Superannuation funds hunt for genuine alternative investments

Alternative investments remain at front of mind for many superannuation fund trustees but, as Damon Taylor reports, the global financial crisis has served to create a greater focus on what 'alternative' really means.

If there is one category of assets that continues to receive closer examination in the wake of the global financial crisis (GFC), it is that of alternative investments.

Composed of assets that, in many circumstances, were considered either volatility insurance policies or countercyclical to equities, the reality was that a number of these so-called alternatives failed to deliver the diversity their investors were expecting.

As a consequence, transparency, governance and liquidity are all top of mind, but according to Joe Bracken, head of macro strategies at BT Investment Management, investors would be well advised to look closely at what defines an alternative investment within their portfolio.

"Oddly enough, definitions matter more these days than they did in the past," he said.

"In the past, people referred to alternatives as basically anything outside of equities and bonds, so investing in timber or infrastructure, private equity, managed futures — they’re all alternatives.

"Now that was a fine definition and that was okay really until the GFC," Bracken continued.

"Out of the GFC, people have really started to say, ‘Hang on, what is actually in my alternatives bucket? What do I mean by alternatives?’. Now they’re applying a slightly stricter definition in saying that alternatives are typically absolute return strategies that are uncorrelated with bonds and equities and have varying degrees of liquidity.

"When investors talk about alternatives, that’s really what they mean now."

Clarifying Bracken’s definition further, Ken Marshman, head of investment outcomes for JANA Investment Advisers, said whether you called it alternatives or something else, what was important was the underlying risks and returns.

"The biggest thing about alternatives, and what really makes them alternative, is probably that they’re untraded — or at least not traded in the same way that other assets are," he said.

"That’s a critical point. The other aspect that defines an alternative is that you expect the underlying fundamental drivers of returns, and risks to those returns, are different from your major asset classes.

"They would be the two defining characteristics of alternatives, and then the question of how much to alternatives or not is really irrelevant," Marshman added.

"What’s important is how much you want of those underlying risks in a portfolio and how well you know those risks.

"So the third element of alternatives is getting a really good handle on those risks, and that’s more difficult because they’re new."

Yet with respect to keeping alternatives allocations balanced and proportional and the relevance of definitions in that pursuit, Greg Nolan, general manager of investments for industry fund Care Super, said that it was more important to worry about what was growth and what was income in the return.

"That’s the most important thing, but the need to keep portfolios balanced brings in another aspect, and that is liquidity," he said. "That’s something we focus on because there has to be a balance.

"We’re long-term investors, so we’re focused on assets that give us that long-term risk/return profile," Nolan continued. "But we’ve also got to be cognisant of liquidity and balance the differing requirements of our investments.

"One is obviously long term and the other is short term."

Point of difference

Of course, the balancing act referred to by Nolan and how well super funds have managed it has had a very real impact on returns post GFC. Alternatives exposure has always been a point of difference between super funds, and for Bracken, individual fund performance is likely to have reflected that.

"The point of differentiation seems to be in terms of the amount of alternatives exposure funds may have," he said. "Some super funds tend to be very, very conservative indeed and would have a 2 per cent or 3 per cent maximum in alternatives.

"Others see the diversification benefits completely and are 10 per cent, 15 per cent, 20 per cent into alternatives and typically, even through the GFC, the absolute return funds did a lot better than your standard equity fund," Bracken added.

"They might have dropped a little or indeed not at all — and some of them actually made money — whereas the typical equity fund dropped about 50 per cent.

"So clearly, alternatives exposures would have made quite a big difference."

Marshman said the other side of the alternatives coin lay in funds’ preparedness to take on the risk of various alternative investments.

"If you want to strip it bare, some funds decided to take on more liquidity risk within their portfolio, more regulation risk within infrastructure, risk within property or the risk of appointing successful managers in hedge funds," he said.

"But whatever that risk is, I think that those risks are quite different from the risks of owning equities or different styles of equity management.

"They are a significant differentiating point and obviously those portfolios that didn’t have a lot of these less liquid alternatives suffered going into the GFC, but have bounced back post GFC."

Disappointment

Unfortunately, not all alternative investments performed as predicted within the environment of tight liquidity that was created by the GFC.

A number of investors, both institutional and retail, were disappointed by hedge funds in particular, but according to Marshman, that disappointment was more a product of circumstance than the returns being delivered.

"Hedge funds, on the face of it, disappointed investors because it was expected that they would deliver positive returns in almost every environment," he said.

"But in a period where people were scrambling for cash, good assets had to be sold in a hurry, and that led to a rapid drop in the valuation of those assets.

