Are alternative investments still a buffer against market volatility?

hedge funds private equity property bonds compliance hedge fund investors equity markets retail investors global financial crisis lonsec

31 May 2010
| By Chris Kennedy |
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Alternative investments traditionally offer a buffer against market volatility. Chris Kennedy finds out how they have fared over the course of the last 12 months. 

Alternative investments are a disparate and wide-ranging asset class, but in general they all provide a supposed buffer effect against the volatility of the share market while diversifying an investors’ portfolio.

Investors were previously prepared to have funds locked up as a trade off for added security, but in the post global financial crisis (GFC) environment the focus is now on liquidity and transparency, as investors who were burned during the crisis look to ensure the same thing does not happen again.

The global economic meltdown that hit in mid to late 2008 showed that some alternative classes are far better protected from economic volatility than others. The performances of those various classes since conditions began to turn around in early 2009 have also varied widely from both the index and other alternatives.

Infrastructure proved to be one of the least affected sectors, with demand and revenue generally remaining stable throughout the economic turmoil despite some changes in valuations.

The long-term nature of private equity investments also helped to shield those assets, although capital raising proved to be an issue and the new focus on liquidity is also keeping sales slow.

Property was affected but tended to lag the market, on both the downside and the upside, with the long-term effects still to be realised.

Hedge funds escaped the worst of the carnage experienced in equity markets, but most strategies have also been somewhat buffered from the market recovery. Investors who poured out of hedge funds during the liquidity crisis began flooding back in towards the second half of 2009 and into 2010 as liquidity returned to the sector.

In the post GFC environment the focus is now on liquidity and transparency, as investors who were burned look to ensure the same thing doesn’t happen again.

Hedge funds

The Credit Suisse/Tremont Hedge Index 2009 Industry Review states that 2009 “marks the best annual hedge fund performance in a decade … and the greatest performance rebound since inception of the index in 1994”.

Globally, hedge funds recouped 77 per cent of 2008 losses from previous peak performance levels, 83 per cent of the funds on the index posted positive performances for the year, and 58 per cent of all “impaired” assets returned to standard liquidity status, according to the report. US$72 billion in impaired assets remained illiquid as of 31 December 2009.

The industry experienced net inflows of US$12 billion in the fourth quarter, although it lost US$74 billion in investor redemptions in the year overall. Including performance gains, the industry grew from a total of US$1.3 trillion in assets under management mid-year to US$1.5 trillion by 31 December.

“Lessons learned from the events of 2008 have led to investor demand for increased transparency and liquidity,” the review states.

“The attention being paid to these areas underscores investor interest in playing a more active role in the investment process going forward.

"This has also facilitated increased communication between clients and investors, spotlighting the importance of investor relations in terms of client prospecting and retention.”

Following the failure of some hedge funds during the crisis, investors are now placing greater emphasis on operational due diligence including greater analysis of hedge fund operations, compliance, control and risk management, according to the review.

The Credit Suisse/Tremont Hedge Index Q1 2010 Review reports returns of 3.1 per cent, with 69 per cent of funds overall in the positive. The industry experienced further inflows of US$2 billion in the quarter.

“We expect industry [assets under management] to continue to grow in 2010, especially if investors continue to allocate away from more traditional assets such as equities, which most believe will not be able to produce the same level of returns seen in 2009,” the review concludes.

“The increased availability of hedge fund exposure through retail channels is expected to offer retail investors access to the uncorrelated return streams of the hedge fund space while also providing an alternate source of fund capital, which previously came almost exclusively from institutional clients.”

Frontier Investment Consulting senior consultant Allison Hill says hedge fund of funds have rebounded very strongly in general over the past 12 months, partially through a normalisation of markets and higher levels of opportunity.

“Given the number of issues working through the markets, hedge fund managers which are able to be quite nimble [will be] able to capitalise on those,” she says.

As far as hedge fund specific strategies are concerned, Hill says credit strategies and long/short equities have worked quite well over the past 12 months, while global macro managers have tended to struggle.

CTA managers, who did quite well throughout the crisis, had some normalisation of returns, she adds.

“Liquidity has by and large returned to the market, [but] there are still some stresses in the credit markets that haven’t fully normalised,” she says.

“There are still some interesting opportunity sets for the managers to exploit. Perhaps not as strong as over the last 12 months, where there were more easy and ready opportunities on the table, but there still should be a reasonably compelling environment for hedge funds over the next 12 months.”

Joe Bracken, head of macro strategies at BT Investment Management, has hopes for a decent year for alternative strategies in general and global macro in particular.

