Fears over public markets add to alternatives’ appeal

Talk of an inevitable correction in equity markets and the continued low yields in fixed income have made alternative assets increasingly appealing to those investors able to gain access and stomach illiquidity. 

Disillusionment with traditional asset classes and products has been pushing an increasing number of investors to use alternatives as a way to help dampen portfolio volatility and generate a steady stream of returns, says Brooks Ritchey, senior managing director and head of portfolio construction at K2 Advisors, part of Franklin Templeton Investments.

He highlights the increasing adoption of alternative credit products, driven by challenges posed to long-only fixed income strategies in such a low interest rate environment. 

“Alternative strategies have been seen by some as more precise tools for delivering the outcomes many investors want. For example, real estate and infrastructure can provide inflation-protected income, and hedge funds can help manage volatility.”

Indeed, he reports that some of the more sophisticated institutions have been abandoning traditional asset class definitions and instead embracing risk factor-based methodologies, a trend that repositions alternatives from a niche to a central part of  portfolios.

Private equity is one area of the alternatives universe which is seeing huge interest, but the high investments required and the need to lock up capital for extended periods mean it is not suitable for everyone. 

Investment office Capital Generation Partners uses private equity as a source of return in portfolios where volatility can be absorbed over the long term, and the firm discusses investing in the asset class when they first take a client on, says founder Charlotte Thorne. 

“Sometimes the clients already know they want private equity and will outline this to us in their investment objectives. For others it’s a lengthier process to get comfortable with the timescales required.”

Different clients view private equity in different ways, she reports. Those with a family heritage of business ownership tend to understand that mindset of business ownership, so there is often an overlap with the family’s own sense of identity. Entrepreneurs come from a slightly different perspective. 

“Their interest in private equity is that they tend to be more comfortable with the notion of evaluating and absorbing volatility and this means they are open to certain types of private equity investing which might not appeal to a more cautious investor.”

There are a number of ways to gain access, each with their pros and cons, but getting it right is vital. “Private equity, of all the asset classes, shows the biggest dispersion between the best and the worst performers,” says Ms Thorne. “It is therefore a manager selection task, not a product sale.”

Club deals, where investors pool together, are more talked about than actually put into practice by investors, she says, as private equity transactions require clear and swift decision-making, which these structures make difficult. Direct investments give the investor more control but can pose too great a burden in terms of management capability and cash requirements on individual investors, who struggle to compete with the funds and tend to make suboptimal investment decisions.

“Although clients are often wary of private equity funds because they have been sold some below par funds in the past, they are built to square this circle,” explains Ms Thorne. “But this does come at a price, not only in terms of fees but also in terms of the restrictions of the fund lifecycle.  Furthermore, access to the best funds is difficult to achieve. Private equity relationships are built over the long term and work best for professional investors.”

There has definitely been a shift towards increasing retail and wealth management participation in private equity in recent years, reports Richard Hickman, director of Investment and Operations for HarbourVest Global Private Equity, and there is clear potential for further growth. 

“Private equity is a truly actively-managed asset class, with managers able to utilise a wealth of information both before and during the investment period,” he says. “This knowledge advantage can help private equity managers to understand a company, improve it, and create value. Listed private equity is one of the few ways smaller investors can tap into this.”

The pace of fundraising in recent years demonstrates the growing popularity of private equity, but also means there is sometimes a surplus of capital chasing certain deals, which tends to push prices up. The industry is responding, he explains, by broadening its reach, and the opportunity set on a global basis is “enormous” if you get the approach right. 

“But the key to successful private equity investing is putting capital to work continuously through the cycle – attempting to time the market in such a long-term asset class is perhaps best avoided,” warns Mr Hickman.

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One trend pushing investors towards private markets is the fact many private companies are choosing not to list themselves on public markets. One reason for this is the increasing regulatory burden public companies face, says David Bellamy, chief executive at St James’s Place Wealth Management. “The governance and regulation that goes with being public is getting ever more onerous; the pendulum has swung too far.”

