Blending in alternatives
The inclusion of alternative investment strategies, like hedge funds, in institutional portfolios is a hot topic at the moment. Pension funds in the Netherlands, Switzerland and Scandinavia, as well as US funds, have expressed a willingness to consider these vehicles as potential asset classes. A report by Indocam/Watson Wyatt predicts huge growth in this area, from the current allocation 1% across European pension funds to 5% in three years time.
This article has three objectives. First, to sketch out the broad range of alternative investment strategies. Second, to explain the forces that govern the current trend. Third, to illustrate how to optimally blend these new asset types into an institutional portfolio.
‘Alternative Investments’ is a broad umbrella term that can cover hedge funds, futures funds, currency overlay, currency funds, private equity/venture capital funds and emerging markets.
The most common form of equity hedge fund strategy is the long/short strategy, using fundamental analysis. Active managers exercise their judgement on available stocks. They buy the ones they like and short the ones they dislike and so remain roughly neutral to the markets ebbs and flows. Traditional active fund management returns are a combination of market return, arbitrage opportunities, good forecasting and a judicious trading process. What this style of hedge fund aims to do is remove the market component. If they are run correctly, these investments should have a pattern of return related entirely to the manager’s skill and independent of any market benchmark.
The other in-vogue equity hedge fund style is merger arbitrage. When two stocks are merging, or one is being taken over by the other, the fund manager buys the cheaper one and shorts the dearer.
Convertible bond arbitrage is where a manager buys a convertible bond and sells short the stock which underlies it. This is a good strategy if you think the market might fall. In that event, the short stock position will usually fall faster than the convertible bond.
Hedge funds specialising in fixed income instruments simultaneously go long and short international bonds of similar maturities. Alternatively, they may go long and short different maturity instruments on the same yield curve.
Hedge funds can also be ‘global macro’ funds, where the fund reflects a view about a macro event and achieves a high return if that event comes to pass, for example Sterling being forced out of the ERM.
Managed futures funds or commodity trade advisors (CTAs), as they are known in the US, use exchange traded futures and options on commodities and financial indices to make money. Their strategy can be computer automated arbitrage algorithms or it can be manual, using their fundamental view.
Leaving aside passive currency hedging, there are two general approaches to currency overlay and currency funds: 1) active currency management using fundamental and technical information and 2) dynamic hedging, which is also called ‘options replication’. Some currency managers incorporate optimisation in their processes. Some also add return using ‘forward rate bias’. Forward rate bias is the pronounced tendency for the forward exchange rate to overestimate the magnitude of the subsequent spot rate change and in many cases even get the direction wrong.
Private equity/venture capital funds have come to the fore in recent years primarily because of the phenomenal returns from the technology sector. A lot of VCs achieved stratospheric returns by investing in technology companies and dot-com startups that were subsequently floated on the stock market.
Emerging market funds are not usually thought of as an alternative asset class. I have included them because a) they currently have low representation in European institutional funds, b) they have low correlations with developed market bonds and equities and c) they have demonstrated good returns in the past. Thus, the factors governing the inflow of capital into this asset class will be very similar to those for the preceding strategies.
Up to now, the vast majority of hedge funds have managed capital from high net worth individuals or family trusts. The business case for these managers to want institutional fund clients is pretty transparent, in that global institutional investment is a multi-trillion euro industry.
The business case for institutional funds to want alternative investment strategies is no less compelling but is a little more opaque.
Historically, pension funds have held portfolios of long-only developed market bonds and equities, with a small allocation to real estate. In the past, these investments have served the funds well. There was an ample supply of fixed income instruments at various maturities. Global equity markets yielded excellent returns in most years. It was possible to diversify across geographical borders. However, in recent times, a number of events, which we can think of collectively as globalisation, have conspired to dramatically erode this geographic diversification. These events include the merging of European currencies into the euro, cross-border commerce via the internet, trans-national mergers and take-overs of large corporations and the gradual global pooling of national financial exchanges. Globalisation is causing international assets to move in almost lockstep fashion, particularly in turbulent times. In the current climate, global sector diversification is more beneficial than country diversification. However, as a number of recent studies show, current global sectors are far more homogeneous than countries were in the past.
At the same time as diversification disappears, global bonds and equities also simultaneously become less attractive. There is a paucity of long dated sovereign debt as cash-rich American and European governments do not need to borrow. Meanwhile, corporate debt has become unhealthily concentrated in the telecom sector. There has been a general transfer of bond demand to instruments with lower credit ratings. In a recent US report, Moody’s stated that the credit quality of syndicated loans is slipping. In the first half of 2000, downgraded companies outnumbered upgraded companies by 200%. Similarly, developed market equities look decidedly overvalued. In his book ‘Irrational Exuberance’*, Robert Schiller soberingly illustrates that US (S&P 500) P/Es are currently three times their long run (120 year) average and 50% higher than their previous peak which occurred in 1929, just before the stock market crash. The rest of the developed world equity markets are arguably in an even more precarious condition. They have all been buoyed up by the US market and historically they have always caught a severe cold whenever the US market sneezed.