"Furthermore, some of these assets didn’t have easy liquidity, which meant that the price fell further than it should have," Marshman continued.

"However, it’s a fact that for the entire period of the GFC and the recovery, hedge funds have outperformed those balanced structures of normal balanced liquid assets; they’ve outperformed what would be a diversified portfolio of bonds and equities through that whole period."

Marshman said hedge funds had suffered largely because they had not lived up to investors’ expectations.

"But in saying that, they’ve actually outperformed the mainstream investment approaches, and I’d go further to say that in the biggest liquidity crisis we’ve had in 80 years, the limited default of those funds is quite remarkable, particularly given the way they’re structured," he pointed out.

"To be honest, I think they’ve stood one of the hardest tests of all time."

Similarly, Nolan’s assessment of hedge fund performance was that they had been significantly impacted by investor sentiment.

"From my understanding there was more to it than structure and currency movement," he said.

"My belief is that some of the trades were crowded trades — they were based on leverage — and at the fulcrum of the crisis people were trying to sell everything, and particularly the quant-based strategies just couldn’t get out.

"It was like everyone was rushing for the same door and only a limited number could get through."

Months down the track, with liquidity concerns easing somewhat, Marshman said investors in the hedge fund space had learnt to know precisely what they were investing in.

"I think people have learned that the term ‘hedge fund’ is a broad grab bag — a label that covers a wide range of different investment strategies," he said.

"And I think what the GFC has taught investors and investment advisers is that people need to understand the nature of the hedge fund that they are buying when they are buying it.

"Experience has shown us that some of these assets had quite a high correlation with equities, where others had quite a low correlation with equities," Marshman continued.

"People have to work out what it is that they really want to buy when they’re acquiring these styles of assets or these styles of investment management."

Liquidity

Providing a point of comparison to the hedge fund scenario, Bracken said that by focusing on the availability of liquidity, BT’s Global Macro fund had been unaffected by the rest of the market’s liquidity concerns.

"When we put together the Global Macro fund in the first place we adopted this idea of what we call ‘TLC’, which is not actually tender loving care but instead transparency, liquidity and control," he said.

"So on the transparency side, we made sure that we put into Global Macro investments that we understood, that we could explain to other people and that we were comfortable with.

"But more importantly, on the liquidity side, we only invest in instruments that give us daily liquidity, so futures and forwards, that’s all," Bracken continued.

"We don’t do options, we don’t do credit, we don’t do over-the-counter stuff, nothing like that — it’s all liquid, exchange-traded futures and forwards.

"So during the GFC we weren’t impacted at all by either shorting bans, liquidity constraints, margin calls, nothing like that, and that was by construction."

Bracken said that with respect to control, the aim was to exercise good risk control.

"We have pretty sophisticated risk management tools and risk measurement tools," he said.

"Measurement so that we know what our risk is but management so that if we think our risk is getting out of hand, we can cut our positions very quickly.

"For us, the real problem during the GFC was that there was only really one bet in the market, and that was to buy US dollars and then buy US treasuries," Bracken added.

"That was it. You either got that bet right or you didn’t. And really, that’s a very difficult environment to be in because if there’s only one bet in the entire market, most people will have taken it and it’s going to be very difficult to make money."

Illiquidity

Naturally, the alternative investments story was about more than liquidity.

On the other side of the coin, the illiquidity of infrastructure assets gave investors much more stable returns, but according to Marshman, they were not immune to some of the more poignant lessons delivered by the GFC.

"By and large, infrastructure did have more stable returns, but the GFC has certainly exposed some methods of investing in infrastructure that were not at all stable," he said.

"What we’ve seen is that the assets themselves have been very resilient — the ports, the roads, the airports themselves.

"The revenues have tended to come through and the costs have been controlled," Marshman continued.

"But what has happened is that the highly leveraged investments in infrastructure have been hurt quite significantly and some of the very highly geared assets have produced worse returns than those that weren’t as highly geared."

According to Marshman, that was particularly the case for those assets that were in the middle of major refinancing when banks were shrinking their lending balance sheets.

"The lesson out of the GFC in infrastructure is to be very cautious of the extent of leverage," Marshman said.

"The underlying assets are sound, but the way in which the capital structure of those investments is established is critical."

For Nolan, the relative success enjoyed by infrastructure assets was driven significantly by investor attitudes in other parts of the market.

"The market was driven to a large degree by sentiment and fear during the GFC," he said.

"And when things are priced by the minute and day by day, there’s plenty of scope for sentiment or that fear to take hold.

