Alternative investments: The trend towards tailored portfolios
As institutions, pensions and sovereign wealth funds raise their holdings in alternative investments, many investors are increasingly seeking customised portfolios and tailored solutions. Greg Robinson-Kok, the Asian head of Alternative Strategies at Franklin Templeton Investments, says: “With the way markets are moving and the way clients are behaving in this current climate, there are far more investors looking for bespoke solutions than we would have seen prior to the global financial crisis.
“A lot of clients have unique needs and they look for managers who are able to satisfy those unique needs not only by offering them a suite of funds, but tailored solutions for the funds.”
Kemmy Koh, Managing Director of the Asian unit of Pacific Alternative Asset Management Company (PAAMCO), says the firm’s investment mandate has evolved towards working with clients to customise hedge fund portfolios that complement their existing investments. PAAMCO has about $8.5bn of assets under management (AUM). We have seen an increase in accounts coming from “institutional investors, large pension funds, sovereign wealth funds and endowments seeking uncorrelated forms of returns,” says David Walter, a director at PAAMO Asia.
As investors shift their investments towards alternatives, the focus is increasingly on hedge funds and private equity, with infrastructure and real estate being the preferred asset classes. Among sovereign wealth funds, the Government of Singapore Investment Corp. said its alternative assets holdings for the year ending March 2012 increased to 27% from 26%, with a gain in private equity and infrastructure investments. Chinese Investment Corp.’s exposure to the sector rose almost 40% in 2011, according to the company’s annual report.
Robinson-Kok says: “There has been increased interest in infrastructure and also in real estate as well in recent years.
“If you look at the number of developing countries in Asia, you can understand why there is such a need for infrastructure funds to promote private and public partnership as many governments don’t necessarily want to meet the demand for infrastructure spending through public finance.”
Mixing asset classes
As interest for alternative investment rises, the trend is moving towards mixing asset classes and strategies that produce more predictable outcomes. “I think you will find that in the next few years, the trend will be towards creating alternative investments based on formalised rule-based strategies and these will be actively managed,” says Stephen Duchesne, former managing director and head of debt markets for Merrill Lynch Australia.
“The theme post GFC (global financial crisis) has very much been about capital preservation and trying to reduce systemic risk by investment in assets or funds with low correlation with traditional asset classes; people are not chasing yield as much as trying to reduce the volatility of portfolio value.”
As a result of changes in strategies, risk management, valuation and monitoring have become more complex. Combined with stringent rules for transparency and reporting, fund companies are increasingly adding expertise and outsourcing administrative functions.
Franklin Templeton announced in September that it will take a majority stake in K2 Advisors Holdings, a fund-of-hedge-funds manager. K2 has a global presence with 115 employees in the US, UK, Japan, Australia and Hong Kong, and approximately $9.3bn in AUM as of Aug. 31, 2012. Robinson-Kok says: “If you look at non-correlated assets you have to include in that class hedge funds and funds of hedge funds capabilities.
“We have been interested in the hedge funds and fund of hedge funds space for some time already, and we have identified it as a growth market for the future.”
Another area to which the company has been devoting a lot of attention is tactical asset allocation, a strategy that aims to deliver better-than-benchmark returns with potentially lower volatility by shifting asset-class allocations, depending on projected returns. “We have been finding some traction in the asset allocation market.”
According to Nick Paparo, executive director and head of sales at J.P. Morgan Worldwide Securities Services (Australia and New Zealand), the company’s business had seen a substantial increase in demand for specialist alternative investment services across the Asia Pacific region.
“The majority of our clients are talking to us about investing in alternatives and our ability to support alternatives particularly on an administration front,” said J.P. Morgan’s Managing Director and Product Executive David Braga. Braga added many funds are considering longer-dated off-market investments such as infrastructure, which require extensive administrative support.
Despite the increased interest for alternatives, growth in the industry has yet to return to pre-2008 levels. According to Eurekahedge, the number of hedge funds increased eight-fold between 2000 and 2007 with 1,200 managers overseeing $176bn worth of assets. (Although this number is likely to be higher because not all hedge fund managers provide information to the database).
