Strategies to suit
The idea of investing in alternative investments is relatively new in Europe, outside of real estate. However, as pension fund managers and consultants consider the asset/liability mismatch and the possibility that equities will not provide sufficiently high returns to meet those liabilities so alternative investments grow in prominence.
In addition, looser restrictions on asset allocation from governments across Europe mean that asset allocators have the ability to look at a broader spectrum of investments. While equities and bonds will remain the core of all balanced funds, a small exposure to alternative asset classes and strategies is likely to be one way that balanced managers obtain the returns they require.
The universe of alternative investments is growing by the year. In the early 1990s the only alternative investment considered by most would be property. Then, for some, private equity or venture capital was added. Now, hedge funds can be included in that list as well as oil, timber, TIPS ? and some more exotic assets such as fine art and collectibles.
Without doubt alternative investments are growing in importance and relevance as managers try to gain positive returns in the current negative return environment. The key reasons for investing in alternative assets and strategies are generally superior performance, low correlation with traditional assets, lower volatility of returns and absolute returns compared with benchmark returns. These factors could make investing in alternative investments a compelling prospect, and indeed with reason in these times.
However, as we highlight below, there are many pitfalls in alternative investments and the past is certainly no guarantee of future performance. In investing, diversification is key, especially among non-correlated assets, and so long as alternative investments fit this bill then a case can be made for investing in them. We would stress, however, that the world of alternative investments, and especially hedge funds, is opaque at best. This can raise substantial problems for traditional investors. Investing in funds or well-established managers can redress this problem to an extent, but many investors will remain wary of alternative investments until better guidelines and industry standards are set.
To assess whether certain asset classes are attractive for investors it is important to see the respective alternative asset class in the context of both the existing assets as well as the risk and reward spectrum of the individual investor.
Therefore we differentiate between two types of investors:
q Group 1: Insurance companies and defined-benefits pension funds. These investors have the requirement of an absolute and largely purely nominal return. Their main risk is that the return on their assets is not sufficient to cover the internal rate of return of their actuarial liabilities. In fact, this risk does not only exist over the whole investment period but also over shorter periods of time as well. This is why most of these investors are heavily biased towards the bond market.
q Group 2: Unit-linked insurance, defined-contribution pension funds and private investors. These investors effectively need a long-term real return and can cope with some volatility. They can, and in fact should, take risks as long as they help increase the expected return going forward. Their biggest risk is not obtaining a positive real return. Therefore, these investors should make sure that a significant part of their portfolio is invested in real assets.
In the following we go through each alternative asset class/strategy and see how it fits to each type of investor. Thus we can derive a recommendation as to whether the investor should consider the respective asset class or not. (The results are summarised in the table.)
q Private equity/venture capital. Private equity and venture capital are quite closely correlated to the performance of listed equities. Their performance tends to be superior to listed stocks but this comes at a price.
The assets are very illiquid, which is a problem for investor group 1 as these investors have to mark to market their assets – and their liabilities in many cases. However, for group 2 that does not really matter since all they want is a long-term real return – illiquid assets tend to have a better long-run return to compensate for the liquidity risk.
The returns are more skewed and have a higher kurtosis than standard equity returns, which is also dangerous for investors in group 1 given their shortfall risk profile. Again, for the second group that is not so much of an issue.
So, overall, the higher performance might be tempting but we recommend that investors in group 1 take on only a limited exposure to private equity and venture capital and, more importantly, reduce their existing equity proportion by the same degree, as the correlation between these two asset classes is very high. For the second group, however, private equity is one of the most attractive asset classes: it is real and gives superior returns in the long run.
q Real estate. Real estate is a sensible alternative asset class for most investors as the volatility is quite low, which is important given the shortfall risks deriving from asset liability management for group 1. We also note the low correlation with both equities and bonds as a key advantage of real estate investments – which is relevant for both, group 1 and 2.
The assets are very illiquid, which, again, is a problem for investor group 1 – but nor for group 2. This risk is manageable though, as real estate investments tend to have a cash rental yield.
Real estate investments are by definition real assets. This could cause problems for investors in group 1 but less so for group 2 – especially in a deflationary environment.
