What’s the alternative?

Written By: Matthew Craig LAPF Investments

Matthew Craig looks at the reasons for the increasing popularity of alternatives amongst investors and outlines some of the challenges they present

Back in the eighties, the supporters of Margaret Thatcher’s economic policies regularly claimed: “There is no alternative”. Whatever the rights and wrongs of that position, there is no doubt that in today’s investment world, there are myriad alternatives to the mainstream bond and equity asset classes.

Alternative investments are becoming widely used by investors for a variety of reasons. One is the current investment climate, according to Joe McDonnell, Head of the Portfolio Solutions Group at Morgan Stanley Alternative Investment Partners: “It is understood that we have now come to the end of the simple beta rally. Traditional asset classes have done very well in the last five years and performed better than what is expected from their normal long-term returns. However, this rally is no longer sustainable.” Many market observers believe that traditional bond and equity markets are now over-valued, with cheap money from quantitative easing policies inflating asset prices. At the same time, an increase in market volatility is reminding local authorities of the need for diversification. Another reason for the interest in alternatives includes the search for returns higher than on offer from core fixed income in the current low interest rate environment. The increased availability of suitable alternative assets is also a factor, as more asset managers are now offering alternative investment products, while another factor is the illiquidity premium for investors who can lock up their assets for longer periods. McDonnell further explained this last point, saying: “Local authority pension funds recognise they have a liquidity budget when many corporate defined benefit, and all defined contribution funds, do not. They have a longer view on things, and can therefore exploit this.”

Merseyside Pension Fund has a 20% allocation to alternatives and real assets. It has increased its initial 2% allocation to infrastructure to 5%, and has 5% allocations to private equity, hedge funds and an opportunistic investments portfolio respectively. Merseyside’s head of pensions, Peter Wallach, said it makes use of the illiquidity premium, particularly in private equity where it has invested for over 20 years, but also in its opportunistic bucket. “Investments in there are a bit more liquid than private equity, with no more than a three-year lock-up, whereas we are willing to lock up assets for up to 10 years with private equity. Returns might be lower than private equity but there is less capital volatility. If these assets can throw off an income, that is an added attraction.” Wallach said that diversification and finding alternative sources of return are among the other reasons for investing in alternative assets.

Assets in Merseyside’s opportunistic investment bracket include insurance-linked securities, which are reinsurance rather than catastrophe bonds, and financing investments, such as direct lending and senior secured loans. Also in this bracket are CLO (collateralised loan obligation) funds, royalty funds and a fund investing in hedge fund managers, as well as aircraft leasing. The use of investments like this shows how alternative investing is now about much more than hedge funds and private equity. According to McDonnell, there has been a recent shift in demand from benchmark-driven strategies to absolute return fixed income. He added: “The search for more income or yield by investors has led to a greater demand for private market yield strategies, for example leasing and royalties.”

In a similar vein, investment consultants Towers Watson sees alternative credit playing an important role for pension funds and other institutional investors looking to reduce their equity risk exposure and find other sources of return. Alternative credit, in its broadest sense, covers everything in credit below the core fixed income assets of highly-rated government debt and corporate bonds. This encompasses high yield debt, bank loans, structured credit and emerging market debt, and less liquid assets such as direct lending, distressed debt and speciality finance. Towers’ global head of credit, Chris Redmond, commented: “Investors have historically accessed alternative credit predominantly via hedge funds or small off-benchmark allocations within existing traditional fixed income mandates. In recent years, dedicated alternative credit specialists and strategies have emerged, making it more accessible. However, there is still a long way to go as the opportunity remains underinvested and misunderstood by many institutional investors.”

As Redmond’s comment indicates, there are a number of challenges for investors when it comes to alternative assets. As he states, one challenge is whether asset classes such as alternative credit belong in hedge funds. Also in this bracket are fixed income, or, as Merseyside does, within an opportunistic investments allocation. Other challenges include the complexity of some alternative investments, and the governance requirements they impose on investors. One approach for pension funds is to gradually increase their knowledge over time. Wallach explained that Merseyside Pension Fund has invested in private equity for a long time and the knowledge and experience it has acquired helped when it went into infrastructure. “It was less of a step change to invest in infrastructure, because we had familiarity with the kind of investment vehicles used for infrastructure, the terminology and the structuring used. It means it has been an evolution rather than a revolution.” Wallach added that a background of private equity and hedge fund investing has helped with investing in the type of non-traditional assets in Merseyside’s opportunistic allocation. “It is a transferable skill set. There might be other factors to take into account but some of the basics remain the same, such as having confidence in the management team, understanding where returns are coming from, and whether returns can be arbitraged away.”

For smaller pension funds, one option when considering alternative investments is the use of a multi-asset approach, such as a diversified growth fund, or a bespoke allocation from a manager able to invest in a variety of alternatives. With this approach, a manager invests in a range of alternatives assets in order to produce an absolute return. This type of fund has become popular as a diversifier to traditional assets and McDonnell commented: “A well-structured diversified alternatives portfolio is better positioned across different economic environments than traditional assets. While equities need good GDP growth prospects to sustain markets, skill-based strategies are not dependent on this.”

But there has also been a backlash among investors such as local authority pension funds against some alternatives products, such as funds-of-hedge-funds, which are seen as adding an extra layer of fees and having performed disappointingly in times of market crisis. Hedge fund “2 and 20” fee structures have also come under pressure, with many investors feeling this is too high a price for performance which, in some cases, is little better than market indices. For larger local authority funds, making an allocation to single strategy hedge funds is often preferred to using a fund-of-funds approach. Wallach commented: “We have a spread of single strategy hedge funds to give some diversification. Fees are a consideration for us. We are looking for strategies for hedge fund characteristics but with a lower level of fees.”

Given that many investors now have a more sceptical view of hedge funds, their performance in 2015 could have an impact in the next set of investment reviews. August saw the MSCI World equity index lose 7%, with another 4% fall in September. The early signs are that hedge funds did not do as badly as this; for instance, the Lyxor Hedge Fund index was down 1% for September but Lyxor said that hedge funds have outperformed traditional asset classes over the year to date. It added that CTA funds, global macro and market neutral equity long-short strategies produced positive results in this period, with most other hedge fund strategies in negative territory for September.

Overall then, it can be seen that alternatives are now playing an important role in pension fund investing. Local authority funds are in a good position to take a longer-term view and benefit from illiquidity, while they can also build up expertise in alternatives. It remains to be seen how moves to create a few, very large pools of assets will impact alternative investing. One option could be for large-scale passive investing at minimal fee levels. Another could be to use the increased scale to invest in alternative assets, which may offer superior returns but with higher fees. And the government has said it hopes this will lead to higher investment in infrastructure, although this raises a whole new area of governance issues. What can be said, without fear of contradiction, is that there are plenty of alternatives for investors who want more than just bonds and equities.