Month: April 2019

Are Kiwisaver Funds, NZ Endowments, and Family Offices missing out on the benefits of Private Investment?

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“Private investments, particularly private equity (PE) and venture capital (VC), have provided the strongest relative returns for decades, and top-performing institutions have been long-time allocators to private investment strategies, reaping the benefits of the outperformance.”

“Cambridge Associates’ past analysis indicates that endowments and foundations in the top quartile of performance had one thing in common: a minimum allocation of 15% to private investments”

These are the key findings of a recently published Cambridge Associates (CA) report.

Private investments include non-venture private equity, venture capital, distressed securities (private equity structure), private real estate, private oil & gas/natural resources, timber, and other private investments.

 

The Cambridge Report suggests a weighting of higher than 15% to private investment may be prudent: their analysis highlighted that top decile performers have higher allocations to private investments and that this allocation has grown over time to a mean allocation of 40%.

 

CA emphasis with proper diversification the risks within private investments can be appropriately managed. Nevertheless, they highlight there is a wide dispersion of returns in this space, as there are across Alternative strategies in general.

 

A critical issue, as highlighted by CA, was liquidity calculations, “investors should determine their true liquidity needs as part of any investment strategy”.

Liquidity should be seen as a “budget”.  An investment strategy should be subject to a liquidity budget.  Along with a fee and risk budgets.

CA emphasis that in relation to Family Offices “the portion of the portfolio needed for liquidity may be much lower than their allocation to illiquid investments would suggest.”

As CA notes, many of the top-performing Funds have figured out their liquidity requirements, allowing for higher allocations to illiquid investments.

CA conclude “Those willing to adopt a long-term outlook might be able to withstand more illiquidity and potentially achieve more attractive long-term returns.”

 

The Institutional Real Estate Inc article covered the CA report and had the following quotes from CA which helps to provide some context.

“Multi-generational families of significant wealth are often well-aligned for considerable private investment allocations,” said Maureen Austin, managing director in the private client practice at Cambridge Associates and co-author of the report. “The precise balance between the need for wealth accumulation for future generations and typically minimal liquidity requirements puts these investors in a unique position where a well-executed private investment allocation can significantly support and extend their legacy. Higher returns, compounded over time in a more tax-advantaged manner, make a sizable allocation to private investments quite compelling.”

  “The long-term time horizon that comes with private investing aligns well with the time horizon for multi-generational families and is often central to our investment strategy with each family……”

 

Although the CA analysis does not look at the New Zealand market, it does highlight that those Funds underweight private investments are missing out.

With regards to New Zealand, Kiwisaver Funds are underweight private investments and Alternatives more generally.

Given the overall lack of investment to private investments and alternatives by Kiwisaver Funds, do they overestimate their liquidity needs to the detriment of investment performance? Yes, quite likely.

It is also quite likely that a number of New Zealand Endowments and Family Offices do as well.

 

There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.

As Prequin note in their recent report, investor’s motivation for investing in alternatives are quite distinctive:

    • Private equity and venture capital = high absolute and risk-adjusted returns
    • Infrastructure and real estate = an inflation hedge and reliable income stream
    • Private debt = high risk-adjusted returns and an income stream
    • Hedge Funds = diversification and low correlation with other asset classes
    • Natural Resources = diversification and low correlation with other asset classes

 

For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.

As this blog post notes, a robust portfolio is broadly diversified across different risks and returns.

Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.

True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

Investors are compensated for being exposed to a range of different risks. For example, those risks may include market beta, smart beta, alternative, and hedge fund risk premia. And of course, true alpha from active management, returns that cannot be explained by the risk exposures outlined above. There has been a disaggregation of investment returns.

Not all of these risk exposures can be accessed cheaply.

The US Endowment Funds and Sovereign Wealth Funds have led the charge on true portfolio diversification with the heavy investment into alternative investments and factor exposures.

They are a model of world best investment management practice.  Much like New Zealand’s own Sovereign Wealth Fund, the New Zealand Super Fund.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

 

Growing importance of ESG within the Alternatives sector

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The growing importance of ESG within the Alternatives sector is one of the key themes from the JP Morgan Alts Survey March 2019.  This survey provides some fascinating detail on the state of the Global Alternatives industry, including Private Equity, Real Estate, Infrastructure and Hedge Funds.

