Allocations for alternative investments at European institutional investors have increased sharply in recent years. The official explanations for these investments often focus on portfolio optimisation in terms of risk diversification and higher long-term returns. Both managers of alternative investment vehicles and investment consultants frequently echo these explanations. It seems likely, however, that the increased popularity of alternative investments as well as the allocations within the alternative investment area are also driven by a myopic focus on recent returns. The steep decline in commitments to private equity funds after the bursting of the technology bubble and the rush into hedge funds following attractive recent returns appear to support this view.
Our firm created an allocation for alternative investments long before these asset classes became mainstream in Europe. We started investing in private equity partnerships in the mid-1980s. The programme was started by committing to a small number of individual US funds, the first of which was the renowned Sequoia fund. Since then the alternative investments portfolio has grown to include hedge funds and commodities. The most recent addition is inflation-linked-cash flow contracts.
The success of the firm’s alternative investments programme is based on the recognition that alternative investments cannot be approached in the same manner as more traditional asset classes. If the unique characteristics of alternative investments are not recognised and adequately dealt with, it is likely that an investor will achieve neither risk diversification nor higher long-term returns.
Despite frequent efforts of market participants to rely primarily on methods borrowed from traditional asset classes (macro-economic analyses, benchmarks, volatily-based risk control and so on), we believe the construction of a private equity portfolio should focus on the quality of individual managers. This view is partly based on the insight that the vast majority of private equity managers achieve a mediocre return. Key components of our strategy to successfully identify and gain access to managers in the top quartile are
q maintaining a constant annual allocation to private equity;
q being proactive in contacts with promising private equity managers;
q adhering to a high-grade due diligence system
q rigorously monitoring progress of both portfolio partnerships and potential portfolio partnerships, and
q becoming a long-term value-added partner of the private equity funds in which the firm invests.
To execute this strategy within a general investment management operation we use an organisational structure in which specialised fund managers work closely with an internal consultant, a strategist, an in-house lawyer and a back office representative. The consultant advises the fund managers on operational issues and facilitates the integration of the alternative investments unit in the organisation.
We manage a private equity portfolio of approximately E1.6bn on a committed basis. The amount currently invested is e700m. The bulk of the portfolio consists of individual partnerships. The geographic focus is on the US where roughly 70% is invested. The remainder is primarily invested in Europe. In recent years we have mainly encountered top-quality funds in the buyout area, resulting in an emphasis on buyout funds in the programme.
The inclusion of hedge funds in the alternative investment portfolio is not based on lofty return expectations for this asset class. Rather, it is based on the expectation that hedge funds will contribute favourably to the risk/return profile of the total client assets. To maximise this expected contribution, our firm has chosen to construct a hedge fund portfolio with a market-neutral profile on aggregate. This profile is achieved by combining various hedge fund styles. Reflecting this, the benchmark that the firm uses to evaluate its hedge fund performance consists of a number of different investment styles, such as convertible bond arbitrage, equity market-neutral and fixed income arbitrage. These hedge fund styles all possess a market-neutral character.
The decision to invest in hedge funds was based on a study of a large set of realised hedge fund performance and volatility data. We studied both the raw original data and data that was adjusted for imperfections like survivorship bias and for the fact that actual recent hedge fund performance may yield inappropriately high expectations for prospective returns. The study indicated that a relatively large allocation to hedge funds results in the optimum level risk diversification. This means that the initial 1.5% strategic allocation might increase in the coming years. The decision to further expand the hedge fund portfolio will be based not only on the expected contribution to the risk/return profile but also by the pace and extent of maturation in the hedge fund market. Both the development of fee levels and the degree of transparency will play important parts in determining our future allocation to hedge funds.
The initial hedge fund exposure was created by investing in three high-grade market-neutral fund-of-funds. The firm has now started investing in individual hedge funds. At this moment the portfolio contains four individual funds. The current size of the portfolio is about e230m. To expedite the transformation to a direct hedge fund portfolio, the firm is considering converting one of its fund of funds to a segregated account. In that situation the original manager would still be involved in an advisory role.
Our approach to hedge fund investing is based on the view that many of the requirements for successful investing in private equity apply to hedge fund investing as well. Especially being proactive in building relationships with promising managers, doing systematic and extensive due diligence and closely monitoring both performance and risk are essential for the long-term success of a hedge fund programme. Top-quartile hedge fund managers are often less willing to increase their assets under management than their counterparts in the private equity industry and hence even more selective in allowing new investors into funds.
Like hedge funds, commodities offer risk diversification. Long-term returns are negatively correlated to all major asset classes. The main reason why we started investing in commodities in 1998 is this negative correlation, rather than expected higher returns.
The firm exclusively uses passive management for its commodity portfolio. It is analysing whether active management is a feasible approach. In making this decision, we will study the risk-adjusted excess returns of the universe of active managers. Subsequently we will determine whether a higher active risk budget should be allocated to commodities by comparing these risk-adjusted excess returns to those of other parts of the client portfolios.
One external manager and one internal manager manage the commodity portfolio. The external manager was selected based on its experience with running passive commodities products in a cost efficient manner. The current 3% weighting of commodities is in line with the long-term strategic target weighting of this asset class. The size of the commodity mandate is about E500m.
Inflation is an important risk factor for the Dutch pension funds that are our clients. This is why the marked increase in expected inflation in the Netherlands led us to introduce a product to partially shield its clients from the impact of inflation. To create this product, we teamed up with a large Dutch real estate investor. By stripping the inflation risk from a real estate portfolio we were able to buy inflation protection at an attractive price while the real estate investor obtained funding on attractive terms.
The inflation contracts constitute 1% or e170m of the firm’s client assets. Because the construction and pricing of Dutch inflation contracts is a time-consuming and non-standard process, we have a buy-and-hold approach to our inflation contract portfolio.
Wouter Pelser and Robert Klap are with Mn Services Investment Management in The Hague