If returns from traditional asset classes mainly depend on asset appreciation, the performance of alternative investments is greatly driven by manager skill and expertise in taking advantage of different market situations. Hedge funds, private equity, real estate and commodities are seen as lowly-correlated assets that investors can use to counterbalance the risk related to potential underperformance in the equity or bond markets.
The recent sharp falls in world stock markets have once again made the investment community nervous about the risks they are taking. Commodities prices, for instance, were hit hard as hedge funds and other investors rushed to reduce their riskier exposures. Alternatives now play a major role in institutional asset management by improving the risk/return profile of institutional portfolios, but in some instances their behaviour does not differ from that of traditional asset classes.
High correlation
Marc Pautz, principal at Mercer Investment Consulting, comments: “In more volatile equity markets there are some commentators who would suggest that the level of correlation [of hedge funds] can actually go up, precisely at a time when you are looking for correlation to be low, so that is a risk. It is not a risk, however, that tends to put people off and interest in hedge funds has been rising.”
He adds that although recent returns in the asset class have been relatively modest compared to those registered in the past, they seem to be in line with what investors currently expect from the sector.
Yannis Procopis, senior analyst at the Geneva subsidiary of fund of hedge funds manager CMA, says: “If you look at the way we run our portfolios, we obviously tend to have some correlation with the equities markets but that is relatively low because we keep a pretty balanced portfolio across the spectrum of hedge fund strategies.”
Mr Procopis explains that over time equity long-short funds will have a significant correlation with the equity markets because most of them tend to be long-biased. “But when you expand this to the entire portfolio, the correlation decreases significantly because you have a lot of strategies that are not correlated.”
He explains that having volatility managers in their portfolio helps in situations like the one seen at the end of last month as they tend to perform quite well when there is a correction in the equity markets. “We also have some short-term systematic managers that were able to make quite a lot of money on those days and some discretionary macro managers that tend to be quite differentiated with the whole of the market.” Overall, he adds, having a well-diversified portfolio across different hedge fund strategies should give investors returns that are lowly correlated to those of the markets.
Other allocations
Private equity is another asset class in which institutions have been investing more and more. According to Mr Pautz around 15 per cent of Mercer’s pension fund clients in the UK have an allocation to private equity. This proportion goes down to 8 per cent when it comes to clients in Continental Europe. However, whereas the average UK pension funds can invest anywhere between 2 per cent to 12 per cent in the asset class, exposures to private equity among pension funds in the rest of Europe can be substantially higher ranging from 8 to 20 per cent of total assets.
However, the current controversy surrounding private equity does not end at the political level. A recent paper published by the Business School of the University of Amsterdam suggests that private equity fund performance estimates found in previous research – used as industry benchmarks – are overstated. Using a dataset of over 1500 mature private equity funds, the authors of the paper believe that commonly used samples are biased towards the best-performing funds. This research shows that after correcting this bias and overstated accounting values, the average performance changes from slight over-performance to substantial underperformance of -3.83 per cent per year with respect to the S&P 500 index. The authors conclude that the huge growth in inflows going into the asset class cannot be attributed to genuinely high performance.
“Private equity is clearly controversial at the moment from a political perspective and also from an investment perspective,” says Richard Lacaille, European CIO at State Street Global Advisors (SSGA). “It is important for investors to know what the returns in the asset class are and what the risks are and then to think about how much reward is available from private equity and how to pick the best managers.” Referring to the paper by the University of Amsterdam, Mr Lacaille says that it shows that private equity returns are closer to the public equity markets “than some of the headline numbers suggest. However, it is also the case that investors are buying individual managers’ skills and if you pick the right manager you could achieve extraordinary returns”.
For the most sophisticated investors the search for non-correlated returns expands outside hedge funds, private equity and real estate. Dutch and Swiss pension funds, among others, are now putting money into commodities, through investments in commodity futures. Other institutions have moved into natural resources, attracted by the long-term return potential of assets such as timber.
Infrastructure moves
More recently, European investors have started to hear about the benefits of investing in infrastructure, an asset class that has been attracting money from Australian and Canadian investors for many years now, according to Arthur Rakowski, executive director at the investment banking fund division of Macquarie Bank. The Macquarie Infrastructure Group is one of the world’s largest developers and operators of toll roads with a portfolio expanding across seven different countries.
“The current interest in infrastructure is just part of a broader shift among institutions away from traditional asset classes,” he says, adding that there is no particular reason why European institutions haven’t moved into infrastructure investments earlier “other than the fact that no-one has been promoting this until recently.”
The infrastructure sector includes investments in both economic and social infrastructure. This covers a wide range of assets from toll roads and airports to gas networks and education and healthcare facilities. At Mercer, Mr Pautz thinks that the big issue stopping more investors from entering the sector is access. “It presents quite a few challenges for trustees. One is an educational challenge, in terms of how familiar an average investor is with the asset class, and the other is how many opportunities they have been able to access.”
However, the launch of new funds investing in infrastructure and the improved knowledge about the potential benefits of gaining exposure to the sector are likely to result in more assets pouring in. “I think it is still an unusual asset class but as trustees start to look beyond the mainstream, they will also be looking at infrastructure,” Mr Pautz adds.
Tony Roper, manager of the HSBC Infrastructure Company, says that there have been more infrastructure fund launches from different providers. He believes one of the restrictions for being successful in this sector is finding quality people with infrastructure experience. “There are some commonalities between real estate investment and infrastructure but the funding and the risks are different,” Mr Roper says. “The thing with infrastructure is that every project is different and contractually is very complex. It is a skill you learn over time.”
Unique position
For Mr Rakowski, infrastructure has the quintessential alternative investment characteristics. “The combination of having a relatively privileged position in the market with the essential services that these assets tend to provide, means these assets and businesses do not tend to move in the same way as other businesses and don’t tend to move with the movements or other asset classes.”
He adds: “These assets are both lowly correlated in the technical sense and also broadly defensive since they are relatively protected from the economic cycle because of the nature of the services they provide and the environment in which operate.”
He believes the interest in the asset class is here to stay. “As with any emerging asset class, once it has emerged it becomes part of the landscape and one of the issues we’ve had in the past when trying to promote our funds was that many institutions didn’t have a specific [target] asset allocation to infrastructure and as a result they found it very difficult to invest in,” he says. “Infrastructure will just mature and become – like private equity, real estate, commodities and hedge funds have – part of people’s portfolios.”
