With traditional asset choices no longer offering the portfolio diversification they once did for Australian investors, Alexander McNab makes the case for alternative assets.
The global financial crisis (GFC) demonstrated that the diversification benefits of investing across asset classes can be illusory when correlations between these asset classes are high.
Too many investors saw the value of their portfolios drop dramatically because of a lack of genuine diversification (measured in terms of underlying correlations rather than asset class titles) within their portfolios.
As a result, building genuine diversification in portfolios presents a challenge to investors and their advisers. If shares, property, cash and term deposits struggle to reduce portfolio risk, generate income or drive performance, where can investors turn?
Overseas institutional investors have long recognised the benefits of substantial allocations to alternative asset classes.
In fact internationally, alternatives are considered mainstream investments.
According to Russell Investments, international institutional investors allocate nearly a quarter – or 22.4 per cent – of their portfolios to alternative asset classes.
The best performing asset managers in the world are widely considered to be United States-based university endowment funds.
Harvard’s fund has delivered better than 12 per cent net compounding returns over more than 30 years, riding out the recent Great Recession, Dot-Com bubble, Asian crisis and a myriad of other unforeseen financially challenging events.
Yale has done even better, with their beneficiaries receiving more than 13.5 per cent over the same time period.
When asked how they have done this, the response is almost always the same:
- We have a high allocation to alternative assets;
- We invest for the long term; and
- We try to find the best managers.
Harvard allocates over 60 per cent of its portfolio to alternative assets. Yale allocates over 70 per cent.
It's not that hard
Alternative assets are not a complicated asset class. Typically, they include: private equity and venture capital – simply equities in companies that are not listed on a securities market; private real estate – unlisted real estate investment opportunities; real assets – tangible assets including infrastructure, agriculture, timber, and water; and hedge funds.
Why do Harvard and Yale value their alternatives portfolios so highly? The common thread across these asset classes is a risk, return, liquidity and correlation profile that differs from the traditional asset classes of equities and fixed income.
When done well, alternatives deliver on three really important components:
- They are usually less correlated with financial markets, providing actual diversification benefits in the tough times
- They give investors access to asset classes not available on public markets; and
- They provide for investment out-performance as a price for their relative illiquidity.
In our experience, the reason these benefits occur is simple. The opportunities for an investment manager to apply skill, networks, proprietary deal flow, and ideas are much greater in unlisted market segments than in listed ones.
Listed markets have a wealth of competition, transparency and live up-to-date information.
Unlisted markets don’t.
Lower liquidity a strength
In addition, if you are in unlisted assets then by definition liquidity is much lower. This is a strength of alternative assets, not a weakness.
Human beings usually sell precisely when they should be buying. Investing in alternatives makes you invest for the long term and stay the course.
It also allows your investment returns to compound rather than give a quick return. It is important to remember investing is not the same as trading.
Unlike traditional asset classes such as equities and fixed income, manager selection is critical in alternative asset classes.
In the academic parlance, most alternative asset classes demonstrate a high dispersion of returns, where high-performing managers generate much stronger returns than their less successful competitors (in contrast to equities or fixed income, where most managers return pretty close to market benchmarks).
Secondly, most alternative asset classes demonstrate persistence of returns where high-performing managers tend to outperform their peers year-in, year-out (in contrast to equities and fixed income, where most manager performance reverts to the mean).
Together, dispersion and persistence of returns make manager selection a critical success factor in investing in alternatives.
Aussies go alternative
Australians generally don’t have a high allocation to alternative assets, but this is changing. The Future Fund has allocated more than 35 per cent of its portfolio to alternative asset classes.
According to Rainmaker, alternatives now make up 16 per cent of the Australian investment landscape and are the fastest growing asset class in the country.
People looking after their own money tend to be the more financially sophisticated individuals in Australia, and they do lots of research on where to put their money.
But one category of sophisticated investors does not seem to follow this upward trend towards alternatives.
Self-managed super funds (SMSFs) have grown to $521 billion of retirement savings, accounting for nearly one third – 31 per cent – of Australia’s total superannuation assets.
However they are estimated to have less than 1 per cent in alternatives.
The reason for this is not demand. It is access. Very few alternative investment managers are structured to provide investment offerings to individual investors: until very recently, unless you were a large institution or a friend of the fund manager, you were unlikely to get a look-in.
What’s more, Australian distribution of financial products and leading investment platforms preclude just about anything without daily liquidity.
Financial planners and wealth managers are therefore limited to products with this liquidity profile, which naturally excludes just about all alternative asset types, with the exception of some forms of hedge funds.
It is no wonder Australia has so little money allocated to alternatives when most planners and wealth managers use administrative platforms that preclude their use.
However, this is changing. Australian investors are beginning to realise the benefits of alternative asset classes apply to them as well and that the current situation is unsustainable.
As a result, they are seeking to allocate to alternatives to take advantage of diversification benefits and the potential to enhance risk adjusted returns.
Sophisticated investors with long-term time horizons are willing to consider illiquid investments, understanding that liquidity comes at the price of returns.
Fund managers catch on
At the same time, some fund managers are beginning to appreciate the importance of broadening their investor base.
The rise of self-managed super has been a key driver of this change. Individual investors, either within or outside their super, have become too important to dismiss.
The benefits of allocating a portion of a portfolio to alternatives are too compelling to ignore, and we expect to see the structural impediments to investing progressively removed, to the benefit of individual investors.
Barriers have already started to come down. We are seeing the market change slowly, with the rise in popularity of vehicles such as exchange-traded funds (ETF), some of which fall into the alternatives category and are a gateway to portfolio diversification.
Similarly, mutual funds and funds of funds are becoming more common and viable options, giving Australian investors broad exposure to varied investment strategies managed by experienced managers.
We are yet to see what will become of the Future of Financial Advice reforms, but all signs seem to point towards positive industry change, which can only be good for investors who wish to diversify their portfolios and access alternative investments.
Alexander McNab is the investment director of Blue Sky Alternative Investments Limited.