Come on in, the water's lovely
Alternative investment strategies are registering notably high satisfaction rates in terms of performance among European institutional investors – despite the three-year bear market. The percentage of investors whose returns have so far met or exceeded expectations ranges from 66% for private equity, 79% for hedge fund investment and impressive figures of 94% for real estate exposure and 97% in currency overlay.
The findings are revealed in the JPMorgan Fleming European Alternative Investment Strategies Survey 2003, which assesses the investment attitudes towards non-traditional asset classes of 341 institutional investors across the continent.
Yet, against the background of positive institutional responses, overall levels of investment in private equity and hedge funds remain low, with an average level of assets among institutions with exposure sitting at 3.3% for the former and 2.5% for the latter.
In contrast, the level of investment in real estate averages almost 11%.
According to the survey, the main reason given for not investing in private equity and hedge funds was ‘perceived risk’, followed by ‘lack of understanding’ and ‘advice from consultants’. More than one in three non-investors also cited ‘lack of liquidity’ as a reason for not holding private equity, despite it being the second most popular alternative asset class across Europe with 48% of institutions invested.
Accordingly, the percentage of European institutions currently invested in hedge funds is still comparatively low at 22%.
More surprising perhaps is the relatively limited take up of currency overlay strategies. Only 23% of European institutional investors currently have an overlay programme in place (including both passive and active strategies).
Conversely, real estate has seen the highest incidence of investment across the alternative asset classes with 70% of the survey respondents across Europe invested.
While the contrast between discussion and action on alternatives remains, the survey notes that those European institutions with exposure now accept the arguments put forward by alternative investment managers, citing the ‘potential for higher returns’ and ‘low correlation with other asset classes’ as the main reasons for holding alternatives.
And those pension funds already committed to alternatives show a strong willingness to commit more funds going forward. More than half (56%) of institutions with hedge fund exposure say they intend to increase their level of investment and close to half (45%) of private equity investors want to increase allocation. Only 1% of institutions with hedge fund exposure and 9% of those with private equity assets say they actively plan to decrease their level of investment.
Peter Schwicht, head of European institutional business, JPMorgan Fleming, comments: “This survey aims to provide a snapshot of the trends in alternative asset classes developing across Europe. Encouragingly, what we have found is that, against the backdrop of a three-year bear market in public stock markets, many institutions have been very satisfied with returns from alternative investment strategies. However, allocations to asset classes like private equity and hedge funds are undeniably low and changing the ‘perception of risk’ is now a key challenge for the fund management industry.”
With this in mind, Schwicht says the alternative investment community still has work to do in convincing institutions of its arguments: “An education process is clearly required to demonstrate that specific alternative investment strategies can actually help to reduce overall downside risk in a portfolio. Given that returns from mainstream investments are likely to remain subdued for some time, there is now an opportunity for fund managers to shape the attitudes of institutional investors across Europe in alternative asset classes.”
Drilling down further into some of the key findings of the survey on an individual asset class basis, across Europe eight out of 10 investors (79%) say they invest in private equity because of the potential for higher returns. Lower correlation with other asset classes is the second most popular reason for holding private equity (cited by 47% of investors).
Faith in private equity, however, has a regional bias. The 48% headline figure of European institutions invested in venture capital masks differences between Nordic, Swiss and French funds, where at least 60% of respondents do invest, and the UK and the Netherlands, where only 44% and 30% of funds respectively have allocations.
In keeping with some of the incongruities of private equity allocations, UK institutions actually have the highest average level of assets (4.4% per fund), while in the Netherlands the allocation is also comparatively high at 3.8%.
The mixed response to private equity may have something to do with the fact that, while 66% of investors say they have been pleased with the returns on their venture allocations, the asset class also has the highest incidence of performance disappointment. Just over a third of investors (34%) say returns did not meet their expectations; a factor that JPMorgan Fleming notes may coincide with the recent bear market in equities.
Nevertheless, pensions schemes cited clear reasons as to why they might not go the private equity route. Chief among these was the ‘perception of risk’ put forward by 64% of non-investors, followed by ‘insufficient liquidity’ (39%). In terms of how pension funds actually approach private equity investing, the consensus appears to be an external funds of funds approach, used by 50% of funds, or an external partnership offering (51%). Only 25% of plans say they use internal resources to identify and invest in venture opportunities directly.
Those considering investing in the future favour external funds of funds (78%) and external partnership offerings (23%).
