Recent correlations in the global equity markets and among various asset classes have heightened the need to search for truly uncorrelated investment to mitigate systematic risk. However, such investment is rare since globalisation and crossover trading strategies have blurred the lines. Yet a new hedge fund strategy - asset-based lending (ABL) has emerged and drawn a lot of attention from investors looking to build a diversified portfolio.

ABL funds commonly demonstrate the characteristics of high single-digit to low double-digit annual return with very low single-digit volatility, and with virtually no drawdown. In terms of risk measurements such as the Sharpe and Sortino ratios, they offer terrific risk-adjusted returns to investors. But as a new emerging asset class, most of the funds do not have a long performance history. And people tend to believe any potential loan impairment problem would make ABL funds behave, to some degree, like most other fixed income or credit investment: negatively skewed with large fat tails.

As a result, most investors tend to invest in ABL funds that have a diversified loan book. When there are more loans in a portfolio, in case of impairment in any loan, the impact should be largely reduced. With the same logic, ABL funds of funds with exposure to more individually managed ABL funds will provide investors with more diversification and thus much safer investment. Therefore, investing in ABL funds of funds with diversified loan books and diversified collateral would protect investors' principal and achieve stable returns.

ABL funds are usually categorised by their underlying collateral exposure. They can be involved in accounts receivable finance, trade finance, inventory finance, real estate finance, entertainment assets finance, insurance premium finance, transportation assets finance, other specialty finance and multi-assets finance. The categorisation can go deeper within the above categories: real estate finance includes two sub-categories - residential and commercial. And commercial real estate finance can be further categorised as offices, retail, warehouses, industrial properties and resorts among others.

ABL funds can also be categorised by the tangibility of the underlying collateral. Examples of hard and tangible assets would be real estate, aircraft, commodities and examples of non-fixed, intangible assets would be account receivables, royalties, insurance and other future cash flows.

Proper and detailed categorisation of underlying collateral can improve the monitoring and evaluation of aggregate risk exposure of any ABL investments, including ABL funds of funds.

Over the past two decades, the US banking sector has been largely reshaped. From structures to business models, changes within the banking industry have fuelled the growth of asset-based lending activities. The phenomenon began in the 1980s when the merger activities of banks accelerated. As their sizes grow, banks are chasing bigger financing deals and they have lost their appetite for small loans that are relatively expensive to operate.

New regulations also contributed to the change of landscape. For example, the principles on lending practices stated in Basel II have put more restrictions on commercial banks' lending activities. Accordingly, banks have become more risk sensitive and are actively reducing their exposure to less creditworthy borrowers.

All these changes in the banking industry have created a vacuum in the small loan segment. ABL funds have been effectively filling the gap by providing small and short-term loans, secured by collateral, to those borrowers.

The chart illustrates the growth of the US asset-based lending landscape. The industry grew 16% in 2005 to a record high of $420bn (€312bn).

 

While traditional market risks (beta) and alternative investment strategy risks are not relevant to ABL funds, these funds are exposed to a certain level of operational and business-related risks.

At a glance, default seems to be a major risk associated with ABL funds. But the mechanism of ABL has already minimised the impact of default, since most of the loans are pledged with excess collateral and typically have less than 80% loan-to-value (LTV) ratios. In a case of default, lenders would foreclose and sell the collateral to repay the loan and the full amount of anticipated interest charges and other related fees.

The largest risk for ABL funds is fraud risk. Despite the introduction of the Uniform Commercial Code (UCC) to prevent borrowers from pledging the same assets to different lenders in the early 1950s, frauds on the underlying loan level cannot be completely mitigated. Therefore, a good ABL fund manager should have a thorough and proven due diligence process and tight internal controls to minimise fraud risk.

Legal risk could be another concern for investors. For example, legal disputes can arise in the merchandise or delivery process in inventory finance and tied up capital in a legal process. The legal risk can be largely mitigated if investors select experienced managers that have paid attention to details of all the terms and clauses within the loan documents.

Investments in ABL funds also have exposure to valuation risk, as loans are carried at cost and not subject to mark-to-market volatility. Also, loan interest income is accrued on a consistent stream along with loan origination fees income amortised throughout the life of the loan. These elements contribute to the consistency and stability of monthly returns but do not necessarily reflect the full picture, as ABL loans normally have very short duration (three to 12 months). Therefore, the extent to which performance figures are smoothed is limited.

Despite the operational and business risks of ABL funds, there are reasons for the growing popularity of the strategy in the past couple of years. Even though most ABL funds are long-only in nature, the over-collateralised nature of the strategy has already provided a natural hedge against any downside risk. The LTV ratio of less than 80% acts as a cushion to absorb losses associated with any unexpected events. Indeed, most recovered all their principals, full interest payments and other related fees and expenses in default situations. Thus, this built-in default loss mitigation mechanism is one of the very favourable features of ABL investing.

 

Another attractive feature is the predictability of ABL funds' returns. Interest income on ABL funds tends not to be affected by macro factors, especially in comparison to other capital appreciation-based investment strategies. As a result, the month-on-month performance of ABL funds is very stable, currently at around 80- 90 basis points a month.

Most importantly, ABL funds exhibit very low correlation to all traditional asset classes or with other alternative investment strategies. Thus, from a portfolio management perspective, adding ABL funds to an investment portfolio could help reduce the portfolio volatility and boost returns during market downturns. A professionally managed ABL fund of funds portfolio with adequate underlying funds diversification will therefore be a better choice than single-manager ABL funds.

 

Geoffrey Lam is director of research at SHK Fund Management in Hong Kong