Appeal for HNW investors 

This contrasts with the picture internationally, where high net worth (HNW) investors are quite keen on the asset class.

According to the Capgemini RBC World Wealth Report 2013, global asset allocations among HNW investors are 10.1 per cent to alternative investments and 20 per cent to real estate, compared to 8.4 per cent for alternatives in Australia and 40.6 per cent to real estate. 

Ibbotson & Associates head of hedge funds, Craig Stanford, is unsurprised by the strong allocations among international HNW investors to alternatives. 

“We are seeing higher interest by HNW and ultra-HNW investors in alternative assets. They are investing money and like alternative investments if they are done properly,” he says. 

“At present, the interest in alternative investments is due largely to the high valuations in the bond and equity markets, and also global concerns such as the Ukraine, which make people uncomfortable about investing in fully priced markets. They are also investing as they like the way a well-constructed alternatives portfolio can behave.” 

While ordinary retail investors remain wary of investments labelled as alternative, many are exposed unknowingly to these assets through other vehicles such as multi-asset and superannuation funds, notes Stanford. 

Big investors believe these mostly non-listed sectors have an important role to play in a well-constructed portfolio and so are continuing to direct assets into them. 

“It is interesting that multi-manager multi-asset funds offered by managers such as OnePath, Mercer and Advance have increased their allocation to alternatives over the past couple of years,” Gault says. 

Simplicity appeals  

Despite acceptance of the value of alternative investments by larger investors, the opinion of smaller retail investors and advisers seems still to be coloured by a desire for simplicity when it comes to investments.

(However, memories of the liquidity problems and redemption gates imposed by some hedge fund-of-funds during the GFC doesn’t help.) 

Stanford believes advisers recognise the investment case for these assets, but remain wary of making allocations to them. “Most advisers can see the benefit of ‘proper’ alternative investments, but some of the alternatives that were used pre-GFC put them off these assets.” 

Gault agrees memories of the GFC-induced problems experienced with some alternative investments still linger. “Alternatives have borne the brunt of investor sentiment since the GFC, and in some cases, justifiably so.” 

Although there have been major improvements in transparency and liquidity across the alternatives industry, sentiment among retail investors towards these assets remains weak, with clients remaining shy of anything unusual or complex.  

“The client drives what advisers do. Most people want what they can understand and what seems secure as an investment,” explains Ross Johnston, head of financial planning at Australian Unity. 

“In the wake of the GFC, clients want simple and boring and are much more wary about anything that is complex or hard to understand.

"My rule is to keep it simple and that’s what 95 per cent of people want from their advisers. Introducing alternative investments can scare clients off.” 

This is particularly the case when advisers are servicing retirees.

“Sixty per cent of our client base is retired and for them, they want things that are simple and pretty boring, so we keep it fairly basic,” Johnston notes. 

He dismisses claims alternative investments are unpopular in the retail market due to a lack of liquidity or an inappropriate industry structure.

“It is not problems with getting them on platforms or the lack of liquidity. If people are not using them it is because clients want to keep things simple.” 

The strong performance by equity markets in the past year is another handicap alternatives are having difficulty overcoming. 

“While equity markets are performing strongly, it’s less likely financial planners will allocate to alternatives. I guess when the rally ends, people might think about diversifying their portfolios,” Gault notes. 

Just what is alternative? 

Even if there is a shift towards diversification, the research required to get under the bonnet of many alternative assets makes them less appealing to many advisers.  

“Interest in alternatives is very adviser- and client-specific. These products require more time and effort to understand,” Gault explains. 

Selling clients on the investment case for alternative assets is also hard going. 

“There are problems in explaining how these assets work to many clients. You can explain them on a conceptual level, but it is hard once you get into the actual assets,” Stanford admits. 

This is further complicated by the lack of clear labelling, as the term ‘alternative’ is often slapped on any asset outside shares, fixed interest and cash. (Internationally, property is viewed as an alternative asset, but in Australia it is classed as a mainstream asset.)  

Alternatives can be divided further into alternative strategies (such as hedge and absolute return funds) and alternative assets (such as unlisted infrastructure and commodities), each of which have different return drivers.  

“We think about ‘proper’ alternative investments as assets that must produce a return stream that is not highly correlated to bond or equity markets. A lot of investments labelled as alternative investments require markets to go up for them to benefit,” Stanford says. 

The reluctance of many retail investors to embrace alternative assets such as infrastructure is due to problems around labelling, access and packaging, according to AMP Capital’s head of infrastructure Paul Foster.  

Prior to the GFC, most retail investors accessed infrastructure assets through listed vehicles and most of these dropped sharply during the crisis, leaving clients badly burnt by the experience.  

“The lesson from this was that while the underlying asset is infrastructure or property, when you buy it through a listed vehicle, you are exposed to equity market beta and this has an impact on both listed infrastructure and listed property returns,” he notes. 

“This contrasted with institutional investors, as they held it in unlisted vehicles and it performed as it was supposed to and insulated their portfolio.” 

In light of this, companies like AMP Capital are currently trying to woo retail investors back into alternatives through new investment vehicles designed to provide a smoother ride than some of the old listed structures. 

“We don’t think retail investors are frustrated with these assets, but with the problems around the deficiencies in how they are packaged for this market,” Foster says. 

This also extends to the SMSF market, he notes. “It seems odd that the SMSF sector has been a non-participant and bystander since the GFC in this sector. We are focusing on how to deliver infrastructure characteristics to the SMSF market.” 

According to Foster, the response to new ways of accessing infrastructure assets has been good so far, with interest in the sector picking up.

“We are seeing a lot of engagement and interest in infrastructure by the retail market, but it is still focussed on how to do it, due to the large scale, capital-intensive requirement of these assets.” 