So it is necessary for wealth managers to provide their clients with ways of gaining access to these private companies. “We are definitely looking to put structures around private equity to make it available. It is not straightforward, but it is possible to get into that marketplace in a way in which you can offer it to the retail market.”

The big technology companies are staying private for longer and anyone overlooking them will miss out in the long run, says Marc Posso, portfolio manager at Man Capital.

The popularity of private markets stems from concerns that public markets could be about to crash, he says, although he does not foresee that happening. “Rather, we see companies exhibiting huge growth potential but which aren’t yet ready for the public markets. These companies are lured by the better risk-return profiles on offer if they partner instead with pools of capital such as private equity.”

Alternatives are not for everyone, he warns, but the level of innovation happening in California, Europe and increasingly Asia, means there are plenty of investment opportunities on offer for sophisticated investors ready to be locked in for 10 years or more.

Many of these opportunities remain the preserve of institutional investors however, says Charu Lahiri, investment manager and head of alternatives research multi-asset manager Heartwood Investment Management. Alternatives have always been a core part of Heartwood’s strategic asset allocation, she explains, but when investing through fund structures there are certain barriers in terms of what you can and cannot invest in. 

“A lot of the true alpha opportunities in the alternatives space were structurally not available to us because of liquidity or operational issues, not because there was anything fundamentally wrong with them, rather there were issues in holding them in the structures we run.”

In response, the firm set up an investment company, the Heartwood Alternatives Fund, which its multi-asset portfolios can make an allocations to, and which can then invest into a whole range of alternatives that would otherwise not be available to its clients.

The vast majority of the assets that are currently in the fund are allocations from Heartwood’s multi-asset portfolios, but Ms Lahiri reports there has been interest from some of its larger, more sophisticated clients, in potentially holding this as a standalone.

The firm views alternatives as diversifiers. “Our selection criteria is heavily skewed towards that,” she says. “If you want volatility, if you want equity-like risk and return, there are cheaper and easier ways to get that.”

Clients are definitely expressing increased interest in alternatives, reports Nicolas Campiche, CEO of Pictet Alternative Advisors, as they have low expectations of returns in traditional asset classes, see the high valuations in equities and are wary of a bond market that presents more risk than upside.

“That is pushing investors to look elsewhere and alternatives are at the receiving end.  We think expected returns in alternatives, broadly speaking, are higher than in traditional asset classes.”

Pictet’s clients might have a maximum allocation to alternatives of around 45-50 per cent of their portfolios, he reports, and of that 15-20 per cent might be in hedge funds, 15 per cent in private equity and 10 per cent in real estate. They are looking for both diversification benefits and returns, says Mr Campiche, though not all alternatives will provide the two. 

“Real estate is both diversifying and can also be an alternate source of income,” says Mr Campiche, who particularly likes the logistics end of the European real estate market.

Those seeking diversification should be aware that private equity can be closely correlated to stockmarkets, he warns, but investors can collect an illiquidity premium. In addition, the ability of a private equity manager to help transform a company is also worth considering, adds Mr Campiche. 

“There is a real expertise now within a number of private equity firms to help companies transform, and that is your downside protection.”

Prices in private equity might be high, he admits, particularly in the large buyout transactions in the US, but that does not mean there are not opportunities worth exploring. “Outside those large transactions there are still some very attractive opportunities.”

Key offering

Wealthy individuals expect private banks to be able to provide them with access to alternatives, says Gavin Rankin, head of managed investments at Citi Private Bank. “Given the ultra high net worth nature of our client base, which typically has a decent degree of liquidity and a tolerance for illiquidity, the ability to access alternatives is a fundamental part of why they come to us. So it is important in terms of asset allocation, but also in terms of our ongoing engagement with clients.”

There is a growing trend for clients to barbell their portfolios, he reports, for example by using low cost ETFs to provide market beta in public markets, and then finding alpha through private investments, where there is a greater chance of generating returns through manager skill.

There has been an increase in assets flowing into illiquid investments, particularly private equity and real estate, adds Mr Rankin, though hedge funds are still suffering from the bad press they received following the financial crisis. “Hedge funds got a bit of bad stick in the credit crisis. Many real estate investments performed badly as well. A lot of private equity also underperformed. But they managed to escape the tarnishing that hedge funds found it harder to brush off.”