Some of the other highlights from the survey include:

  • Diversified benefits – correlation matrix
  • Strategy and manager selection is vitally important – dispersion of manager returns
  • Detailed analysis of the varying Alternative categories e.g. hedge funds and real estate, including drivers of returns

 

As noted in previous Posts, Kiwisaver Funds are underweight Alternatives relative to the rest of the world, an alternatives allocation would be beneficial for Target Date Funds, and US Endowment have provided superior long term returns after fees due their successful allocations to Alternatives.

 

The benefits of Alternatives have been well documented and they are set to continue to become a larger part of Client portfolios over time as outlined by the recently published Prequin Global Alternatives Report.

 

Therefore, not surprisingly, according to JP Morgan, “Institutional investors are flocking to hedge funds this year, even after a turbulent 2018 marked by poor performance and market volatility.”

The demand for hedged funds is driven by the search for market-beating returns and diversification.

They found that about a third of respondents plan to boost allocations, up from 15 percent in 2018. Just 13 percent expect a decrease while 55 percent said they plan to maintain current allocations.

As a recent Bloomberg article highlighted, the hedge fund industry took its biggest annual loss last year since 2011, declining 4.8 percent on a fund-weighted basis, according to Hedge Fund Research Inc. Managers were hurt by volatility that trampled markets, and hedge funds saw $33.5 billion in outflows.

JPMorgan polled 227 investors with about $706 billion in hedge fund assets for its annual Institutional Investor Survey.

 

For those new to Alternatives, a recent Investment News article provides some wonderful insights into the benefits of Alternatives and implementation challenges with clients.

With regards to the benefits of Alternatives, comments by Dick Pfister, founder and president of AlphaCore Capital, a firm that allocates between 15% and 30% of client assets to alternative investments, are worth highlighting.

“We look at some alternatives as diversifiers,” he said. “But we will also look at other alternatives as ways to capture chunks of up markets.”

The article notes the “message that investors, advisers and allocators like Mr. Pfister understand is that the big picture perspective rarely looks good for alternative investments, which is why those who dwell on broad category averages often get stopped at the gate.”

The article continues “Making the case for alternatives, which are generally designed to neutralize market beta and enhance alternative alpha, is never easy when market beta is robust in the form of a bullish stock market.”

“That is the reality of allocating to alternative investments. To benefit from the diversifying factors, investors and advisers must appreciate that losing less than the market can often mean gaining less than the market.”

“There’s always something to complain about when you have a diversified portfolio,” said Hans-Christian Winkler, a financial planner at Claraphi Advisory Network, where client portfolios have between 20% and 30% allocated to alternatives.

“A diversified portfolio will never outperform the market, but in times like the last quarter of 2018, when we saw the market down 20% from the high, our portfolios with alternatives were down 5%,” he added. “By using alternatives, you are spreading out your risk and making your investment portfolio a lot less bond-market- and stock-market-dependent.”

 

These are key points, they highlight the benefits but also the challenges when it comes to positioning Alternatives with clients and stakeholders e.g. Trustees, Investment Committees.

Alternatives “underperform” on a relative basis when equity and bond markets perform strongly.  This can have some challenges with Clients, the article is well worth reading from this perspective, as it provides insights into how a number of Advisors are positioning Alternatives with their Clients.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

Pioneering work on yield-curve inversions and risk of economic recession

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There is no doubt that global economic growth has slowed over the last six months. The Reserve Bank of New Zealand (RBNZ) highlighted rising global economic risks in its recent Policy statement. The RBNZ noted that economic growth has slowed in our major trading partners of Australia, China, and Europe.

Economic growth has also slowed in the US. Although US financial conditions have eased in recent months, they did tightened over the course of 2018.

The risk of a US recession has risen in recent months. Albeit calls of a US recession have been around for some time.

A recent article by Gary Shilling in Think Advisor captures the type of the analysis undertaken on the US economy over the last 18 months.

Leading economic indicators for the US have weakened. Nevertheless, they are not consistent with forecasting a looming recession, except perhaps one, an inverted yield curve which is discussed below.

Overall the US economy is in good health, with record low unemployment, growing incomes, high saving rates, strong household balance sheets, business investment is set to increase, as is Government spending.