“What we’re looking at is a relatively uncertain environment where bond markets are flip flopping all over the place [and] equity markets are up and down. In this kind of an uncertain environment strategies like global macro tend to do well,” he says.

“I think it will be an uncertain market; it’s not obvious that equities are going to continue to rally or that bonds will do particularly well or that inflation is going to pick up — there’s a lot of uncertainty out there.”

The liquidity crisis, which saw many funds freeze redemptions, damaged the image of hedge funds, and fund of funds in particular.

“That really left a bad taste in investors’ mouths and I think that since then they’ve struggled,” he says.

Investors believed that with their funds locked in they would be protected in the event of adverse market events.

“[Since] that didn’t happen they are now demanding much higher liquidity, and they’re going to push back on the whole lock-in idea.

"Getting investors to accept even quarterly liquidity now is tough. The hedge funds that are beginning to attract inflows will be the ones that have institutional backing and the ones that have very good liquidity.”

Bracken believes investors in the current environment are no longer looking for an absolute return fund returning 20 per cent per year, rather they will prefer cash rate plus 4 per cent or 5 per cent, with about 5 per cent volatility.

“They’re perfectly happy to accept a more consistent outperformance at a lower risk budget,” he says.

HFA managing director Oscar Martinis sees opportunities for hedge funds in the new economic landscape.

“One of the unintended consequences of the GFC is that a lot the larger investors pulled back from international expansion efforts in those higher growth economies, and the withdrawal of those investors has left behind real outsized opportunities for those that remain,” he says.

“We’re also seeing that reduced activity at the banking level has left a big gap in the sense that the banks that have traditionally handled a lot of the market making for a lot of the positions out there [have scaled back].

"In a lot of cases, the hedge funds have been able to capture that market making function as the banks have constrained their trading activities.

“The fact that hedge fund managers have the opportunity to go long and short in markets and trade very quickly in and out of areas will be quite beneficial for investors through the course of 2010 and beyond.”

Fund of hedge funds

Lonsec senior investment analyst Deanne Fuller says there has been a big drop off in demand for fund of hedge funds, especially in the retail sector.

“It took a long time for investors to get their money out as a number of fund of funds closed to redemptions during the GFC. Investors have been nervous about getting back in,” she says.

“Lonsec rated nine fund of hedge fund managers this time in 2007 and we’ve currently got four on our list, so that just highlights the lack of demand we’re seeing for these funds at the moment.”

Some investors have turned away from fund of hedge funds altogether due to a lack of transparency, although these funds were endeavouring to be more transparent now, she says.

Fees are still an issue, but work has been done to get fees lower, while work has also been done to align the liquidity levels of the overall funds with the underlying assets, she adds.

“Fund of hedge funds have done reasonably well performance-wise this year and they do offer the diversification benefits that just aren’t there in some of the other asset classes available, [but] I think it will be another six to 12 months before we start to see any kind of real movement back into that space.”

Infrastructure

Gerald Stack, portfolio manager of Magellan’s Infrastructure Fund, says the important thing to understand about infrastructure is that there’s a consumer price index linkage, which leads to stable earnings.

“What makes infrastructure attractive is it provides a service that’s essential; it faces little if any competition; it’s extremely price inelastic and it’s protected from inflation,” he says.

These factors lead to reliable long-term earnings, he adds.

“The infrastructure universe is growing due to demand increases; there’s more demand for infrastructure, for example car ownership per capita is increasing.”

There is also a massive amount of money to spend on infrastructure around the world, running into the trillions of dollars, he says.

This spending will be divided between governments and the private sector, with governments unable to afford the entire budget.

Andrew Coutts, senior investment analyst, property and infrastructure, at Lonsec, says in terms of global infrastructure drivers, long-term structural factors are likely to be the main contributors.

“This includes a combination of economic and demographic trends such as population growth and increased urbanisation, a requirement to replace or expanding aged infrastructure assets, privatisation of infrastructure assets and the increased government investment in the sector as part of their stimulus packages,” he says.

Volume recoveries across the globe are also contributing to the positive outlook in the near term, which will help drive improved earnings for transport related infrastructure.

More stable credit markets may provide for a lower cost of debt for infrastructure assets, along with a return to simpler capital structures and sustainable distribution practices.

As the prospect of inflation is increasing, the sector may become more popular for investors as an inflationary hedge, since many assets and companies have long-term contracted cash flows with built in increases and the ability to pass on increased costs to customers, Coutts says.

Performance in the 12 months to March 2010 has been strong, which reflects rallies that have taken place across global markets since the lows experienced in March 2009.

