The alternative alternatives
It has been much ignored by institutional investors, and yet timber has offered some of the strongest returns of the last decade. The asset class produced an annual compounded return of 12.44% in the period between 1989 and 2003, according to the National Council of Real Estate Investment Fiduciaries (NCREIF) Timberland Index. It also exceeded the S&P 500 for nine of those 15 years, with a standard deviation of 9.98%, compared with the equity market’s 18.4%.
Yet most institutional investors are still unfamiliar with the asset class, says Bill Muysken, global head of research at Mercer Investment Consulting. “It’s an asset class that people don’t really understand. Broadly, we think it makes sense, and we have been discussing it internally. But we haven’t approached clients about it yet,” he says.
Managers point out the obvious benefits. “It is the only asset class that has given you reliable returns when you’ve needed it,” argues Jeremy Grantham, chief executive of Boston-based boutique GMO. Grantham has always had a passion for forestry. He hired Eva Gregor and Eric Oddleifson, timber experts who had sold their independent firm to UBS in 1995, to head GMO’s Renewable Resources division.
“My main interest is in global asset allocation, and unlike most timber experts, I tend to think of timber as an alternative to everything else. Its main attraction today is that although it is priced higher than it used to be, everything else is overpriced,” Grantham argues. He also points out that unlike other commodities, timber has always trended up, and during great bear markets the asset class has either risen or remained steady, but never declined.
Timber investment can be very hands-on, with only a few specialist managers, known generally as TIMOs, having the necessary expertise in one type of forestry or another. Investing can include from buying raw land and managing forestry, to producing cash flow and felling when the markets are good to spur further growth.
For her part, GMO’s Gregor argues that specialist knowledge is critical. “You need someone who has experience in the asset class. It’s quite complicated and specific knowledge is required. There are various problems, for example with tree measurements, that can occur and you need someone with experience to handle those.”
And there are other issues that investors need to consider. Like all asset classes, timber does have some volatility that stems from supply and demand and pricing. Liquidity must also be taken into consideration, and timber can never be a short-term investment.
“Investors have to have a 10-15-year time horizon in order to build up a successful investment programme,” explains Peter Mertz, chief executive officer of Global Forest Partners, the firm that was created by a management buyout of UBS’s timber business in 2003. Mertz believes that timber should be considered as an illiquid private equity investment, but argues that because it is non-correlated to other asset classes, there are good diversification benefits.
He also dismisses concerns about forest fires and other biological risks. “A well-diversified portfolio, located in many geographies, helps minimise exposure to biological risks in forestry investments. However, in the US, all the biological risks combined have had an effect of less than two-tenths of a percent per year in asset value.”
And for investors who are worried about environmental considerations, managers point out that forests are continuously replanted. “We seek certification of our forests to assure investors that they are being managed to the highest environmental and social standards,” insists Mertz.
But not everyone is convinced about the merits of timber. Critics claim that even if investors are sold on the returns from forestry, there is not much they can do about it. The market currently stands at an estimated $12bn (€10bn). This means that there are capacity issues to consider. GMO’s Gregor points out that the company does not charge fees on commitments, only when the money is invested. The firm also tries to align the interests of the manager and investor by taking profits over a certain hurdle rate.
And one observer dismisses concerns about capacity. “At the moment, there aren’t enough investors to have this problem so why worry about it?” he jokes.
When the £15bn British Rail Pension Fund sold off the last piece in its fine art portfolio two years ago, many observers believed art and institutional investing would not mix again.
The fund had begun collecting art in 1974, when the rate of inflation in the UK was high, and it was difficult to diversify out of property, equity and bonds. With more than 2,400 pieces in the portfolio, Railpen made returns in excess of 11%, largely due to the sale of a few masterpieces, such as Canaletto’s ‘Two Views of Venice’. Still, members of the scheme were concerned that art was too much of a gamble.
Now, managers are trying to convince institutional investors to think again, with varied amounts of success. It is understood that several organisations - such as ABN Amro, which attempted to set up a funds of funds art business - discovered that the market was too small to set up a viable business. Others seem to be holding steady for the long term.
One such body is the Fine Art Fund, which was set up by Philip Hoffman, a former executive at art dealer Christie’s. He is backed by heavy hitters such as Bruno Schroder, whose family owns a minority stake in Schroder Investment Management, and Christopher Wright, the former chairman of private equity at Dresdner Bank. Both sit on the board of the fund.
Hoffman declined to comment on how much the fund has raised to date, but said it has been meeting its return targets (average industry returns are estimated at 10%-12%). In the case of one sale, it made a 52% cash-on-cash return over 12 months. The fund has a 10-year lock-in period, although Hoffman anticipates liquidating in five years. “Art reduces the risk in your portfolio because of the characteristics of art, and the lack of correlation to equities,” he says.
But art has not outperformed the equity markets over the long term. The Mei/Moses Annual All Art Index shows a 50-year compound annualised return of 10.47%, compared with 10.95% for the S&P500. Managers argue that art has done well in difficult markets.
“Art is an asset class that has demonstrated that it can be of specific value over time. Investing in art is not a new idea – it’s the oldest one. Since the days of antiquity, as wealth is created, a portion always goes into art,” says Bruce Taub, founder of Fernwood Art Investments, the US manager that has just launched its two funds.
The former Merrill Lynch veteran says he made a financial decision when he set up the firm. “What I was looking for was an inefficient market with an asset class of scale that had yet to be fully developed into a broad platform. I was not looking for art, I was looking for an asset class,” he insists.
Taub’s first fund, the sector allocation fund, identifies eight areas of the art market in which it will invest primarily for capital appreciation: Old Masters; Impressionists; 19th Century Europe; American; Modern; Contemporary; Post-Modern; and Emerging. “We populate these eight, based on buyer behaviour,” he says. The second fund will invest in the business of art, helping to finance art transactions.
But not everybody is sold on the idea. “A lot of people have the idea of creating some sort of investment fund. I have my personal doubts over whether this concept works. It takes a lot of time to sell art. The market is very small; you can’t liquidate a big portfolio in one day. Not everything can be sold at the same place at the same time,” says Karl Schweizer, head art banking, gold and numismatics at UBS Wealth Management.
He believes institutional investors will have problems with the lack of transparency in the industry. A large number of transactions are private, and cannot be tracked down. There are also heavy insurance and maintenance costs. And transaction costs are also a big concern. Auction houses carry both buyers’ and sellers’ commissions of 10% or more, and dealers can charge up to 50%.
“You have to be aware that you probably want to sell the pieces again one day, and then you’ll have to pay a substantial commission to the provider,” says Schweizer.
Institutional investors who allocate to commodities because of the high returns the asset class has posted in the last few years will inevitably be disappointed, says Bob Greer, senior vice-president and manager of real return products at Pimco. “People need to be reminded that it is not about big returns, it’s about diversification and protection from unexpected events. The last thing we want is for people to be chasing returns thinking there’s a whole bunch of money to be made, because sooner or later, they will be disappointed,” he says.
Instead, he says, investors should consider average allocations of about 5%, accepting that the allocation is for diversification purposes, and has a favourable correlation with liabilities.
Kevin Norrish, head of commodities research at Barclays Capital, points out that, historically, the relationship between commodity index returns and returns generated by other asset classes such as stocks and bonds have been negative. “That’s important, because it does help an investor increase their risk/reward ratio by including commodities in a portfolio.”
The firm conducted a survey of 150 investors and corporates at its Barcelona conference earlier this year and discovered that 60% of respondents invested in commodities for diversification purposes. Other investors used the asset class for yield and US dollar inflation hedges. One such investor is ABP, Europe’s largest pension fund, which also uses commodities to hedge against event risk. It started investing in 2001, with a 2.5%, or E4.5bn allocation.
Traditionally, investors access commodities via an index, focusing on commodities futures, because the prospect of taking delivery of something like oil or wheat is problematic. A commodities futures index measures the returns that an investor would generate from long positions on futures contracts and rolling these positions forward over time, selling them as the delivery date approaches. Funds invest passively or benchmark against the indices like the S&P Commodities Indices, or the GSCI Index.
“To really understand commodities, one has to understand the futures market,” says David Blitzer, chairman of the index committee. He says that investors need to be educated about how futures contracts work, and how positions are rolled forward. “You have to understand that contracts don’t last forever and that contracts have subtleties,” he argues.
Blitzer also believes that investors who are making initial allocations should not consider enhanced indexing or active products. “I think the place to begin is passive investments, probably through an index. Down the road, if you believe you’ve identified a manager who is going to give you substantial benefits, then you can consider investing with them.”
Still, investors who have been following commodity returns for the past few years may be forced to take a more active approach if they want to see such returns again, active managers believe. In the five years to December 2004, the GSCI Index produced average returns of 15%, compared with 8% on bonds and -1% on stocks, according to research from Barclays Capital. Managers say commodities will not trend higher in the future.
Goldman Sachs already has a passive fund tracking the GSCI, as well as a commodities hedge fund. It is one of the first firms to introduce an actively managed commodity fund which aims to deliver 100 basis points, for investors who want to add alpha.
Investors can also get exposure through structured products. Last year, Barclays Capital launched the world’s first collateralised commodity obligation (CCO), a credit instrument that allows fixed income investors to access commodities using a debt-style pay off.
Still, consultants believe that investors are not entirely sold on the asset class. Over the five years to 2004, volatility from the GSCI index was 22%, compared with 15% from stocks and 5% from bonds.
Consultants suggest that investors are also unsure about the risk premium of commodities. They believe that education is still an issue, with many pension funds still a long way from being comfortable with the asset class. Despite this, in the last two years, institutional allocation has grown from around $10 billion to $15 billion, and most industry participants expect allocations to increase significantly.
Investing in wine may seem like a glamorous thing to do, but it is not without its pitfalls, warns Chris Erwin, investment principal at Aon Consulting. “You are buying a physical, breathing asset, and it has to evolve and mature, and you don’t know how well it’s done that until it is finished. You don’t know if the cork is faulty, or how storage conditions have been,” he says.
Erwin, who is himself a wine enthusiast and invests as a private individual, argues that wine investing is better suited to high net worth individuals with smaller allocations to make than pension funds.
Unsurprisingly, merchants disagree. “You can make realistic returns of about 10-20% per annum,” says Paul Milroy, the Bordeaux buyer at Berry Bros & Ruud. He says he has talked to pension funds which have wanted to learn more about the asset class, and have considered investments for diversification purposes.
Merchants point out that some wines become legendary in their returns. The Chateau Rayas produced a wine in 1990, for example, and made only 2,000 cases. Because the wine gained an excellent reputation and had a decade later been mostly consumed, its price rose by 1,118%.
Traditionally, wine portfolios invest primarily in red Bordeaux from great vintages. But it is a capacity constrained market; there is not enough room for everyone. According to Wine Searcher.com, the top 30 chateaux produce no more than 500,000 cases a year. New world wines have raised their visibility, but have yet to become collectible over time.
Investors make the greatest returns from wine futures, when wine is purchased after it is made but before it is bottled. The process is known as ‘en primeur’. Wine is generally bottled and shipped around two years later. “It is the cheapest way to access wine, providing that the vintage is good to start off with,” says Christopher Keiller, director of Fine Wine Services.
Merchants say they have seen increasing interest in wine from institutional investors, some of whom have made allocations of about £5m to £10m into portfolios. And specialist portfolio funds, such as the UK’s Vintage Wine Fund, which has posted returns of 5.52% in the year to July, do allow for quick and indirect allocations.
But Erwin says he does not know of any pension funds investing currently. And, like with many commodities, investors need to take a long-term view. “It takes at least five years before you see a return on your investment,” says Alan Rayne, chief executive of Magnum Fine Wines.
Investors also need to be concerned about fraud. Erwin, who was given a bottle of wine, supposedly from the (which/who) Czar’s own cellar following the collapse of the Soviet Union (1989-1991???), found that a fake label had been attached to the bottle. “It is an unregulated market with strong peculiarities,” he says.
Cellarage is also costly, eating into margins. Still, wine brokers believe that institutional investors should consider the asset class. “You need to decide the amount of money you want to invest, the length of time, and give the broker some idea of what the investment should materialise into, and when it needs to mature. Be advised that investments can go up as well as down, but if you choose correctly you should be in with a chance,” says Keiller.
But for institutional investors, with limited time and resources, being in with a chance is probably not a good enough proposition.
They were once considered taboo, but the hunt for liability matching solutions has led pension funds to consider the use of derivatives in their portfolios. Consultants have broadly welcomed the products, although one suggests that investment banks need to stop pushing their offerings so aggressively at clients. And, surprisingly, a derivatives expert at one investment bank agrees. “Sometimes we are in a bit too much of a hurry, and the risks are not totally understood,” he says carefully.
Still, despite the bad press derivatives have had in the past, many pension funds have been buffered by successful derivative plays. ATP, the Danish labour market supplementary pension scheme, made a €3.5bn return on its interest-rate hedging instruments in the first six months of 2005, for example.
Günther Schiendl, head of investments at Austria’s APK Pensioskasse, says his fund was able to add some 80 basis points to its overall equity portfolio, and over the last four years around 200 basis points on the fixed income side, from its derivatives plays. The fund uses currency forwards, as well as futures contracts on the EuroStoxx 50 and S&P 500. On the interest side, it has Bund futures on the Eurex. It also uses exchange traded funds.
“This for us has been more of a measure of risk management than a measure associated with trying to find new return potential,” he says.
Experts believe derivatives can offer value in different ways. They can be used to express directional views, express range views, enhance yield, or protect against the downside, says Kevin Chang, director of the derivatives solutions group at Credit Suisse First Boston (CSFB). “I personally think that sooner or later all funds will have to include derivatives amongst the instruments in their investment set,” he says.