The arena of institutional hedge fund investing also shares some of the surprising inconsistencies of private equity, according to the JPMorgan Fleming report.
While the UK and the Netherlands experience the lowest level of hedge fund exposure (8% and 17% respectively), in terms of asset allocation per fund both are near the top (4% UK, 3.8% Netherlands). Only German institutions allocate more to hedge funds (5%).
The prime reason for holding hedge funds is given as ‘low correlation with other asset classes’ (named by 76% of institutional investors). The other key prompt is the ‘potential for higher returns’ (42%). Both reasons appear crucial to the fact that while hedge funds may currently languish in the exposure stakes, going forward things look rosier. Hedge funds prove to be the most popular of the four asset classes surveyed in terms of future interest with 37% of non-investors saying they were considering investing.
Those institutions not tempted by hedge funds share the ‘perception of risk’ that many also link with private equity. 56% of non-investors say they would not invest for this reason, while ‘advice from consultants’ was the second most popular reason for not investing.
Fund of funds strategies are the vehicle of choice across Europe (61% of current investors) with German investors proving themselves particularly keen fund users (94%).
The second most popular strategy is direct investment into a single manager hedge fund (44%), a route mainly exploited in the UK (71%), but not in Germany (just 17% of investors) reflecting the current detrimental tax treatment in the country.
Real estate, meanwhile, continues to enjoy almost universal approval amongst European funds with two thirds citing ‘low correlation with other asset classes’ as the key reason for investing and just over half noting that ‘low volatility’ had pushed them in the direction of property.
Such ‘defensive’ strategies shade performance in the list of priorities with the ‘potential for higher returns/income’ cited by just 32% of institutions.
Historical property holders, the Swiss, have the highest incidence of property with 94% of investors investing in the asset class.
The Swiss also hold the broadest allocations with 17.1% of assets, while the Netherlands (12%) and the Nordics (10.1%) are also strong property investors.
One reason why property is enjoying such a renaissance, above and beyond the current market uncertainty, is that the perceived level of risk surrounding it is much lower than for private equity and hedge funds.
Just 13% of those surveyed say they perceive real estate as risky, suggesting a high level of investor comfort with the asset class.
Such comfort levels may explain why ‘direct investment’ is the most popular investment strategy for investing in real estate (81% of investors in Europe ex UK), particularly in Germany (90% of investors) and the Nordics (94% of investors); which the survey points out is probably due to familiarity and expertise in the domestic market.
Real estate funds are the second most popular way to invest (36%); particularly for institutions in Germany (62%), Netherlands (42%) and Switzerland (41%), possibly because in Europe these countries have the highest incidence of investment outside their domestic markets: 50%, 68% and 41% respectively.
Amongst potential investors, direct investment also finds favour (52%) followed by real estate funds (36%).
Nonetheless, the survey suggests that real estate may have reached its zenith in terms of exposure. Most current investors (45%) remain unchanged about plans to increase or decrease their exposure to Real Estate (Europe ex UK), although the survey argues that this does not rule out possible plans to change the geographical allocation in order to diversify risk, as many have done with equities in the last decade or so.
The popularity of currency overlay strategies in Europe also appears attributable to this global diversification trend. Three quarters of funds using currency management say risk control is their primary motivation, suggesting it’s use as a means to reduce foreign exchange risk rather than as an alternative asset class.
In turn, one key reason for not adopting an overlay programme was given as ‘not having significant foreign exposure’ (39%). Nonetheless, a slightly higher number of pension funds (42% - Europe ex UK) remain unconvinced that the strategy can provide excess returns.
Interestingly, however, active currency overlay is the most common strategy adopted amongst current investors (37%), suggesting that a large number of institutions do believe they can add alpha via currency hedging.
Similarly, the majority of those institutions likely to adopt a currency overlay programme in the future say they plan to use external managers whether on an active (55%) or passive basis (48%) – in contrast to existing investors where the split is more evenly balanced.
In geographic terms, currency overlay is most popular in the Nordics (51% invested) and Switzerland (50% invested), probably, according to JPMorgan, because institutions in these countries hold a high level of foreign equity.
In summary, JPMorganFleming’s Schwict believes the indicators suggest these alternative strategies will continue to grow in importance for the continent’s pension funds: “Given the high levels of volatility and relatively low rates of return that traditional equity markets continue to generate, it is therefore fairly safe to predict that interest – along with asset allocation – in these alternative asset strategies will continue to grow across Europe.”
Details of the survey are at: www.jpmorganfleming.com/institutional