Major global infrastructure indices have shown returns of about 30 per cent in this period, with some managers covered by Lonsec delivering returns in excess of 40 per cent. Over a period of three years returns have drifted into positive territory.

“This has been an unusual period and one that has shown listed infrastructure to be less defensive than hoped in terms of correlation with the broader markets.

"In the case of Australia, debt fears and unsustainable capital structures drove the poor performance during the downturn, issues that have now largely been addressed,” Coutts says.

“Globally, the sector suffered as stocks were oversold during the broader market rout. As markets have stabilised, the sector should return to longer term trend levels in terms of volatility and returns.

"Individual stock fundamentals will be the main driver of share price performance during 2010, and it is therefore a market where professional investment managers with strong stock picking capabilities will perform well.”

Mercer’s global investment leader of alternatives beta research, Dragana Timotijevic, says infrastructure managers still hold a large amount of un-deployed capital.

“ A few years ago we had a strong supply of funds raising a lot of capital but now there seems to be less funds, and those funds are generally looking to raise less capital . Also, they tend to be more country focused rather than global,” she says.

“Looking at infrastructure opportunities now, Europe seems attractive — offering opportunities in the core and core plus space; while the US still seems to be a bit of a wild card. In general, I would say … if you’re looking for returns generated by core or core infrastructure, from a risk return perspective, you would probably be better off getting exposure to private infrastructure debt rather than going into core infrastructure equity.”

Allocations to infrastructure from Australian investors at the moment are likely to be very targeted, for example towards social infrastructure, rather than broad based, she says.

Hill says that in Frontier’s view the infrastructure cycle has largely bottomed, although we haven’t seen substantive revaluations yet.

“Direct infrastructure relies substantially on transactional evidence to allow for repricing and there have been very limited transactions to date.”

The transactions we have seen indicate that there may be a few more deals finalised in the short term, she says.

“All things going as expected, we should see some positive movement in the valuations of unlisted infrastructure. Listed infrastructure has risen along with the equity market.”

There is also more interest on an opportunistic basis in entering into infrastructure at the moment, she adds.

The chair of Industry Funds Management, Garry Weaven, says infrastructure has lagged the general market trends, both on the downside and on the recovery.

“Infrastructure tends to be more stable in terms of the businesses, so they would expect to do relatively well in a flight to quality. Good quality portfolios have exhibited much more resilience in earnings than the average company,” he says.

“During the GFC there was some movement out of the balanced fund into cash, so that made it more difficult for us to raise new equity for new infrastructure deals.

"That constraint is now removed again and our clients are starting to come back with significant allocations to infrastructure, and it’s probably a good time to do that because for the first time in many years there are opportunities in Australia and around the world to buy really good quality infrastructure assets at reasonable prices.”

Private equity

Timotijevic says in the private equity market funds are still struggling in terms of capital raising, and the opportunities seem to be the opportunistic, debt oriented strategies or hybrids rather than just on the pure equity side.

“In terms of private equity selection, you have to be very particular. Generally, in the private markets we prefer strategies that are either very focused [in terms of approach, country, sector, etc], are opportunistic, or ones that are highly structured, like the ones sitting in the mezzanine space.”

These tend to be more favourable on a risk/return basis, if not necessarily offering the same absolute returns as pure private equity, she says.

“In private equity, with funds still struggling to raise capital, there’s a lot of unemployed capital. We haven’t seen a lot of interest from investors with private equity,” she says.

Mercer has also seen some interest in secondaries, according to Timotijevic.

“Even though there’s been quite a lot of capital raised in that space, we think there will be more assets coming up for sale over the next two to three years,” she says.

Opportunistic private equity investors can move across the capital structure and can potentially capture the best kind of risk/return potential on offer.

They also tend to have shorter investment time horizons, which investors may also be more comfortable with given the current premium on illiquidity and general economic uncertainty, she says.

“With private equity you need to believe in the growth story and you need to believe that the listed market will be strong because this is how you’re going to realise those investments in most cases.”

Hill says there have been some re-evaluations of private equity investments in line with the re-rating of markets over the last year.

“That has seen some positive returns, and we’ve also seen a general high level of confidence in the markets seeing some exits from the private equity space. [But] there still can be some issues associated with debt, which is not as readily available as it was prior to the crisis,” she says.

“In terms of Frontier’s view in regards to [private equity] investment, we recommend a consistent allocation across timeframes overall; it’s not something you can trade into or out of very easily, so any investment is made as a long-term investment.”

Direct property

Peter Ward, director of fund services at Standard & Poor’s, says a strong beta rally in 2009 and the subsequent improved performance of property securities continuing from last year are affecting listed property securities fund performance, as companies that were punished during the GFC rebound.