When you add to the above, a sliding euro, rising oil prices, the dot-com bubble bursting and never-ending structural problems in Japan, few would disagree with the suggestion that the prospects for our developed world financial markets look less rosy now than they have in the past. Some would retort that this time is different and the old rules no longer apply. Maybe! Even in that scenario, most people would agree that upside potential is far less today than it was a few years ago.
An additional influence that will help to bring in alternative investments into the institutional fold is the global shift from defined benefit (DB) to defined contribution (DC). The latter introduced a more consumerist and less conservative element into the fund manager selection process.
At the same time, continental European investors who have traditionally invested principally in bonds are broadening their investment horizons to include more equities. The timing of this is opportune for alternative investment managers because continental European investors focus on the absolute returns and risks of their portfolios. This mindset starkly contrasts with the old equity market cultures of the US and UK who emphasise return relative to a market benchmark. The latter customarily view a market downturn as akin to an act of God and not the result of an investment decision for which someone is responsible. Their continental European colleagues do not share this view.
The preceding discussion points to a desperate need for more financial instruments with good prospective upside, low volatility and which have low correlations with traditional equities and bonds. It also shows a more receptive audience than existed previously. Hence the current opportunity for alternative investment strategies. Alternative investments have the potential to diversify traditional investments away from market risk, thereby reducing overall volatility. While the above broadly explains the forces that drive the alternative and institutional markets towards each other, there are other forces at work also. Forces that act to keep these groups apart. These negative forces arise from the very different cultures and structures of institutional investors and alternative investment managers.
On the surface, institutional investors and alternative investment managers attend different conferences, read different publications and deal with different consultants. However, their differences run a lot deeper than these. Hedge funds expect to explain very little about their investment process, while institutional investors want to know as much as possible about how their money is being managed. Most institutional investors are fearful about short selling but this is a core component of most alternative investment strategies. Alternative investment managers charge performance related fees which can earn them a lot of money. Institutional investors are accustomed the low margin (but high volume) service of the traditional investment houses.
The last point highlights a substantial and insurmountable difference between alternative investment services and the service of the established fund management industry. Alternative investment strategies, in particular hedge funds, are small businesses in comparison to traditional asset management houses. They have to be. If they become too large, their volume would drive away the price around the anomaly that they aim to exploit. Investing with small business presents a cultural challenge to institutional investors who have habitually derived comfort from the size and public profile of the asset manager entrusted with their investments. For similar reasons, alternative investment structures tend to be pooled vehicles. Funds that are large enough to be segregated are too large to exploit the pricing anomalies at the heart of the strategy. Therefore, institutional investors choosing such a strategy also forgo the comfort of having their own custodian hold their assets.
Another impediment to bringing alternative and institutional investors together is that blending alternative strategies with the established institutional holdings is not a trivial task. One of the biggest problems is the lack of history for many of alternative investment strategies. Many of these funds have only been in existence for a year or two. There are methods of using proxies and sampling at higher frequencies, but none of these are satisfactory substitutes for sustained performance. Another major problem has to do with the shape of the return distribution for these funds.
Last year, two academic researchers, William Fung and David A. Hsieh addressed the question “Is mean-variance analysis applicable to hedge funds?”** They conclude with a weak approval for mean-variance optimisation of hedge funds. They found that mean-variance preserved the rank ordering of hedge funds in terms of the standard utility model. However, the model has serious shortcomings when the underlying returns are not normally distributed, as is the case with hedge funds.
One solution to this problem is to characterise the empirical distribution of alternative investment returns as a combination of two or more normal distributions. Each of these normal distributions is associated with a particular ambient state of the market. The idea that the market goes through states or phases (for example bull or turbulent) is not alien to practitioners and these states tend to persist, once they have been entered. The state one period ahead can be predicted using a Bayesian switching rule. The states of individual alternative investment strategies may be related and also these relationships may be leading or lagging. The time sequence of these relationships can be revealed with a cross-autocovariance treatment of the historical data. Our firm has carried out backtests of this technique, using a sample of alternative investment returns sampled at monthly intervals. Early results indicate the model is a very effective method of finding optimal portfolios of combined traditional and alternative assets.
The forces driving institutional investors and alternative investment managers towards each other make some form of convergence seem inevitable. One impediment is the difficulty of optimally blending incompatible investment styles together. The method described above appears to solve that problem. Other problems remain, including the cultural difference and the lack of performance data.
Time will provide a solution for both of these. When such issues are resolved, the fund management industry could look radically different from what we are used to.
Frank McGroarty is managing director of Q.E.D. Ltd in London
* Shiller, Robert J., 2000, “Irrational Exuberance”. Princeton University Press
** Fung, William and David A. Hsieh, January 1999, “Is mean-variance analysis applicable to hedge funds?”, Economic Letters