As with other types of investment, alternatives have been buffeted in the last year, but given the cyclical nature of this asset class is now the time to invest? Andrew Sheen reports
Alternative investments make up an important and growing part of any well diversified investment pension portfolio. However, with global markets in continuing turmoil, knowing where to turn and how to invest has become more important than ever.
As International Asset Management (IAM) investment manager Sean Molony said: “We saw unprecedented market conditions around the world last year. Equities have experienced their second worst period in a hundred years and in most investment areas, there have been disappointments.”
Despite this, it seems most pension funds have held firm and not taken any hasty decisions in terms of asset allocations. Perhaps because of the time horizon pension funds operate in, and the relative age of many schemes, Capital Dynamics, managing director and head of research Katharina Lichtner, said many funds had greater perspective on market cycles: “Many pension funds have been in alternatives for a long time and have been through previous cycles – they’re sticking with their investments. We feel that investors have a greater need for information – pension funds are looking for greater guidance in markets like these.”
Molony continued: “We have found that many pension funds have become more interested in investing in funds of hedge funds – they see an expanded opportunity set in hedge funds and exposure levels are still comparatively low in comparison to the total size of their portfolios.”
Although there may not have been a trend to funds trading out of alternatives over the past few months, as BlackRock’s Multi-Asset Portfolio Strategies group managing director Ewen Cameron Watt, explained, there had been a slowdown in terms of new allocations and decisions being made: “I think the second half of 2008 was difficult for people thinking about allocations to alternatives – there was downward pressure and correlations between previously de-correlated assets rose. A lot of clients said ‘hold on’ and did little or nothing until correlations came down again and a lot of the decisions have been on hold.”
He added: “Long term, I don’t think that has put people off – there’s still belief in diversification. It was a second half of 2008 story – there’s still belief in that view. We think that funds could look at allocations up to 15% to get the appropriate diversification benefits, but there’s a clear view that different approaches to alternatives work better in different parts of the cycle.”
Credit Suisse chief operating officer, single manager hedge funds, Stephen Foster agreed: “Some markets have not been operating in an understandable way and this has hit investments. When things calm down again, hopefully investors will return.”
S&P Index Services’ vice president of commodities indices Eric Kolts added another reason for many funds ‘holding the course’ with their alternative allocations was that most took allocation decisions as part of their triennial valuations and so were unlikely to change allocations until the next valuation.
“The main thing is the fact that we haven’t seen institutional investors leave the market, considering the situation. They still see the diversification benefits,” he said.
Looking ahead, everyone agreed there were opportunities in the market – providing pension funds as investors knew where to look.
Watt said: “We think we’re nearer to the bottom of the cycle than six months ago, so is it time to invest? Well, in many ways it’s one of the most attractive times to invest in alternatives in the last 25 years [because] the current situation has created an enormous dislocation in prices. There’s no need for leverage – prices are attractive already so leverage isn’t needed.
“If you believe there’s still a business cycle, the present dislocation has provided opportunities.”
Foster agreed: “There could be opportunities for pension funds. There’s scope for the long-term appreciation of assets. It’s an interesting time to invest.”
However, Lichtner said it would be a mistake for funds to try to cherry pick individual investments on an opportunistic basis: “We try to discourage clients from trying to time markets, because by the time you notice a trend it’s usually too late. We think it’s better to be adequately diversified across all strategies and focus on manager quality.”
The tide turns
In terms of individual strategies, it was clear the ongoing economic turmoil had caused changes in each market, although most were upbeat about the opportunities these changes afforded.
Molony said the hedge fund industry was “currently contracting” although he added this should not necessarily be viewed as a negative: “The industry can cope with some degree of shrinkage. Market conditions have clearly been challenging for many hedge funds but there remains some excellent hedge fund talent out there for us to invest in. Furthermore, many high quality managers that have been closed for some time have now opened for new capacity because of the increased opportunities available.”
Foster said that as absolute return vehicles, as hedge funds have sometimes been labelled, “they probably haven’t done too well”.
“But in terms of declining indices, hedge funds are down, but not by as much as equity markets,” he added.
Molony said there were four hedge fund strategies which the company had a particularly positive return outlook on: credit, although he said the view needed to be balanced with the risk outlook as the market was still illiquid and default rates were rising; commodity trading adviser, which “historically perform well in dislocated markets like last year because of a negative correlation with equities”; long/short equities, as he said there was evidence of a return to more fundamental drivers; and macro, where he saw a “constructive top-down environment”.
Of course, the most high-profile hedge fund case of the last few months has been the spectacular unravelling of the Madoff fund, which has provided salutary lessons of what precautions schemes should look out for when investing.
Foster said the Madoff case was an “almost a textbook example” of investors not carrying out the correct due diligence – “the smooth returns month after month didn’t make sense. You would have expected to see more volatility”.
Molony agreed: “[Things like Madoff] are not helpful to the industry as a whole. There needs to be more due diligence – a lot of it is just hard work, being thorough and getting on with it. The mistakes come when people don’t do that and make errors in that area.”
Although private equity deals have also been smaller in the recent past than in the period before the credit crunch hit, with no new large deals completed in that time, Lichtner said small to medium sized deals in the US$1 to $3bn market hadn’t disappeared entirely.
She explained: “A lot of people say deals aren’t happening because there’s no leverage. That’s too simplistic an explanation, leverage is tight but not impossible to arrange, but prices on the sell-side are often still too high. Sellers haven’t adjusted yet, and as the recession continues, prices will come down further. That’s to say, in a few months time companies could be acquired for a better price. Part of the low investment activity at the moment is driven by funds aren’t willing to invest just yet.”
Going forward, Lichtner said the operating environment would change, with less emphasis on leverage as the main return driver: “In the last cycle the value creation of many deals was driven by the use of leverage, in the next cycle we think this will play a reduced role. The value creation will come from other drivers than leverage, such as operational inputs.”
Watt agreed: “Private equity used to be a case of investing and holding for a decade or more – it got away from that earlier this decade. The excessive reliance on leverage in the hedge fund space was the most obvious mistake, and there wasn’t nearly enough focus on manager selection, and the consideration of these things as long-term investments.”
The long-term view of investments has played against some asset classes however. Kolts said most pension funds investing in commodities accessed the asset class through indices and passive vehicles, such as exchange traded funds (ETFs).
With oil about a third of the price at the time of going to press than at its peak in mid-Summer 2008, there were persuasive arguments in favour of investing in the asset class.
He added: “Obviously, there’s an attractive price point for entry, but saying that, there are some major commodity markets in contango [an upward-sloping forward curve, meaning the price of a commodity for future delivery is higher than the spot price] at the moment.
“The price may look attractive but sophisticated investors realise that there may be a drag on returns.”
Yet whatever the asset class within alternatives, the message was simple. As Watt noted: “As an investor, the financial crisis has thrown up challenges. Funds should be sure that assets are what they seem to be and are priced properly.”
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