Along with equity raisings continuing into 2010, credit markets have been opening up again, making credit more available and affordable, although he says debt maturities will continue to be a key focus for managers.

Direct property markets are starting to see an increase in transaction frequency, while valuations are stabilising and even starting to improve in some markets.

“The managers have generally moved to a more balanced footing from what was probably a more defensive positioning. An influencing factor over the last year and looking forward over the next year is how the economic recovery is going to pan out in the various global property markets,” Ward says.

The performance of direct property tends to lag the listed market, and the same is likely in this economic recovery.

Ward says that in Australian real estate investment trusts (A-REITs) and global REITs, the equity raisings that have occurred over the last 18 months or so have enabled those entities to strengthen their balance sheets and in some cases reposition themselves to take advantage of the opportunities emerging.

“There’s probably a refocusing from balance sheet related issues now that the sector is more conservatively geared ... to cash flow related issues,” Ward says.

“In Australia that’s certainly the case in the rising interest rate environment. In terms of what’s happening in Europe at the moment, that is likely to influence the performance of the REITs in that area, and that’s something that the managers will need to focus on.”

It’s a time when managers are looking at the geographic weightings in their portfolios and potentially reweighting to areas that provide better growth opportunities while reducing weightings in areas that may have growth issues going forward, according to Ward.

The glut of distressed real estate asset sales that some predicted may not have eventuated yet, but if interest rates continue to rise, some may eventuate, Ward says.

Despite this, we are seeing improving investor sentiment and real estate is gaining more investor interest in Australia compared to 12 to 18 months ago. Managers seem to be of the view that both here and in the US the fundamentals are at least heading in the right direction, he adds.

Globally, merger and acquisition activity is starting to emerge. This may have a particular impact in Australia given the concentrated nature of the A-REIT sector, Ward says.

“With additional [initial public offerings] coming to market, that will increase the size of the opportunity set for managers. If it goes the other way and there’s consolidation, reducing the number of stocks available to the investor, that’s a bit of a negative [for the sector].”

The better performing global listed property fund managers over the past three to five years were ING Clarion, AMP, BT, MLC and Zurich, the performances of which came down to the key capability they had and have been able to maintain throughout that period, according to Ward.

“They’ve been able to navigate the volatility of the last couple of years and start to take advantage of the opportunities that are emerging in the improving economic and market environment; maintaining the experience in their teams, keeping their teams stable, not reducing the resources associated with those capabilities, looking at finessing their processes along the way and picking up issues that perhaps didn’t hold them in as good a stead in the past and refining those.”

Although it hasn’t had the degree of volatility that the listed property market has had, Ward predicts the timing of the recovery of direct property will continue to lag the listed side. The last quarter has started to show some indications that direct property is starting to improve in Australia, he says.

The big picture

Fuller says the general trend in alternatives in the multi manager landscape is towards more liquid and transparent strategies.

“A couple of years ago we saw multi managers move quite heavily into private equity and some of those strategies with longer lockups that were really quite illiquid, but that’s changed a lot in our conversations with multi managers over the last 12 months.

"They’re really looking for the most liquid kinds of strategies that they can get into the funds,” Fuller says.

“Hedge funds are still on their radar, while private equity is one that’s fallen off the radar a little bit due to the liquidity. They’re no longer as attractive in the retail space. There’s a liquidity premium there and the institutional funds are much more able to deal with that.”

Morningstar co-head of fund research Tim Murphy agrees that the major theme with alternatives for retail investors at the moment is liquidity.

“Fund of hedge funds a few years ago was certainly the focus of demand in alternatives, but post GFC the demand is about as close to zero as you can get,” he says.

“If you look at what’s been successful for fund managers recently with liquidity as a big theme, the ones that have attracted the most fund flows are the ones that are more liquid.”

While commodities are getting talked about a lot and infrastructure is getting talked about as a possible alternative to listed property, there haven’t been massive flows into those areas so far, Murphy says.

“The broad theme overall is there’s not a whole heap of money flowing into alternative investments because a lot of the so-called alternative type investments that people had previously didn’t really do what people expected them to do during the GFC, so that’s warned people off a bit.”

Murphy says Morningstar does not have any dedicated allocations to alternatives when dealing with clients, and has dedicated allocation to alternatives in their model portfolios.

“The very nature of alternatives means that very few are the same. There’s so many disparate things that you could throw in there, so we say to our clients if you want to use an alternatives fund that’s great, but understand what the respective risk and return volatility dynamics of that strategy are likely to be through a cycle and then use it proportionately within the portfolio.”

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