Magazine Issues » July-August 2019

Multi-asset investing: Illiquidity is the new price to pay

LionMulti-asset funds are evolving but require investors to become comfortable with illiquidity. Fiona Rintoul looks at what sort of assets fund managers and investors are seeking.

Multi-asset portfolios are diversified by nature. Including alternative investments in the mix can bring additional diversification, though there is often a price to pay in terms of liquidity.

Enthusiasm for diversification into alternatives tends to be determined by investors’ views on the future trajectory of the traditional – and pleasantly liquid – bond and equity markets.

“We speak to clients whose alternatives allocation ranges from a few percent up to nearly 50%,” says Chris Teschmacher, multi-asset fund manager at Legal & General Investment Management. “Those at the top end typically have quite a bearish outlook for either traditional fixed income or on equities, given their view on the economic cycle.”

Right now, investors find themselves in a particularly excruciating kind of bind, as they try to make that call. Yields are low and likely to stay that way, as central banks pull back from normalising monetary policy. Because of or despite that (depending on your view), many are anticipating the end of the bull market. But the end does not come.

As a result, those who run multi-asset portfolios are looking for strategies or managers that can provide a buffer if the market goes down, but without taking away too much of the upside if the market continues to go up. As multi-asset portfolios tend to be measured against long-only benchmarks, the latter part of the equation is important.

“If you’re massively underperforming, that’s not great, but you also realise that the way to outperform long-term is by limiting your drawdowns,” says Patrick Ghali, managing partner at Sussex Partners.

Dealing with the weirdness of the current situation is leading investors into all kinds of alternative investment silos. This is not wholly new. In many ways, it dates back more than ten years, to the day Lehman Brothers blew up.

“Pre-financial crisis, the alternatives bucket consisted mainly of investments in liquid hedge fund strategies,” says Maurice Harari, senior portfolio manager at SYZ Asset Management. “Since then, the environment has evolved a lot, primarily with the heavy intervention of central banks distorting asset prices and making life more difficult for macro players.”

In recent times, distorted asset prices have been joined by a febrile political environment, even in normally stable developed markets. These twin monsters make necessary new solutions that can help protect investors’ long-term returns.

“Our alternative allocation aims to be ballast in our portfolios,” says Christopher Mahon, director of asset allocation research in Barings’ multi-asset group. “We look for areas that should plot their own course and whose price is unrelated to the latest tweet from Trump or the next Federal Open Market Committee meeting, and where there is a reason to expect appreciation over many years.”

What does that ballast look like? For Barings, classic areas have been aircraft leasing, physical property and discount plays in the closed-ended universe. Recently, the company has moved into green infrastructure investments.

“So far they have been delivering the steady returns that characterise our alternatives,” says Mahon.

SYZ Asset Management also targets aircraft, along with investments in the music industry, pharmaceutical royalties, real estate and shipping. These form the yielding component of a bucket of diversified and partially uncorrelated assets that also includes commodities – mainly gold – and alternative strategies such as private equity and equity market-neutral funds. The yielding component is the largest and requires compromise.

“To capture yield, you have to pay the price in terms of liquidity, given these investments – most often closed-end funds or investment companies – have a longer maturity profile due to the assets they own or manage,” says Harari.

Bond alternatives
And it is the search for yield that lies partly behind the current drive for greater diversification in multi-asset portfolios. Traditionally, bonds have been a diversifier within multi-asset portfolios, says Eric Tazé-Bernard, chief allocation adviser at Amundi. That remains the case in the sense that they still play a safe-haven role, but they do not provide the yield that investors want, particularly in Europe.

“They have to look for other sources of yield, and this is why we see an increasing interest in including some forms of private debt as a substitute in particular for high yield and credit within euro markets,” he says.

Real estate and infrastructure can be another solution to the yield conundrum, claims Eric Wohleber, head of real and alternative assets sales, also at Amundi. A tenanted commercial property, for example, looks like fixed income because investors receive immediate yield in the form of rent.