Hedge fund holding pattern 

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Although alternatives like infrastructure may be garnering fresh attention, the hedge fund industry appears to be maturing, rather than growing strongly. 

According to ASIC research, in 2013 there were 603 active single-strategy hedge funds and fund-of-hedge funds operating in Australia. This number has been fairly stable over the past couple of years, with only 11 new fund launches recorded in 2012, down from the peak of 75 new funds in 2006.  

While performance between the different hedge fund strategies varied markedly in the past 12 months (see table), many of the results came courtesy of the strengthening equity markets. The big winners have been equity market-linked hedge fund strategies such as equity 130/30 and equity long/short funds.  

In contrast, hedge funds focusing on currency or commodities have given their investors a rough ride. According to Stanford, this is likely to be reflected in the inflows for these types of alternative strategies.  

“A lot of investors are momentum-driven and recent performance influences their allocation, so you would expect to see this reflected in flows. \

"Macro and CTA strategies have had a very difficult time and so probably have had negative flows, but direct equities and credit strategies have done well, so inflows have probably increased,” he says. 

“This is not what we are doing, however, as we are taking a contrarian approach. When capital is chasing an asset, there are usually better opportunities elsewhere.”  

Stanford believes hedge funds seeking to capitalise on the continuing European problems and the turmoil in emerging markets are more attractive investments and could be worth considering. 

He believes there are still many attractive areas when it comes to absolute return funds.

“For example, we are allocating to hedge funds that include Australian shares without directional exposure and taking some European credit market exposure. We are looking for areas of opportunity, but it must be specific.” 

In Gault’s view, the high correlation between asset classes over recent years has meant there have been less opportunities for alternative investment managers to exploit and produce sizeable returns. 

“In a number of funds, particularly quantitative strategies, the realised risk was considerably lower than the target risk. While we appreciate the risk management side of the equation, most funds struggled to deliver investors their target returns.” 

Investors remain wary 

Although there may be good opportunities on offer, from an adviser perspective hedge funds still remain a no-go area for most clients due to their complexity and performance. 

As Chris Gosselin, CEO of hedge fund research firm, Australian Fund Monitors, explained to Money Management late last year: “The perception of hedge funds by advisers and the public is not good and it is often hurt by the performance of just one or two funds.  

“There is no such thing as a typical hedge fund and this makes analysing them and putting them in a single bucket dangerous. Funds that do well in one type of market can under-perform in a different type of market.” 

Johnston believes retail investors are yet to forgive hedge funds for their perceived performance faults during the GFC. “When it comes to hedge funds, people are comfortable with things like Platinum, but not hedge funds generally.” 

While smaller retail investors may remain wary of hedge funds, Stanford believes HNW investors are more sanguine. 

“A lot of investors were quite pleased with the performance of hedge funds during the GFC, as often they declined less than equity markets fell. HNW investors are always looking for downside protection and portfolio protection, so they have always been keen on hedge funds.” 

He believes advisers should look more closely at the benefits hedge funds can provide. “Advisers are always keen on portfolio diversification benefits and so hedge funds should be attractive to them.” 

Clients and advisers need to recognise the hedge fund landscape has changed over the years.

“When they started, hedge funds were much more about return and taking large concentrated bets. Today we see almost the ‘institutionalisation’ of hedge fund markets. Hedge fund managers don’t want big down months, so they need to constrain the risk and the return potential is less,” Stanford notes. 

“You will now get more diversification even if that is not what you are looking for due to the changed nature of the hedge fund market. A lot of flows are going to the big funds due to their institutionalised framework and risk management emphasis.” 

Looking good 

Those investors interested in adding alternative assets to their portfolio are finding markets fairly buoyant.  

“The search for yield is pushing up the price of most assets and alternative investments are definitely not immune from that,” Stanford notes. 

“A lot of infrastructure assets look expensive and the same goes for private equity, so we are not allocating more money into these areas at the moment. Even insurance-linked securities are being bid up, so we are reducing our allocation to these assets, as relatively speaking, they are expensive at the moment.” 

For some asset sectors, the level of deal flow has started picking up strongly.  

While the outlook for alternative assets generally is positive, the Australian private equity market in particular is having a great year.

The value of locally-based private equity deals in the 2014 financial year to date has already surpassed the total value of deals completed in the previous year. 

According to Dr Kar Mei Tang, head of research at the Australian Private Equity and Venture Capital Association (AVCAL), the local market is in a good space as it comes off a number of sombre years following the GFC.  

“Average fund size has grown considerably, from $116 million in the period FY04 to FY08 inclusive, to $230 million in the period FY09 to FY13 for growth funds,” he told the AVCJ Forum in Sydney recently.  

Attractive pricing is likely to encourage an increasing supply of alternative assets to appear on the market over the next few years.  

“There will be a lot more high quality deal flows and assets will be increasingly available as governments address their infrastructure backlog. So we will be seeing increasing opportunities for private investors to become involved,” Foster notes. 

“Every major state government intends to privatise and monetise its assets, so lots of market opportunities are coming. And not just in greenfield projects, but also in mature brownfields assets. This is a pretty interesting time to try and open up infrastructure assets to the SMSF market.” 

He believes new investment vehicles that package together various infrastructure assets to provide liquidity and protection from equity market beta will be very appealing to retail investors.  

Funds targeted at different types of investor requirements – such as growth and income – are also likely to appear.

This could see social infrastructure assets such as schools and hospitals being packaged up and offered to investors looking for stable income streams, while assets like airports – which require more reinvestment and therefore have a lower running yield – could be offered as growth vehicles. 

“Operating brownfield assets tend to have quite a high yield for those seeking income,” Foster notes.