September 2011

ALTERNATIVES: A genuine alternative

AppleThere are signs that approaches to investing in alternatives are changing. Fiona Rintoul finds that some investors group long/short investment into a broader equity allocation. However, complexity dissuades other investors.
The credit crunch took its toll on alternative investments. Illiquid, risky and expensive, hedge funds and private equity in particular went out of favour as liquidity became prized and investors ran scared. Pension scheme assets invested in funds of hedge funds (FoHFs)  rose by 51% in 2007 – and fell by 20% in 2008. This is according to Towers Watson’s Global Alternatives Survey 2011 covering the top 100 alternative asset managers.  “The 33 FoHF managers that participated in the last five years are still recovering from an aggregate drop in assets during 2008,” Towers Watson says.  The situation for private equity funds was different. Prior to the 2008 financial crisis, private equity funds of funds (PEFoF) assets had risen by 38% in 2007. Flows held up in 2008, growing by 13%, and then fell by a not particularly sharp 0.4% in 2009.  In the meantime, assets have come back to hedge funds and private equity, though not as strongly as before (see box, right). But as institutional and other investors come back to alternative investments, the way in which they are investing in hedge funds in particular is changing.  The term ‘hedge fund’ has always been a hard one to define. It covers a multitude of sins, some of which – emerging-market debt, for example – have ceased to be seen as ‘alternative’ and have been pulled out into their own categories. In theory a hedge fund should hedge out risk and be nice and safe; in practice, however, we all know that some hedge funds have gobbled up risk like sweeties. The term ‘alternative’ too is open to interpretation. Andrew Cole, manager of the multi-asset fund at Baring Asset Management, warns against mistaking the use of leverage for an ‘alternative’ strategy.  “In terms of the alternative space, we are always sceptical about their claims, certainly when it comes to the use of leverage,” he says. “That’s not an alternative asset; that’s just gearing. We wouldn’t want to pay for just gearing.” Thus, in 2007 Barings looked around for an alternative that was not correlated and not leveraged and came up with gold. “No one had looked at it for the best part of 20 years,” says Cole. “In 2010, we sold some of our gold. The price had gone up a lot but as an alternative it had become more correlated with other risky assets. A month or so ago, we bought some back.” Partly because the hedge fund universe is such a broad church, a change is noticeable in how allocations to hedge funds are being perceived by investors. Instead of making an X% allocation to hedge funds, investors are in many cases allocating to hedge funds within asset classes.  The bigger picture
“We try to figure out what people are doing within their total portfolio and help them emphasise that objective through hedge funds,” says Morten Spenner, CEO of fund of hedge fund manager International Asset Management (IAM). “If they are conservative the exposure should enhance that or complement it.” Thus, some clients have a fairly low allocation to hedge funds because they don’t see it as an asset class. Instead within, say, a 60% equity allocation, they might choose to allocate a proportion to a long/short equity fund.  “Institutions that treat hedge funds as a separate allocation have 5-15%,” says Spenner. “Those that just use hedge funds for active management choose them a little bit more specifically. We’ll see more of that coming to the fore.” Similarly, Ashish Kapur, European head of institutional solutions at SEI, sees alternatives as part of his overall toolbox.  “We try to structure portfolios to minimise risk relative to liabilities. We see a number of alternatives as extensions of what we can do in the equity and bond space.”  At the same time, an alternative must offer something genuinely alternative. “There’s no point in having an alternative that behaves like an equity,” says Cole, at Barings. “Alternatives either have to be cheaper, or less risky, or less correlated.”  Because there is “an ongoing demand for asset classes that are not correlated”, Spenner says there is a broader array of strategies within FoHF products than there was four years ago.  “Post 2008, there was a lot of discussion around CTA [commodity trading advisers] managers because they decorrelate to traditional asset managers in times of stress. Institutions have got eyes up for that, and with everything that is going on in the world today people have been embracing notions around macro and within that commodities.” For Cole, however, the FoHF is “a breed that is slowly dying” with returns becoming more and more correlated and high fees and total expense ratios.  “We never had much and we have less now,” he says. “They are complex structures that are over-engineered. It’s difficult to see how they can grow materially from here.” Single-strategy hedge funds are a different matter – sometimes. “You are buying alpha and if you think you can get that on an ongoing basis very good, but you have to be choosy.”  At the moment, the focus for Kapur is on dealing with the fact that when Western economies come out of recession there will be interest rate rises and falling bond yields. That could involve moving to shorter duration bonds, high-yield bonds (which also tend to be shorter duration) or using strategic bond funds. Or it could involve alternative strategies.  Reflecting concerns about costs, the alternative strategies Kapur uses are sometimes cheaper alternatives to alternatives. Thus Kapur likes relative value trades, which involve buying one index and selling another.  “Hedge funds do provide diversification, but they tend to be more expensive,” he says. “Some of the relative value trades in the equity and bond space are cheaper.” Kapur also sees private equity as expensive – and of course it requires a long lock-in. “A lot of pension funds that want to diversify are looking at different kinds of solutions,” he says. “We have started to look at structured products – swap-based solutions and option-based solutions – to help clients.”  Spenner, meanwhile, calls to mind a recent information release from Calpers, which showed the US pension fund’s private equity returns and losses cancelling each other out. “People who quite like hedge funds also historically have liked private equity, but it’s really important that you understand what’s going on,” he says. “Hedge funds, even if we take simple indices, have been able to do better.”  Returns among the wreckage
Private equity funds will no doubt dispute this. Listed Private Equity Group (LPEQ), a group of European listed private equity companies, suggests that although private equity ranks fourth among alternative investment allocations by high-net-worth investors, it is also the only alternative asset class they think will provide high returns. Accordingly, half of respondents to the LPEQ survey anticipate increasing their allocation to private equity.  However, Cole believes private equity is still in the part of the cycle where there is a lot of wreckage. At the moment, he is therefore mainly interested in the type of managers “who pick over the wreckage like vultures”. The future, however, will be different. Banks will not be providers of liquidity in the next round of economic expansion, and other conduits will be needed to transfer long-term capital to businesses. “The next private equity round will not be down to financial engineering and leverage,” Cole says, “but to an environment where private equity is about expertise and driving growth and productivity.”  Allocation to alternatives is evolving. The shock of 2008 underlined the purpose of assets not correlated with equities and bonds, but it also introduced an element of fear that sometimes pushes investors away from the assets that might provide that.  Just as there is no return without risk, you can’t have alternative assets that are non-correlated and just the same as mainstream assets. Thus, listed private equity avoids the lock-in problems of private partnerships, but is it not then very similar to equity?  For similar reasons, Cole suggests that Ucits III hedge funds are a bit of a waste of time. Capturing illiquidity premia is what differentiates hedge funds from other market strategies, he says. If you try to circumvent that the fund loses its difference.  “You can see why everyone will go down the Ucits III route,” he says, “but the consequence in returns will be disappointing.”  ©2011 funds europe

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