IPE at 20: Time for a new implicit contract in alternative investments
An outstanding phenomenon of the past 20 years is the relentless rise of alternative investments.
From a peak of $6.6trn (€6.2trn) before the 2008 crisis, their assets under management reached a new high of $11.3trn in 2016, and are set to hit $19trn by 2020, according to data from the latest CREATE-Research annual survey. Alternatives have yet to plateau, despite well-publicised problems at specific hedge fund and private equity houses since 2012. If anything, their setbacks suggest that alternatives are coming of age.
The 2008 crisis was the catalyst. The unprecedented scale and speed of sell-off then killed the old dictum ‘ fix asset allocation and the numbers will follow’. Traditional diversification, based on a 60 equity/40 bond mix, came unhinged when most needed. The iconic Yale model favouring alternatives fared just as badly. In 2008, hedge funds lost about 20% and real estate 40% when panic selling hit indiscriminately. It was a defining moment. The old approach based on mechanical allocations began to morph in the face of losses.
Liquidity risk: the Achilles heel
There is a growing belief that the world of investing is reverting to its pre-1982 days when high volatility and time-varying risk premia were the norm. The bull market of 1982 to 2000 was an historical aberration on this argument, caused by the US Federal Reserve’s over-eagerness to pump fresh liquidity at every whiff of a market correction.
Quantitative easing (QE) is the latest in the series of tools to fuel the markets artificially and disconnect them from their fundamentals. In the process, strategies like hedge funds have struggled to deliver the outsized returns of previous periods.
“Alternatives have yet to plateau, despite well-publicised problems at specific hedge fund and private equity houses since 2012. If anything, their setbacks suggest that alternatives are coming of age”
Worse still, QE has borrowed the future returns of almost all asset classes. Like long-only funds, alternatives have entered an era of low returns and high volatility. Success in them requires an attitude shift on the part of investors – from a distant buyer to a thinking partner. What investors do after making their allocations makes a big difference to overall returns. This was one of the key messages from the 2017 Cayman Alternative Investment Summit that brought together asset owners and asset managers from key global jurisdictions.
The message speaks to an important shift. Despite the turbulent recent history, three core principles of investing remain solid: buy low and sell high; asset valuations always revert to the mean; and low risk means low returns. What has changed, however, is the primacy of the role of investors in the implementation of these principles. Critical to success in alternative investments is an explicit recognition that the most successful strategies in recent years have centred on buy-and-hold illiquid assets that carry significant time and risk premia.
Yet liquidity risk has raced up the agenda of their investors. It is a risk that occurs when an investor cannot convert an asset into cash without loss of capital or without incurring high charges – due to lack of buyers at the other end of the trade.
Over the past seven years, investors have moved up the risk curve in response to accommodative monetary policies in America, Europe and Japan. However, such policies have fostered the belief that there is a lot more liquidity than actually would be available if and when the market sentiment shifts abruptly. The key culprit is regulatory shrinkage. It has forced banks to set aside higher levels of Prudential capital while prohibiting them from engaging in market-making.
The experience of the past three years reveals numerous episodes when liquidity has dried up in the blink of an eye, exposing investors to fat-tailed risk. For example, the flash crash in US Treasuries in October 2014 was a seven-sigma event, the Swiss currency attack in January 2015 was a 29-sigma event, and the Chinese equity crash in August 2015 was a four-sigma event.
“There remains scope for improvement in the quality of engagement between pension funds and their alternative managers – all the more so nowthat central banks are winding down their QE programmes”
Of course the impact of such events has been more pronounced in equities, bonds and currency markets. Being mostly in private markets, alternative investments have not been directly in the line of fire. But investors in illiquid alternatives such as private equity, real estate and infrastructure still worry whether, in the long run, there would be buyers of their assets, if they were to be turned into forced sellers, as happened in the crisis of 2008, causing indiscriminate fire sales.
Winds of change
Despite progress since then, there is still scope for improvement in the quality of engagement between pension funds and their alternative managers – all the more so now that central banks are winding down their QE programmes. In the resulting low-return/high-volatility environment, the need for joined-up thinking has never been so acute, focusing on two imperatives.
Pension investors need to recognise that most alternative asset classes are – first and foremost – illiquid. When choosing such assets it is essential to benchmark them against the time profile of a pension plan’s future liabilities instead of the changing financial market sentiment. By ignoring the term structure of their contractual obligations, pension investors have paid dearly by resorting to ‘wrong-time’ risk arising from panic selling in times of crisis, only to be followed by ‘regret’ risk when the markets recover.
On their part, asset managers need to develop a more holistic understanding of their clients’ future liabilities and funding needs so as to ascertain what can and cannot be delivered over a definable time horizon. Key to expectation management is ensuring that pension investors understand the ‘health warnings’ in legal agreements. More than that, it is also about creating:
• An alignment of investment beliefs that ensure that investors and their managers share a similar degree of conviction towards the chosen strategy;
• An alignment of time horizon that ensures that investors remain committed to the strategy during periods of market stress; and
• An alignment of financial interests that ensures that gains and losses are shared more equally.
These actions enjoin alternatives managers to embrace the role of a trusted adviser– someone in the client’s inner circle of confidants, someone who is open about things that matter most to their clients. Many alternatives managers already enjoy this status with sovereign wealth funds and large pension plans that report upper quartile results. The future dynamism of their industry requires extending it more widely across the alternatives space. Without it, alternatives investing may become a high-dispersion space for returns.
Amin Rajan is CEO of CREATE-Research and Anthony Cowell is senior partner for alternative investments at KPMG in Grand Cayman