“It’s a typical mixed asset,” says Tazé-Bernard. “There are some fixed income rates and stability, and there is some equity sensitivity, because the development of real estate prices depends on economic growth.”

Private equity is another diversifier that can play multiple roles. It gives access to different types of companies, different sectors and different maturities, but it can also be combined with public equity in a thematic approach, for example in an institutional mandate. Wohleber also notes that some private equity firms invest in logistics or opportunistic real estate projects, providing a way of investing in such projects before they are complete.

“The border between public and private equity is not clear, and the border between private equity and real assets is not strict,” he says.

The issue with investments such as real estate, private equity and private debt is, of course, liquidity. Strategies that provide diversification and maintain liquidity may sound like the Holy Grail, but some providers see ways of squaring the circle.

“Another option for a diversifying approach over the mid-term is to build an exposure to equities that can perform in a broader range of scenarios,” says Edouard Laurent-Bellue, head of fund solutions at La Française Group’s asset manager, LFIS. “For example, using simple derivatives strategies like put-selling allows for performance in stable as well as rising markets, and remains very liquid when implemented on major equity indices.”

A varied diet
In fact Ghali at Sussex Partners, an investment advisory firm, sees investors bifurcating when it comes to liquidity. “We’ve seen people looking at more illiquid investments, such as direct lending, and a lot of money has been flowing into these strategies, but some investors have gone very liquid,” he says.

There can be no doubt that liquidity is a concern for many investors. Portion control in a varied diet is one way to manage this risk. “The size of holdings in less liquid assets should reflect the risk that the size could inflate under stressed conditions for the fund,” says Teschmacher. “Managers should be cognisant and comfortable with potential size these holdings may represent under those stressed conditions.”

For private assets, another way to mitigate liquidity risk is by diversifying across vintages, such that there are intervals of liquidity. “This is a nice way to manage illiquidity in line with your liabilities,” says Tazé-Bernard.

But some investors just don’t want that kind of liquidity risk. For those investors, Luc Dumontier, head of factor investing at LFIS, claims that alternative risk premia approaches can provide a solution.

“Here, rather than investing in asset classes, portfolios are comprised of various premia strategies which combine long and short positions across asset classes to capture structural market premia linked to investor behaviour and/or constraints,” he says.

Alternative risk premia strategies rely on the concept that certain risks such as value, carry and momentum are compensated over time and deliver returns. However, they carry their own risks. In a value strategy, the investor buys assets that appear to have cheap valuations and sells assets that appear to have expensive valuations, in the expectation that the valuation gap will narrow, explains Teschmacher. The risk is that the cheap assets are cheap for a reason and the expensive assets grow, fulfilling the promise of their valuations.

“If this is the case, the risk is not rewarded, but research suggests that a value strategy like this can perform in different market regimes, therefore improving performance,” says Teschmacher.

There is also a view that liquidity risk is something investors just need to get used to – and something that is not a binary concept. Tazé-Bernard cites the example of high yield, which is supposed to be a liquid asset class but isn’t always. “We know that in difficult market circumstances, you cannot get rid of your high yield exposure except with a very strong discount,” he says.

By contrast, some private assets offer selling windows, for example on a quarterly basis, and so they do include some elements of liquidity. In the end, the most important thing is that investors know what they’re buying.

“Where it is dangerous is when people are being offered something that should be very illiquid in a liquid format,” says Ghali.

Opposition
In order to avoid that, it may be time to reassess the kinds of investment vehicles we use. Wohleber reminds us that alternative funds in Europe are not eligible under Europe’s Ucits regulations for funds sold to the public. An opposition exists, therefore, between the need to diversify into alternatives and the ability to do so. And too often, the answer to the liquidity question has been to create “liquid illiquids” such as Ucits hedge funds and real estate investment trusts.

“Liquidity is the new price we have to pay in asset management,” says Wohleber, who suggests that “we could reinvent multi-asset” with a vehicle such as the European Long-Term Savings Fund.

©2019 funds europe