Overall, we believe that the advantages outweigh the risks for real estate investments for both types of investors. They should be kept limited though for investors in group 1.
q Natural resources. Natural resources have a very good track record of performance. In many cases supply is limited and demand remains solid at least – especially when looking at the Asian economies and most notably China.
Correlation to other asset classes is low and most natural resources are very liquid assets – either in the cash market or in the corresponding derivatives market.
We strongly recommend that investors in both groups build some exposure to these assets. Their real nature should only be of limited concern to investors in group 1.
q Collectors’ items: art, cars, wine etc. This asset class definitely looks risky. The only real advantage is its low volatility but its correlation qualities are doubtful. The historical performance has not been great but the data quality is admittedly poor. There are some data that suggest that the performance was about zero in real terms (1975– 2001) – although others show a performance of about 8% a year (1986–2001) in nominal terms.
The risks, on the other hand, are substantial – especially for anyone who has to perform a strict asset liability management. We do not recommend these assets to investors in investor group 1 – especially considering the huge problems of a daily asset liability management.
For investors in group 2 these items might be interesting but doubts about diversification qualities must be allowed. Luxury items do not tend to be bought in times of economic uncertainty.
q Convertible arbitrage funds, fixed income hedge funds and equity market neutral funds. These hedge fund strategies can be very attractive for investors that need an absolute and (very importantly) nominal return with, ideally, low volatility as well.
All three strategies tend to fulfil these criteria and we therefore believe that they should be part of the portfolio for this investor group. As with other hedge fund products we stress the importance of diversifying across more than one fund and more than one hedge fund strategy. Given the cost of these investments, we believe that the risk-return-gains that can be made with these investments can be achieved with a relatively low proportion of the portfolio.
Considering the often substantial government bond investments of investors in group 1, equity market neutral hedge funds are a very good fit to the existing portfolio as they add an absolute return component to a mainly fixed income biased portfolio while reducing overall risks. In fact, we believe that this is one of the most attractive alternative investment strategies for this group of investors.
The key problem for investors in group 2 is the nominal return, which will be of a concern once inflation returns. Having said that, in a deflationary environment these strategies can be very attractive. Also, one should note that many trades that are necessary for these three strategies can effectively be put on by classic long-only and long-term funds as well – at least when looking at relative bets against a benchmark.
q Systematic futures funds and global macro hedge funds. Similar to the strategies described below, the volatility of these funds is much higher than other hedge fund strategies. And so is the skewness in the historical performance, which is a risk investors should not underestimate – especially in group 1. Investors in group 2 can draw some comfort from good performance and correlation figures of these two strategies though.
q Long/short equity funds. Although the returns are not as skewed as for the two strategies mentioned above, the biggest problem is the fact that their performance has not been great at all. This is a very important point if one also considers the survivor’s bias in the performance figures (the average hedge fund has a very short life).
Another problem is an increasing number of hedge fund managers would chase a decreasing number of trades, which can hardly be positive for their returns. Given these risks and poor performance figures, most investors would probably prefer other hedge fund strategies.
q M&A arbitrage funds. The volatility of these funds is much higher than other hedge fund strategies. On top of that the diversification effects are much lower than one might think. This is mainly due to the fact that most M&A activity tends to happen when the market is performing well anyway. Also, it is worth considering that standard, long-only equity funds can use the opportunities arising from M&A as well – so the actual value added by these funds is limited.
This is part of the reasons why the performance of these funds has not been great over recent years. Given these risks and problems, investors in general will probably not find it worth investing in this asset class.
q Distressed securities funds. This strategy is a clear no for investor group 1. The volatility of these funds is much higher than other hedge fund strategies. On top of that we found a very high skewness of the historical performance, which is a risk investors in this group should not underestimate.
Probably the main criticism from the point of view of these investors will be the fact that the correlation to other asset classes – most notably equities – is very high as a change in the general risk premium results in similar price movements for both asset classes.
We believe though that investors are on average paid well for these risks. Those investors that are interested in long-term real returns particularly (which one tends to find within group 2) will find that they can cope with the volatility in this asset class whilst enjoying the higher return.
Rolf Elgeti is head of European equity strategy research at Commerzbank Securities in London