 

As Shilling notes in his article, the US economy could go several ways e.g. economic growth rebounds over 2019, the US experiences a period of prolonged moderate economic growth without a recession, or the US experiences a classic economic cycle and tips into a recession at a later date due to the US Federal Reserve raising interest rates.

By Shilling’s count, there have been 12 occasions since World War 2 that the Fed raising interest rates has resulted in a recession. Presently, this would appear some time away  given the Fed has indicated it is unlikely to undertake further interest rate increases in 2019.

The later scenario is most consistent with the consensus view – it is a little early to call a US recession, yet the risks of a recession within the next 2-3 years are growing. For the time being the US continues to expand and will enter its longest period of economic expansion in modern history in July 2019. Recession will eventually be triggered by the Fed increasing interest rates resulting in a more “garden variety” recession.

 

And this leads to a key point in Shilling’s article, the word recession invokes images of a Global Financial Crisis (GFC) type outcome – not surprising given this was our last experience.

His expectations are that the next US recession will not be as severe as the GFC.

He has a similar view with respect to the next US “Bear” market (i.e. fall in value of greater than 20%).

I’ll leave it to him to explain:

“Recession” conjures up specters of 2007-2009, the most severe business downturn since the 1930s in which the S&P 500 Index plunged 57 percent from its peak to its trough. The Fed raised its target rate from 1 percent in June 2004 to 5.25 percent in June 2006, but the main event was the financial crisis spawned by the collapse in the vastly-inflated subprime mortgage market.

 Similarly, the central bank increased its policy rate from 4.75 percent in June 1999 to 6.5 percent in May 2000.  Still, the mild 2001 recession that followed was principally driven by the collapse in the late 1990s dot-com bubble that pushed the tech-laden Nasdaq Composite Index down by a whopping 78 percent.

The 1973-1975 recession, the second deepest since the 1930s, resulted from the collapse in the early 1970s inflation hedge buying of excess inventories. That deflated the S&P 500 by 48.2 percent. The federal funds rate hike from 9 percent in February 1974 to 13 percent in July of that year was a minor contributor.

The remaining eight post-World War II recessions were not the result of major financial or economic excesses, but just the normal late economic cycle business and investor overconfidence. The average drop in the S&P 500 was 21.2 percent.

 

In short, history shows that US sharemarkets drop by about 21% when the economy falls into recession, remembering the S&P 500 fell almost 20% during the last three months of 2018.

 

Inverted Yield Curve

As you will know, the slower economic growth has resulted in several Central Banks, with the RBNZ the latest, to turn more cautious on the outlook for economic growth and inflation. This list includes the US Federal Reserve, European Central Bank, and Reserve Bank of Australia.

This sudden change in direction of interest rate policy (Monetary Policy) has witnessed a flattening of yield curves (when longer-dated interest rates are at similar level to shorter-term interest rates).

In the US, the yield curve has become inverted, where longer-term interest rates are lower than shorter-term interest rates.

The inversion has primarily been due to the significant reduction in longer-term interest rates rather than the increase in shorter-term interest rates (inversions normally occur when short term interest rates are increased rapidly by Central Banks).

The significance of this is that prior to the last 7 US recessions the yield curve has inverted each time.

Nevertheless, not every time the yield curve inverts does a recession follow and on average the inversion of the yield curve occurs 12 months prior to a recession.

 

As you can imagine a lot has been written in recent weeks on the implications of a negative yield curve, I would like to highlight the following three articles, which pretty much sums up the current debate:

  1. A very recent interview with the person who undertook in 1986 the pioneering work on yield-curve inversions and their foreshadowing of economic downturns (RA-Conversations)
  2. Mohamed A. El Erain’s article of “Beware of Misreading Inverting Yield Curve “
  3. BCA LinkedIn Post, Yield Curve Inversions and S&P 500 Peaks, don’t get bogged down in the noise.

 

It would appear, that when it comes to the current inversion of the US yield curve, we have “Nothing to fear but fear itself” (Franklin D. Roosevelt). This is certainly the view of Mohamed A. El Erain.

 

I have blogged previously on the history of inverted yield curves and their predictive ability. Similar there is also a previous post on the anatomy of equity Bear markets.

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement