Looking at the alternative side of things

Hope William-Smith finds out if it is policy makers, investors, advisers, or fund managers making the moves at the grassroots level to get alternatives off the sideline.

Concerns around investing in hedge funds and the general angst surrounding alternatives is lifting; the trepidation that once held investors back is slowly melting away and the Australian economy has continued its regrowth, 10 years on from the global financial crisis (GFC).

According to experts, a new era for alternatives came off the back of shifts across the equity market, strong growth on the innovation front, and a competitive sector fuelled by the risks many investors had taken.

The hedge fund industry entered 2016 on the back of one of its few negative years on record and is currently worth $3 trillion, eVestment's Hedge Fund Industry Performance Report for Q4 2016 found.

In 2016, the average hedge fund outperformed the equal weighted equity/fixed income benchmark for the second year in a row, as corporate capital markets provided the best environment for hedge funds to return consistent gains.

For investors, the Alternative Investment Management Association (AIMA) director, Michael Gallagher said the perception of hedge funds as risky, complicated, and expensive had fast been superseded since the GFC by a better understanding of the benefits they offered to a total portfolio.

Gallagher said many planners had begun to embrace alternatives and hedge funds specifically, but continued to struggle to gain the full confidence of investors who were against developments in regulation.

Sowing the seed

A recent report by KPMG International, AIMA, and the Managed Funds Association (MFA) into the hedge fund industry suggested that the globally-regulated alternative sector was perhaps more transparent now than ever before, with technology the catalyst behind its new found popularity.

Some industry experts have labelled hedge funds as misunderstood, and have indicated that the asset class was becoming the leading alternative style.

Others have argued against alternatives by drawing attention to the volatility associated with global geopolitical movements such as the Trump election and the upcoming elections in Germany and France.

State Street Global Advisors head of asset allocation Asia-Pacific, Mark Wills, said the use of alternative strategies in Australia had historically been aimed at trying to shield multi-asset portfolios from market shocks. However, in recent months, central bank intervention in asset markets across the US had brought back the possibility of those shocks.

"The implementation of the Trump administration policies is unknown but currently many market participants are fearful of additional shocks," he said.

"This combined with the falling efficacy of central bank intervention means that many alternative strategies could start performing in line with normal expectations."

Blue Sky Alternative Investments chief investment officer, Alex McNab, said high performance of alternatives had been forecast for 2017.

"We are at a moment in time when traditional asset classes have an unattractive medium-term return outlook and unusually high levels of risk," he said.

"These dynamics have supported the growth in alternatives, and we expect it will continue."

McNab said the biggest misconception for investors around alternatives was volatility as investors could be confident that alternatives would not be more volatile than stocks and bonds in the immediate future and notably with hedge funds, strategies would be less volatile than traditional asset classes.

"Because they are often uncorrelated to traditional asset classes, allocations to hedge funds tend to bring down the overall level of volatility across an investor's entire portfolio," he said.

"Volatility is typically much lower than the levels seen in public markets where valuations change in real time."

Wills said that while alternatives were subject to natural periods of good and bad performance, the volatility experienced during the GFC was long gone, and fund managers and planners should step up to the mark.

"The search has moved to managers who can deliver uncorrelated positive returns from non-traditional asset classes and exposures," Wills said.

"Institutional investor interest in hedge fund strategies has cooled due to poor performance and high fees."

Gallagher said that growth in commodity investing and private lending would assist the hedge fund industry to recover from its slight slump.

"2016 was a year of rotation for hedge funds, where investors redeemed from underperforming funds, and reallocated to better performing funds," he said.

"Against a background of greater regulatory oversight, we have seen improved transparency, lower fees, and a better alignment of interests with investors."

Embracing alternatives

While the market may have entered a recovery period, and allocation towards alternatives had progressed, there was still uncertainty from advisers and investors.

Infrastructure and real estate have long interested Australian clients but the willingness to invest in hedge funds could remain limited by their historic absence from Australian portfolios.

"Global hedge fund assets under management are almost 10 times larger than global allocations to infrastructure funds, an asset class more familiar to many Australian investors," McNab said.

"We continue to see strong demand among these investor segments for hedge fund strategies that offer genuinely uncorrelated return streams that can enhance the risk-return characteristics of portfolios."

Commodity investing and private lending were major growth areas in the past 12 months which suggested hedge funds had filled a gap that banks could not and provided the capital for non-bank lenders to meet credit demand from businesses.

"Many planners today embrace alternatives for their hedge fund qualities," Gallagher said.

"There has been a ‘starburst' of new investment styles across the globe as tougher capital rules saw banks ditch propriety trading, with investment teams left to set up their own funds.

"The role of alternatives is to provide an uncorrelated source of alpha and downside protection to the other investments in a portfolio."

An investment green thumb

Last December hedge funds returned an average of 1.07 per cent, 0.78 per cent in Q4, and +5.34 per cent for the full year 2016, according to eVestment.

However, many investors still questioned the logic of paying higher fees for buying long exposures to alternative markets.

KPMG director, Mandeep Sandu, said: "Advisers should give investors everything they can to have complete transparency. This will improve trust".

"Investors are really looking for those types of flexible attributes," he said.

McNab noted that investors had a growing interest for hedge funds, as well as a new awareness of strong risk/return balances.

"We are in an environment where equity markets are expensive, bond yields remain close to long-term lows and cash returns are paltry; traditionally constructed portfolios are unlikely to provide the medium-term returns that investors need, and expose investors to unusually high levels of risk," he said.

"Increasing allocations to alternatives represent a search for sources of returns in a low-returns world.

"While many planners have been consistent allocators to alternatives, others are newer to the space, and for these advisers, the inclusion of alternatives represents a step change in their portfolio construction approach; these changes are playing out across hedge funds specifically."

McNab said planners could seek tactical investments in individual alternative asset classes, build strategic and diversified alternatives through various managers, or allocate to diversified programs through single products.

McNab said planners could build strategic and diversified alternatives through various managers, or allocate to diversified programs through single products.

"Planners should be aware that in the alternatives space manager selection is critical. In contrast to traditional asset classes, the differences in performance between high and low performing managers in alternatives can be quite marked," he said.

"It's critical to interrogate the investment track record, investment capability, and organisational stability of the manager as part of the allocation process."

Traditional assets challenged

Wills suggested fund managers could expect to see more interest in fixed income, emerging markets would likely be back in fashion, and more sector specific moves could be expected within the equity market in 2017.

McNab said alternatives would play a critical role for investors, particularly those who worked to the popular five-year time horizon.

"We are living at a moment in time when traditional asset classes are challenged. Equity markets are expensive and bond yields are low," he said.

"An allocation to alternatives is more relevant today than it will ever be — a signal that a large number of institutional, family office, and planning investors are responding to."

The KPMG/AIMA report found 56 per cent of fund managers thought technology would impact competition in the immediate future of the hedge fund sector.

"While some may suggest that the hedge fund sector has been somewhat shielded from the disruption that has been wrought on other financial services sectors by digitisation and technology, it seems clear that the sector is now undergoing a period of technology and innovation-led competition," the report said.

The report found that over the next five years, the role of technology for hedge funds would be most important for portfolio risk management (86 per cent), data management (86 per cent), and data analytics for front office (84 per cent).

While onset of technology has promised to increase transparency, trust, and efficiency, and in turn could calm investor nerves, Sandu noted that even in 2017, innovation could never quite outdo the human factor.

"Investors really need to understand the processes and the mechanisms of investing — that aspect of things is not going to change."