And there can be no doubt that derivatives are becoming more popular. The notional amount of credit derivatives grew by 123% in 2004, and now stands at $8.42trn. In the same year, equity derivatives grew by 21%, according to the International Swaps and Derivatives Association (ISDA).
Managers say that the products are not costly in the long term. “They are cheaper to use than cash instruments in most markets, and also have lower transaction costs than traditional cash investments in most markets,” says Stewart Russell, co-chief investment officer of Francis Fischer Trees & Watts.
Amongst pension funds, the largest use of derivatives is through interest rate swaps and inflation swaps, which can be used as an overlay on top of asset allocation decisions of trustees, explains Jack Berry, a consultant at PSolve. Still, he warns pension funds to make sure that they have the right documentation in place before they start to use derivatives strategies.
Other consultants agree. “You might have executed the most fantastic derivatives strategy ever, but if the other side defaults you won’t have anything. So collateralisation, making sure the document allows termination if the credit of the counterparty deteriorates, is important,” says Nick Horsfall, a senior investment consultant at Watson Wyatt.
But there is still a steep learning curve for investors, many of whom have not yet gotten to grips with derivative products. One provider suggests that the problem has become even greater because nobody is prepared to acknowledge their ignorance. Others say investors must accept that they will not be able to control every aspect of their investment, and must consider it carefully.
“In such a specialised world with many derivative based products, it is important for pension funds and retirees to address the fundamentals, what value does the derivative add and what is the motivation behind using the derivative. This is part of the knowledge process before using the products,” says Amlan Roy, a director in fixed income research at CSFB. He believes that investment banks, asset managers, and consultants should stop “playing the blame game”, and that they need to work more closely together so that trustees are not swamped with a myriad of different solutions.
Observers also want investors to realise that derivatives have a potential downside that needs to be considered. “There is no free lunch in this business. The only way you get a free lunch is off your parents,” says one.
Pension funds have become more sophisticated in the ways in which they use currencies, and the demand for currency managers has never been higher.
“In the old days, people looked at currencies as a way to manage risk in their international equity or bond portfolios. The idea was to let managers buy what they wanted and bring in a currency manager to add alpha on top of that. Then some clients got smarter and realised that the true value of currencies is not that they improve the equity performance, but that the return stream can be a diversifier of other assets,” explains Arun Muralidhar and chairman of Mcube Investment Technologies.
Institutions are using currencies in three different ways, says Tony Spence, global head of currency management at State Street Global Advisors (SSgA). Currencies are used to passively hedge the risk of an institution’s foreign portfolios. They are also used for active currency management, allowing a manager to decide when to hedge on a portfolio and mitigate risk. More recently, investors have begun to consider currency as a separate source of alpha, with an ability to generate returns from accurately predicting currency movements from the underlying assets held in a portfolio.
Managers say that the currencies have benefited from pension funds rethinking of asset and liability matching. “Pension funds continue to expand their knowledge about active management returns. Risk budgeting is now a more widespread practice and understanding and comparing where returns can be generated on top of the strategic asset allocation decision has become more important,” says Spence.
They also believe that in a low-return environment, investors have been reluctant to miss out on any opportunity. “When the stock markets were doing great, there was no worry about currency. Now you don’t get the same types of returns you used to get, and a substantial number of pension funds are in deficit. So they believe that any basis points they can save are of benefit,” says Thannos Papasavvas, global head of currency group at Credit Suisse Asset Management.
One way to add alpha is through absolute return products. Record Currency Management, the UK boutique which has posted significant asset growth in the last two years, has seen demand for its absolute return products increasing. As of June this year, the firm’s assets under management totalled $20.2bn including overlays. Of that, around $4.2bn comes from absolute return mandates, which the group has only been offering for two and a half years. “There are a lot of clients who at one time would have hired us as an active currency manager to reduce risk and also earn returns,” says Robert Bloom, director and portfolio manager at Record. “Some of these same types of people have now bought the argument that there is a better way to reduce risk and earn return than active currency overlay. That better way is to passively hedge part of your exposure and do currency alpha on another part of your exposure.”
Currencies also offer other advantages. Spence points out that the currency market offers extremely high levels of liquidity, which allows for efficient implementation with low transaction costs. “Also, as one of the largest capital markets in the world, the currency market has almost no capacity restraints for active investment strategies,” he says.
For investors who are concerned about the potential downside of the market, Record’s Bloom suggests that even at its worse, currencies make fast recoveries. Based on simulations completed by the firm, the most difficult period for currencies was around mid-1993, when cash drawdowns would have been in the order of 5%. It would have taken roughly a year to recover after that. “We haven’t seen anything either half that size in the 12-13 years since, so we’re very confident in saying that the worse drawdown is about 5%,” says Bloom.