Hedged Funds vs Equities – lessons from the Warren Buffet Bet Revisited

“The Bet” received considerable media attention following the 2017 Berkshire Hathaway shareholder letter in 2018.

To recap, the bet was between Warren Buffet and Protégé Partners, who picked five “funds of fund” hedge funds they expected would outperform the S&P 500 Index over the 10-year period ending December 2017. Buffet took the S&P 500 to outperform.

The bet was made in December 2007, when the market was reasonably expensive and the Global Financial Crisis (GFC) was just around the corner.

Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10-year period.

There are some astute investment lessons to be learnt from this bet, which are very clearly presented in this AllAboutAlpha article, A Rhetorical Oracle, by Bill Kelly.

Before reviewing these lessons, I’d like to make three points:

  1. I’d never bet against Buffet!
  2. I would not expect a Funds of Funds Hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Funds.
  3. Most if not all, investor’s investment objective(s) is not to beat the S&P 500. Investment Objectives are personal and targeted e.g. Goal Based Investing to meet future retirement income or endowments

This is not to say Hedged Funds should not form part of a truly diversified investment portfolio.  They should, as should other alternative investments.

Nevertheless, I am unconvinced Hedge Fund’s role is to provide equity plus like returns. 

By and large, alternatives, including Hedge Funds, offer a less expensive way of providing portfolio protection as their returns “keep up” with equities, see the previous Kiwi Investor Blog Sharemarket crashes – what works best in minimising losses, market timing or diversification

One objective in allocating to alternatives is to add return sources that make money on average and have low correlation to equities.  Importantly, diversification is not the same thing as “hedging” a portfolio

Now, I have no barrow to push here, except advocating for the building of robust investment portfolios consistent with meeting your investment objectives. The level of fees also needs to be managed appropriately across a portfolio.

In this regard and consistent with the points in the AllAboutAlpha article:

  1. Having a well-diversified portfolio is paramount and results in better risk-adjusted returns over time.

Being diversified across non-correlated or low correlated investments is important, leading to better risk-adjusted outcomes. 

Adding low correlated investments to an equities portfolio, combined with a disciplined rebalancing policy, will likely add value above equities over time.

The investment focus should be on reducing portfolio volatility through true portfolio diversification so that wealth can be accumulate overtime. 

Minimising loses results in higher returns over time.  A portfolio that falls 50%, needs to gain 100% to get back to the starting capital.  This means as equity markets take off a well-diversified multi-asset portfolio will not keep up.  Nevertheless, the well diversified portfolio will not fall as much when the inevitable crash comes along.

It is true that equities are less risky over the longer term.  Nevertheless, not many people can maintain a fully invested equities portfolio, given the wild swings in value (as highlighted by Buffett in his Shareholder Letter, Berkshire can fall 50% in value).

100% in equities is often not consistent with meeting one’s investment objectives.  Buffet himself has recommended the 60/40 equities/bond allocation, with allocations adjusted around this target based on market valuations.

I am unlikely to ever suggest to be 100% invested in equities for the very reason of the second point in the article, as outlined below.

  1. Investment Behavioural aspects.

How many clients would have held on to a 100% equity position during the high level of volatility experienced over the last 10-12 years, particularly in the 2008 – 2014 period.  Not many I suspect.  This would also be true of the most recent market collapse in 2020.

The research is very clear, on average investors do not capture the full value of equity market returns over the full market cycle, largely because of behavioural reasons.

A well-diversified portfolio, that lowers portfolio volatility, will assist an investor in staying the course in meeting their investment objectives.

An allocation to alternative strategies, including a well-chosen selection of Hedge Funds, will result in a truly diversified Portfolio, lowering portfolio volatility.  See an earlier Post, the inclusion of Alternatives has been an evolutionary process, not a revolution.

Staying the course is the biggest battle for most investors.  Therefore, take a longer-term view, focus on customised investment objectives, and maintain a truly diversified portfolio.

This will help the psychological battle as much as anything else.

I like this analogy of using standard deviation of returns as a measure of risk. It captures the risks associated with a very high volatile investment strategy such as being 100% invested in equities:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

Happy investing.

Please see my Disclosure Statement

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

The psychology of Portfolio Diversification

In a well-diversified portfolio, when one asset class is performing extremely well (like global equity markets), the diversified portfolio is unlikely to keep pace.

In these instances, the investor is likely to regret that they had reduced their exposure to that asset class in favour of greater portfolio diversification.

This is a key characteristic of having a well-diversified portfolio. On many occasions, some part of the portfolio will be “underperforming” (particularly relative to the asset class that is performing strongly).

Nevertheless, stay the course, over any given period, diversification will have won or lost but as that period gets longer diversification is more and more likely to win.