Private equity and real estate may have suffered following the crisis, but they recovered and have since performed strongly, whereas hedge funds have suffered primarily because a lack of volatility in markets, he says.

It is not rare to find clients with 20 per cent of their portfolio in private equity and real estate, says Mr Rankin, but allocations to hedge funds have fallen significantly. “You would have found 15 or 20 per cent in portfolios even five, seven years ago. Today that is going to be low single digits.” 

Some of that money has flowed into other alternatives, he says, and some into public markets, but he does think there is an opportunity for hedge funds to reclaim some of those assets, though this will be a gradual shift in conjunction with a broader change in how markets are performing.

And hedge funds have had a better year in 2017, in contrast to 2016, which saw outflows totalling $70bn, the worst since 2009, according to Ken Heinz, president of Hedge Fund Research. “The outflows have stopped and inflows are small, but there. And assets are at record highs,” he says.

There has been such an extended cycle of positive performance in equity markets that investors are now looking to adapt their exposure, explains Mr Heinz. “I think investors want to continue to participate in the equity gains, but also to have a little bit more downside protection.”

Meanwhile the pressure on hedge funds to reduce their fees continues, he says, with institutions always looking to reduce their costs.

“Pricing structures are very important, and increasingly so because returns have become compressed,” agrees Mr Campiche at Pictet AA, which has launched an internal initiative it calls ‘value for money’.“We want to see managers taking action on their costs and are actively negotiating with them.”

Private banks are displaying a renewed interest in this sector, claims Patrick Ghali, managing partner and co-founder of hedge fund advisers Sussex Partners, as they look to protect their clients in the event of an equity sell-off while alternative credit strategies also appeal . “A lot of the funds had focused on pensions over the last few years, but interest has now shifted to what is a more natural client base for hedge funds.”

But alternatives providers will have to work hard to keep hold of these new sources of assets, warns Amin Rajan, CEO of Create-Research. “HNWIs are showing renewed interest in hedge funds and private equity. But in the light of past losses, they have become ultra demanding about performance and fees. It’s not business as usual.”  

VIEW FROM MORNINGSTAR: Booming stockmarkets put alternatives’ returns in shade

The largest euro alternative strategy funds have delivered better performance during the past 12 months than in 2016, although returns may still appear disappointing in a historical context and against a background of strong equity market returns. 

However, since we are looking for these funds to show low correlation and hence the potential to bring diversification to investors’ portfolios, it is not surprising that they have not kept up with equity market returns during a strong bull run. In a longer term context, negative euro rates during the past 12 months have been a headwind for alternative strategies that often make significant use of derivatives backed by collateral deposit. That deposit incurs a cost when rates are negative versus being a source of return when they are meaningfully positive.

One fund that stands out for its exceptional performance is JPM Global Macro Opportunities. After a difficult 2016, the managers of this fund switched from a theme of lower for longer growth and inflation to a view of cyclical recovery. In keeping with this, they have shifted the portfolio away from alternative strategies to traditional assets (with a bias to cyclical equities and removing all government bonds) pushing up beta to over 60 per cent. 

Additionally, during the year they have become more positive on Asia and emerging markets led by China, and have introduced a new theme about the growing use of technology, which has been a strong driver of returns, helped also by the managers’ stock selection here.

The managers of Insight Broad Opportunities also aim to manage the portfolio’s beta through its mix of alternative and traditional assets, and have generally benefited from having a bit more of the latter, also based on a view of continued cyclical recovery.

Based on the story told by fund flows (continued shift into multi-asset alternatives), investors generally seem to have looked through disappointing returns in 2016 from alternative strategies and the better returns on offer from equities during the past 12 months. SLI’s GARS has been an exception, with outflows from the middle of 2016. Very disappointing performance in 2016 might have been a factor, but there are other issues including capacity management. That said, outflows have reduced our concern on capacity and performance has recovered this year.         

Randal Goldsmith, senior analyst, Manager Research at Morningstar