Putting alternatives in perspective

Alternative investments remain front and centre for superannuation funds as they devise their asset allocation strategies but, as Damon Taylor reports, thorough due diligence is proving to be the key ingredient. 

In a broad assortment of both liquid and illiquid asset classes, alternative investment strategies are ever changing. As investors seek to diversify their portfolios, to find assets that will safeguard their portfolios in the case of market events, different alternatives rise and fall but for Kim Bowater, Senior Consultant at Frontier Advisors, there are certain themes that are constant. 

“So I think at Frontier, we kind of bucket alternatives into two broad areas,” she said. “One is real assets, so unlisted infrastructure and property, and they’re areas of investment that we’ve focused on for a long time and they continue to be an area of focus in terms of maintaining a reasonable allocation and finding well priced opportunities.” 

“But the other area of alternatives that we’re spending a bit of time on is the private equity and hedge fund type bucket,” Bowater continued. “And that ends up being the more opportunistic segment of an allocation.” 

“At the moment, there’s interest in liquid strategies that are diversifying so, depending on your fee budget, that might be multi-strategy type hedge funds or global macro or it could be some of the lower cost niche market or multi-asset type strategies as well.” 

Looking less at alternative investment’s more constant themes and more at what was currently topical, Simon Eagleton, Leader of Mercer’s Investment business in Australia, pointed to tail risk hedging. 

“But there seems to be a few different dimensions to those discussions,” he said. “On the one hand, we certainly see activity from investment banks spruiking their capabilities and the argument goes something along the lines of 'first level volatility is low so wouldn’t this be a good time to insure against a spike in volatility?’” 

“However, from my perspective, that’s always a bit of a simplistic argument,” Eagleton added. “Whenever we’ve been exploring some of these sorts of strategies, its always a bit more complicated than that.” 

“In fact, put option type insurance, true tail risk hedges, aren’t especially cheap and, to be perfectly honest, can often be quite expensive.” 

Yet while dialogue around tail risk hedging is currently a common topic of conversation within alternative investment, Eagleton said that such discourse was equally tied to super funds’ post-retirement strategies. 

“There are so many funds out there at the moment who, if they haven’t already, are starting to think about appropriate strategies in the post-retirement or transition to retirement stages,” he said. “They’re saying maybe we should put some downside risk protection in place for those members who are immediately rolling into retirement or even pre-retirement to protect them against event risk should markets take a sudden correction.” 

“So there’s that kind of chatter going on as well and we’re seeing a number of alternative investment strategies around the market along those lines.” 

Of course, while the alternative investment strategies being spoken about may be those within the private equity and hedge fund space, fund managers and asset consultants alike must keep in mind that for many investors, the status quo has changed. 

The alternative investment stereotype of complexity in terms of both strategy and fee is no longer appropriate but for Dania Zinurova, Investment Consultant for Towers Watson, that stereotype is only valid in certain asset classes. 

“So the first thing I’d say is that not all alternative investments are complex,” she said. “If we’re talking about infrastructure and real estate, I would say that they are a lot less complex in terms of the strategies and the fee structures.” 

“They tend to be very transparent and historically, investors here have been investing in those sorts of asset class for a long time and are therefore quite sophisticated when it comes to both their strategies and their appreciation of risk,” Zinurova continued. “But its slightly different in the case of hedge fund strategies, private equity or some of the strategies within illiquid credit.” 

“They do tend to have more complex strategies and fee structures, are not always transparent and certainly aren’t easy to understand.” 

Indeed for Zinurova, gaining comfort with any investment inevitably relies on thorough due diligence. 

“Your due diligence process has to be robust,” she said. “At Towers Watson, that involves numerous meetings with the fund manager and with senior team members but we also assess the skills of the more junior or support staff, conduct quant analysis on their track record, even do asset tours in the case of real estate and infrastructure.”  

“And in some of the newer alternatives like agriculture, timber, water rights and so on, it goes even further than that,” Zinurova continued. “We do a deep study of the macro economic drivers and market fundamentals and pay a great deal of attention to assessing potential risks and ways to manage them.” 

“That due diligence process is our key strength and it allows us to educate investors as to how a particular asset class works, what the risks are and, most importantly, what the benefits to their portfolio might be.” 

Echoing many of Zinurova’s comments, Bowater said that the 'complex and expensive’ label was certainly justified in the case of certain private market and hedge fund strategies. 

“They’re strategies that can be complex to understand and expensive relative to other asset classes,” she said. “But no matter what the asset class or specific investment, our approach is always based on a good understanding of the investment case.” 

“Is it attractive in the current environment relative to other asset classes? Does the philosophy make sense? Is there sufficient transparency into the processes and how decisions are made?” Bowater outlined. “So if something goes wrong, could we foresee that or could we understand how that might have happened?” 

“Those things are important and in terms of the cost, is it worth the fees? Is it doing something different relative to other investments, providing a meaningfully different outcome net of fees to warrant that?” 

Offering a similar perspective from a global standpoint, Jennifer Bridwell, Global Head of Alternatives Product Development for PIMCO, said that in the case of hedge funds, claims that certain strategies or funds lacked transparency were entirely legitimate. 

“Gone are the days when people could be unclear about what they’re doing and say this is highly proprietary,” she said. “A manager should always be willing to tell an investor exactly how a portfolio is positioned and its risk posture is.”  

Naturally, the sort of transparency focus described by both Bowater and Bridwell should not be surprising, however for Eagleton, such measures have taken on greater weight in the wake of the Australian Prudential Regulation Authority’s portfolio holdings disclosure requirements. 