True diversification comes from introducing new risks into a portfolio. This can appear counter-intuitive. These new risks have their own risk and return profile that is largely independent of other investment strategies within the Portfolio. These new risks will perform well in some market environments and poorly in others.

Nevertheless, overtime the sum is greater than the parts.

 

The majority of the above insights are from a recent Willis Tower Watson (WTW) article on Diversification, Keep Calm and Diversify.

The article provides a clear and precise account of portfolio diversification.  It is a great resource for those new to the topic and for those more familiar.

 

WTW conclude with the view “that true diversification is the best way to achieve strong risk adjusted returns and that portfolios with these characteristics will fare better than equities and diversified growth funds with high exposures to traditional asset classes in the years to come.”

 

Playing with our minds – Recent History

As the WTW article highlights the last ten-twenty years has been very unusual for both equity and bond markets have delivered excellent returns.

This is illustrated in the following chart they provide, the last two rolling 10-year periods have been periods of exceptional performance for a Balanced Portfolio (60%/40% equity/fixed income portfolio).

WTW Balance Fund Performance

 

WTW made the following observations:

  • The last ten years has tested the patience of investors when it comes to diversification;
  • For those running truly diversified portfolios, this may be the worst time to change approach (the death of portfolio diversification is greatly exaggerated);
  • Diversification offers ‘insurance’ against getting it wrong e.g. market timing; and
  • Diversification has a positive return outcome, unlike most insurance.

 

WTW are not alone on their view of diversification, for example a AQR article from 2018 highlighted that diversification was the best way to manage periods of severe sharemarket declines, as recently experienced.  I covered this paper in a recent Post: Sharemarket crashes – what works best in minimising losses, market timing or diversification.

 

WTW also note that it is difficult to believe that the next 10-year period will look like the period that has just gone.

There is no doubt we are in for a challenging investment environment based on many forecasted investment returns.

 

What is diversification?

WTW believe investors will be better served going forwards by building robust portfolios that exploit a range of return drivers such that no single risk dominates performance. (In a Balanced Portfolio of 60% equities, equities account for over 90% of portfolio risk.)

They argue true portfolio diversification is achieved by investing in a range of strategies that have low and varying levels of sensitivity (correlation) to traditional asset classes and in some instances have none at all.

Other sources of return, and risks, include investing in investment strategies with low levels of liquidity, accessing manager skill e.g. active returns above a market benchmark are a source of return diversification, and diversifying strategies that access return sources independent of traditional equity and fixed income returns. These strategies are also lowly correlated to traditional market returns.

 

Sources of Portfolio Diversification

Hedge Funds and Liquid Alternatives

Hedge Funds and Liquid Alternatives are an example of diversifying strategies mentioned above. As outlined in this Post, covering a paper by Vanguard, they both bring diversifying benefits to a traditional portfolio.

Access to the Vanguard paper can be found here.

 

It is worth highlighting that hedge fund and liquid alternative strategies do not provide a “hedge” to equity and fixed income markets.

Therefore they do not always provide a positive return when equity markets fall. Albeit, they do not decline as much at times of market crisis, as we have recently witnesses. Technically speaking their drawdowns (losses) are smaller relative to equity markets.

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Private Markets

TWT also note there are opportunities within Private Markets to increase portfolio diversification.

There will be increasing opportunities in Private markets because fewer companies are choosing to list and there are greater restrictions on the banking sector’s ability to lend.

This is consistent with key findings of the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The factors mentioned above, along with the low interest rate environment, the expected shortfall in superannuation accounts to meet future retirement obligations, and the maturing of emerging markets are expected to drive the growth in alternative investments over the decade ahead.

A copy of the CAIA report can be found here. I covered the report in a recent Post: CAIA Survey Results – The attraction of Alternative Investments and future trends.

 

TWT expect to see increasing opportunities across private markets, including a “range from investments in the acquisition, development, and operation of natural resources, infrastructure and real estate assets, fast-growing companies in overlooked parts of capital markets, and innovative early-stage ventures that can benefit from long-term megatrends.”

Continuing the theme of lending where the banks cannot, they also see the opportunity for increasing portfolios with allocations to Private Debt.

WTW provided the following graph, source data from Preqin

WTW Private Market Performance

 

Real Assets

In addition to Hedge Funds, Liquid Alternatives, and Private markets (debt and equity), Real Assets are worthy of special mention.

Real assets such as Farmland, Timberland, Infrastructure, Natural Resources, Real Estate, TIPS (Inflation Protected Fixed Income Securities), Commodities, Foreign Currencies, and Gold offer real diversification benefits relative to equities and fixed income in different macro-economic environments, such as low economic growth, high inflation, stagflation, and stagnation.

These are a conclusive findings of a recent study by PGIM. The PGIM report on Real Assets can be found here. I provided a summary of their analysis in this Post: Real Assets offer real diversification benefits.