"But when you’re dealing with infrastructure assets that are real assets for which revenue over the long term is driven by economic growth, the situation is a bit different," Nolan continued.

"There aren’t the trades going through on a daily basis, so there’s obviously a lot more stability there.

"It’s just a function of them not being pushed around by short-term sentiment."

Risk management

Taken as a whole, moves within alternative investments post GFC seem to be towards risk management in terms of liquidity, transparency and governance.

Most people knew that some alternatives would suffer during a period of tight liquidity, but Marshman believes shrewd investors are firmly set upon policy changes that will protect them from similar circumstances in the future.

"Right across the board this question of liquidity management is top of mind," he said.

"That need to avoid overextension into less liquid assets or assets that could have significant cash drawdowns is now hard wired into the processes and thinking of most superannuation funds, and that is the significant change.

"Step number two in terms of the hedge funds space is that we now have the understanding and learning as to the different characteristics of hedge funds," Marshman continued.

"There will be a change in direction about what other assets they’re replacing in a portfolio, so if they’re being used to replace debt then you’ll want a different structure than if they’re being used to replace equities or property or something.

"As an industry, we’ve got a much better understanding of the role hedge funds should play in a balanced portfolio."

In the infrastructure space, Marshman said anything highly geared with fee structures that encouraged higher leverage were also out.

"Around the rest of the world, they might want to take those," he said.

"But I think in Australia we’ll see a huge resistance to investing money in highly leveraged assets where the promoter or the manager or whoever is highly incentivised to accelerate that leverage and pass the risks off to the investor."

Bracken suggested that change within alternative investments would not just be about policy but also about the way investors viewed individual assets.

"It’s odd that people are saying that concern over liquidity has eased," he said.

"To be honest, when I speak to both superannuation funds and to advisers and individual investors, the first thing that they talk about and indeed the fifth thing that they talk about is liquidity, about how they never want to get into products that have quarterly liquidity or yearly liquidity, and how having daily liquidity is fantastic.

"So that’s something that really hasn’t changed, even months down the track — liquidity is still the most important thing on peoples’ minds," Bracken added.

"The second thing that’s changed, however, is that before the GFC people just assumed that Australian equities in particular, but equities in general, would always go up.

"The GFC very quickly showed that not only do equities not always go up but that they can always fall, and they can fall very, very quickly, and over the space of a couple of months you can unwind all of the good work that was done over a number of years."

For Bracken, the wake up call for many investors had been the realisation that there was a huge amount of risk in putting too much of an investment portfolio into the stock market.

"It kind of reinforced for people the idea of diversification," he said.

"That you actually need to have more diversified portfolios and indeed these absolute return products that aren’t linked to benchmarks and that try to preserve your capital as much as possible.

"In an odd way, the GFC has been rather good for us in that it’s altered peoples’ value for the risk that was always there but they never recognised."

Looking to the future and whether the composition of superannuation funds’ alternative investment allocations were likely to see meaningful change, Marshman said the key lay in recognising the lessons learned during the financial crisis as well as how current market trends were impacting various assets.

"The advice we’re giving is that we think that these alternatives, for want of a better term, have proven themselves through the GFC if properly executed," he said.

"There are two other points here too. One is that there is a shortage of available funding at the moment, so many of these so-called alternatives are ripe — they’re really ready at the moment.

"Secondly, the debt overhang is a significant issue for some of the non-alternatives," Marshman continued.

"So whether you’re looking at the risks of inflation or the risks of deflation, some of the traditional assets look highly uncertain right now.

"We think some of these alternatives represent a good management strategy to deal with that uncertainty."

For his part, Bracken predicted that the alternative investment focus moving forward would be on absolute return strategies.

"To be honest, I find it difficult to believe that people will forget the fact that they lost 50 per cent through the GFC, and even now that markets have rebounded, they’re still nowhere near the levels they were at," he said.

"To me, when I look at investors’ behaviour, they’re now extremely reticent to put all of their money in to the equity basket and just go for it again.

"The lessons of the GFC have been learned and going forward people will be far more interested in having products that offer daily liquidity," Bracken continued.

"They’ll be far more interested and attentive to how risk is managed and they’ll be far more interested in not just having the same old equities and bonds but also having some absolute return focus as well."

Bracken said that at the end of the day, if an investor gave him $100 and he gave them back more than that $100, he had done a good job.

"And obviously, if I do a bad job, I’ll be giving them less than that $100 back," he said. "It’s really all about absolute return.

"It’s not about benchmarks, it’s not about relative return, it’s about absolute return and building your wealth, and I think people are going to be far more attentive to that going forward."