“Its been interesting,” he said. “I think the clarity that we now have with regard to holdings disclosure and RG240 (Regulatory Guide 240 - Hedge funds: Improving disclosure) has exposed, I think, a variety of historical practices when it comes to fee disclosure,” he said. “And look, its nothing we haven’t seen this in the past.” 

“As an example, when you invest in a hedge fund of fund, once upon a time you might have done that but you would only disclose the hedge fund of fund manager’s management fee in your MER (management expense ratio),” Eagleton continued. “The underlying hedge fund fee, you wouldn’t disclose, that would just come through the net return.” 

“But I think its quite clear within RG240, that if you reasonably know that there are underlying fees, that you would disclose those and, in some circumstances, a fund’s MER could suddenly increase.” 

Yet Eagleton was quick to point out that the burden of transparency and disclosure was not about one individual party but all parties involved in ongoing alternatives investment. 

“The onus is on super funds, fund managers, everyone involved in a transaction to better disclose,” he said. “But just to be clear, I would say that there are a number of super funds, perhaps many super funds, who will have found that these new disclosure requirements haven’t had any impact on them at all simply because they’ve always been disclosing very thoroughly.” 

“But practices do vary and perhaps MySuper has caused this to bubble to the surface because you’ve got new disclosure requirements and you’ve got this whole category of product where administration and investment fees are suddenly front and centre,” Eagleton continued. “So that’s the backdrop and perhaps its also tied to what we might call the increased professionalism of our Australian super funds.” 

“They’ve built internal capability and brought investment professionals in-house, they’ve got the capability to select their own hedge funds, do their own research, their own due diligence and increasing disclosure and transparency is simply the logical next step.” 

For her part, Bowater said that APRA’s portfolio holdings disclosure requirements had only been a focus for super funds where new strategies were being invested in. 

“So in those situations, its really important that before an investor goes into a new strategy, particularly if its something that might not be fully transparent, that the investor and the manager agree what they’re going to receive and that it quite clearly meets known requirements,” she said. “So that could eliminate managers, absolutely and its an important decision for the manager as to whether they’re comfortable but to date, I don’t think these requirements have materially changed investors’ decisions.” 

“Its been an extra area of due diligence but so far it hasn’t gone beyond that.” 

But while the super industry must grapple with alternative investment allocations and how they may be impacted by altered reporting requirements, the perennial challenge for fund executives is how best to balance diversification benefits with liquidity requirements. 

However for Zinurova, how difficult that balancing act becomes is largely dependent on the individual client. 

“Some of our clients have quite significant illiquidity budgets so they’re not even slightly concerned about illiquidity,” she said. “They would have a target allocation to alternatives and be quite comfortable with that because they have liquidity elsewhere in the portfolio.” 

“Other investors have quite strict liquidity requirements within the alternatives portfolio and so one of the solutions to deal with that is to add liquid strategies,” Zinurova continued. “Global real estate securities or global listed infrastructure are the perfect example and very often, that will allow them to be more flexible in deploying capital within the unlisted space.” 

“It allows a more patient approach to investments in real estate and infrastructure by relieving the pressure of just deploying capital in order to meet target allocations.” 

Again offering a more global perspective, Bridwell said that illiquidity tolerance was something that every investor had to determine for themselves. 

“The return from liquidity sacrifice is historically attractive right now,” she said. “Alternatives investors should consider maximising their illiquid buckets.” 

Similarly, Bowater said that once a super fund’s illiquidity tolerance had been established, they then had to be conservative about it. 

“But what I would also say is that we’ve seen those tolerances change over the last 5 or so years as memberships have become older,” she said. “So this isn’t necessarily something they can set and forget.” 

“As member switching patterns change, a fund understanding its total fund liquidity tolerance and the tolerance of their individual portfolios becomes even more important,” Bowater continued. “And understanding the individual liquidity characteristics of their investments and getting the right mix in terms of liquidity and income is just as vital.” 

Alternatively, Eagleton suggested that if one was to be a purist when it came to superannuation investment, then portfolios would not contain any illiquid assets at all. 

“So for me, the question is whether a defined contribution super fund, the typical super fund, should be investing in illiquid assets in the first place,” he said. “Plausibly, every single member could switch to cash at any moment and such requests have to be honoured.” 

“That’s the theory but in practice, we know it just doesn’t happen like that and so we’re prepared, as an industry, to run what appears to be a liquidity mismatch,” Eagleton explained. “The Superannuation Guarantee pours in every week and so funds’ investment strategies can be a bit more illiquid than they otherwise could or would be.” 

“But the theory is still relevant and I think a number of funds got a reminder of exactly that during the financial crisis.” 

For Eagleton, the point to remember was that while super funds had long term liabilities and long term time horizons, their tolerance for illiquidity would always be limited because there was no individual body or institution to bear the risk. 

“With defined contributions schemes, its the individual members that bear the risk and there are a whole lot of problems that come with that in terms of volatility and behavioural inefficiency and so on,” he said. “So I’m often asked what the big trends are in alternative investment and the reality is that asset allocations across all sectors don’t change very much.” 

“If anything, any sort of dynamic shift is, quite frankly, at the margin and most often not in the areas of unlisted assets because they’re very hard to move within anyway,” Eagleton added. “But you have to remember that we have a compulsory contribution system, money is pouring in everyday and it has to be invested.” 

“So even if fund allocations to illiquid alternatives remain unchanged, that’s still a substantial increase in terms of capital and therefore the opportunity set that the Australian superannuation industry requires.”