 

Conclusion

To diversify a portfolio it is recommended to add risk and return sources that make money on average and have a low correlation to equities.

Diversification should be true both in normal times and when most needed: during tough periods for sharemarkets.

Diversification is not the same thing as a hedge. Although “hedges” make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term. Think of this as the cost of “insurance”.

Therefore, alternatives investments, as outlined above, are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

Importantly, investing in more and more traditional asset classes does not equal more diversification e.g. listed property.  As outlined in this Post.

 

As outlined above, we want to invest in a combination of lowly correlated asset classes, where returns are largely independent of each other. A combination of investment strategies that have largely different risk and return drivers.

 

Good luck, stay healthy and safe.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

 

CAIA Survey Results – The attraction of Alternative Investments and future trends

Alternative Investments have doubled as a share of global asset markets since 2003.

They have moved from 6% or $4.8 trillion of the global investment universe in 2003 to over $13.4 trillion, or 12% of the global investment universe in 2018.

 

CAIA Association members expect alternatives to grow to between 18% and 24% of the global investible universe by 2025.

Further growth is expected, based on the combination of very low interest rates, the shortfall in superannuation accounts to meet future retirement obligations, the maturing of emerging markets, and structural shifts in capital formation e.g. companies are remaining private for longer.

Private equity and venture capital are expected to benefit most from the future growth in alternative investments.

Private debt and real asset allocations are also expected to grow.

Although future growth in liquid alternatives is expected, hedge fund growth is anticipated to trail.

 

Manager selection is key to success within the alternatives universe given the dispersion in manager performance.

 

These are the key findings of the recently published CAIA Association report, The Next Decade of Alternative Investments: From Adolescence to Responsible Citizenship.

The assessments and predictions of the survey are based on the results of a comprehensives survey of over 1,000 CAIA members.

CAIA = Chartered Alternative Investment Analyst, the Association website can be accessed here.

 

The Attraction of Alternatives

CAIA members expect alternatives to grow to between 18 – 24% of the global investible universe by 2025, as highlighted in the following graph from the CAIA report.

Percentage of Global Investible Market CAIA

Of note, Retail investors have around 5% of their investments in alternatives, institutional investors have substantially higher allocations.

This is significant, it is increasingly becoming apparent that continuing to invest in cash, fixed income, and developed market sharemarket alone is unlikely to generate the returns necessary to meet future retirement obligations.

Those saving for retirement have several options, including:

  1. Reducing their expectations as to the standard of living they wish to have in retirement;
  2. Increase their level of savings = work longer and/or forgo current consumption for a higher level of consumption in retirement; and
  3. Find new sources of returns.

 

From a portfolio perspective, the introduction of alternative investments, including hedge funds, liquid alternatives, private equities, and real assets can provide new sources of returns.

Investing outside of the developed markets, with appropriate exposures to emerging market currencies, fixed income, and equities can also provide new sources of return for many portfolios. The current environment offers several potential opportunities outside the developed and traditional fixed income markets.

 

In relation to alternatives, they are generally added to portfolios for two primary reasons:

  • Enhance Returns e.g. private equity and venture capital
  • Diversification – e.g. hedge funds and liquid alternative to reduce portfolio declines at time of severe sharemarket market fails as currently experienced.

Inflation hedging and yield enhancements are other reasons for allocated toward alternatives.

The following graph presents the rationale for investing in alternatives based on the CAIA Members surveyed.

Rationale for investing in Alternatives CAIA

 

As an indication to how much institutional investors have invested in alternatives, US Pension Funds increased their allocation to alternatives from 8.7% to 15.7% over the period 2001 and 2009.

Since 2009 they have increased their alternative allocations to 27%. The largest allocations include Private Equity, Real Estate, and hedged funds.

 

Interestingly, more than 50% of CAIA Association Members expect to have a greater allocation to private equity and venture capital in 2025 than they current hold.

According to CAIA, this is consistent with a Prequin survey that most investors are likely to continue to grow allocations to private equity and private debt over the next five years.

 

Manager Selection

As the Graph below from the CAIA report highlights there is a wide dispersion of manager performance in a number of strategies, particularly private equity, venture capital, infrastructure, and hedge funds.

By contrast, manager performance dispersion within public equities (listed markets) and global fixed income managers is relatively tight.

Therefore, avoiding underperforming managers is a key success factor when investing in alternatives.

Manager Performance Dispersion CAIA

 

Future Trends

Hedge Funds and Liquid Alternatives

Portfolio diversification was the key rationale for including hedge funds, managed futures, and liquid alternatives in a portfolio amongst more than half the CAIA members surveyed.

Lessening the impact of severe equity markets declines on portfolios was a motivating factor “over 92% believe that hedge funds will outperform global equity during times of weakening stock prices.”

As the report emphasises, “This script played out dramatically in the first quarter of 2020 and is reinforced through history: volatility of returns on hedge fund indices is approximately half that of global stock market indices.”