Following the 2008 financial crisis, redemptions, heavy losses and closures took a toll on the industry causing total AUM to decline to $104.8bn by the end of April 2009. The industry bounced back in the second half of 2009 and a more moderate growth was registered in 2010. In 2011, the industry witnessed a net outflow of funds and growth this year has so far been weak. As of the end of July, the size of the industry stood at $125.5bn. A number of funds closed in the second half of 2011 and the first quarter of 2012, according to Eurekahege. Since then, the “launch rate” has improved to exceed funds’ closure rate and the database said it expects to see growth for the rest of this year.
Walter at PAAMCO adds the industry has become more institutionalised since the financial crisis of 2008. “After the crisis, what happened is a lot of the European private banking type business and the high net worth business has really diminished.”
Robinson-Kok adds: “In my personal view, we are more likely to experience slower growth over an extended period rather than an immediate jump back to previous highs and previous interest rates and the reason I am saying this is that investors are displaying a more cautious approach these days.”
Among common hedge fund strategies, the best-performing in 2011 was CTA/managed futures, which registered a return of more than 6%. The most profitable strategy based on 3-year annualised return was Asia event-driven investing, which earned clients 8.26% over the period. A flurry of Asian corporate activity provided the opportunities for managers to flourish, such as the IPO markets in 2009 as Asia led the world with 183 Chinese and 61 South Korean companies coming to the market, according to Eurekahedge. Large volumes of mergers and acquisitions within the Asian region also fuelled managers’ returns.
In the last five years, the largest change is the percentage of assets in long/short equity funds, which has fallen from more than 60% to only 36.6% of the industry as of July this year. The change reflects a growing and maturing Asian hedge fund industry as managers and investors explore newer and less crowded strategies.
To prevent a repeat of the 2008 financial crisis, industry regulators have passed a series of laws designed to protect investors, maximise transparency and ensure liquidity in capital markets. In the US, the Dodd-Frank bill was signed into law in July 2010. Under Dodd-Frank, alternative investment managers with over $150m in AUM have to register with the Securities Exchange Commission and will have to report on a wide range of business activities including AUM, use of leverage, counterparty credit risk exposure and trading and investment positions.
In Europe, the Directive on Alternative Investment Fund Managers came into force in early 2011 with full implementation required by 2013. Provisions under the Undertaking for Collective Investments in Transferable Securities (UCITS), which came into effect in 2011, limit on the use of leverage, concentration limits in individual securities and restrictions on direct investments in commodities, which have been deemed too volatile for UCITS funds.
Following the rules for more disclosures and accountability, hedge funds now pose a more limited risk to the stability of the financial system, according to a recent survey by the U.K.’s Financial Services Authority. “Banks and other counterparties of hedge funds have “increased margining requirements and tightened other conditions on their exposures to hedge funds since the financial crisis,” the report stated.
The opacity of the alternative investment industry was previously viewed as an important factor for the protection of proprietary asset allocation strategies. However, this lack of scrutiny also protected managers from questions about excessive risk taking in illiquid securities. These risks became exposed during the global financial crisis and for many investors the revelation was too late to protect their investment.
Amid the emphasis on transparency and risk management, administrators have taken a larger role in the hedge fund industry. The last five years have seen the consolidation of the Asian hedge fund administrators’ industry as smaller players exit and larger funds attract more capital from institutional investors. The top three administrators, namely HSBC, CITCO and State Street, account for 49.26% of the market now, an increase from 47.87% in 2007.
Increasingly, back office operations have shifted from being viewed as a purely administrative role to one that is integral to an alternative fund’s success, Koh says. “We have been very active on the corporate governance aspect, working with hedge funds to make sure that they are set up properly in terms adequate and appropriate back office and also funds structure.
“While we at PAAMCO have always insisted upon full transparency, I think the industry has improved as the amount of information on offer to most investors is more than it used to be. In the past some saw it as a complete black box.”