Assets managed by hedge funds has plateaued over recent years. “Among CAIA Members, two-thirds of those who allocate to hedge funds have an allocation of less than 10%, while more than one-quarter have an allocation exceeding 15%………….. only 37% of CAIA Members who currently allocate to hedge funds expect to have a higher allocation in 2025 than they do today.”

Growth has been experienced across liquid alternatives. Assets allocated to liquid alternatives have grown to $900 billion, up from $200 billion in 2008. Liquid alternatives have grown from 12% of hedge fund assets in 2008 to over 22% today.

With the growth in liquid alternatives, which tend to be more transparent, provide greater levels of liquidity, and cheaper fees compared to hedged funds, it is of little surprise that hedge fund fees have declined as noted in the CAIA report.

 

A comparison of the performance and characteristics of liquid alternatives compared to hedged funds, undertaken by Vanguard, can be found here.

 

Private Equity and Venture Capital

As noted above, more than 50% of CAIA Association Members expect to have a greater allocation to private equity and venture capital in 2025.

The change in capital markets, with companies remaining private for longer, and the increased globalisation of capital are underlying trends expected to boost the investment into these types of strategies.

By way of example, the CAIA report highlight that in “2012 over two-thirds of venture capital investments were made in North American companies. By the end of 2016, over 45% of portfolio companies were in Asia, while only one-third of investments were made in North American firms.”

The growing trend of Emerging Market company’s requirements for capital will see an increased asset allocation to these regions by private equity and venture capital.

Considerations in determining an optimal private equity portfolio allocation are covered in this Kiwi Investor Blog Post.

 

Real Assets

The survey highlighted that there are several reasons for investing in real assets. By way of example, Real estate and infrastructure are invested in for the following reasons, offering diversification, an inflation hedge, and as a source of income.

The report noted that investments in real assets has increased from $2.7 trillion to $4.3 trillion from 2004 to 20188.

Those CAIA Members who invest in real estate and infrastructure, the majority have an allocation of less than 10% of assets. However, nearly one-third have an allocation above 10% and nearly 90% expect to have an allocation in 2025 that is greater than or equal to what they currently hold.

 

The benefits of real assets are noticeable in different economic environments, like stagflation and stagnation, and particularly for those investments where objectives are linked to inflation. In a previous Post I provide an outline of the characteristics of different real assets and the benefits they bring to a Portfolio.

 

The CAIA Report has a very good case study on climate change and real assets, highlighting the impact of increased Environment, Social, and Governance (ESG) integration within investor portfolio will in their view be transformative for the real asset classes e.g. Real Estate and Infrastructure carbon-neutrality and stranded assets within the Natural Resources sector.

 

There is also an interesting section on Private Debt, which has experienced a dramatic increase in assets, reflecting historically low interest rates and regulatory changes that have caused banks to reduce lending to risker parts of the economy. Allocations to private debt are expected to grow.

 

The CAIA also unveil a four-point call to action for the industry:

  1. Commit to Education
  2. Embrace Transparency
  3. Advocate Diversification
  4. Democratise but protect

 

The CAIA report is well worth reading.

 

Happy investing.

Please see my Disclosure Statement

 

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

Sharemarket crashes – what works best in minimising losses, market timing or diversification?

The best way to manage periods of severe sharemarket declines, as recently experienced, is to have a diversified portfolio, it is impossible to time these episodes.

A 2018 paper by AQR evaluated the effectiveness of diversifying investments during sharemarket drawdowns using nearly 100 years of market data.

They analysed the potential benefits and costs of shifting away from equities, including into investments that are diversifying (i.e. are lowly correlated to equities) and investments that provide a market hedge (i.e. expected to outperform in bad times).

To diversify a portfolio AQR recommends adding return sources that make money on average and have a low correlation to equities i.e. their returns are largely independent of the performance of sharemarkets.

They argue that diversification should be true both in normal times and when most needed: during tough periods for equities.

Furthermore, as AQR emphasis, “diversification is not the same thing as a hedge.” Although “hedges”, e.g. Gold, may make money at times of sharemarket crashes, there is a cost, investments with better hedging characteristics tend to do worse on average over the longer term.

Therefore, alternative investments are more compelling relative to the traditional asset classes in diversifying a portfolio, they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

 

The analysis highlights that the funding source can matter just as much as the new diversifying investment. Funding from equities reduces drawdown losses, however, longer term returns are on average lower when compared to funding the allocation proportionally from the 60/40 equity/fixed income split.

 

Portfolio diversification is harder to achieve in practice than in theory. It involves adding new “risks” to a portfolio. Risks that have their own return profile largely independent of other investment strategies within a Portfolio.

Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.

 

Any new lowly correlated investment should be vigorously assessed and well understood before added to a portfolio.

The success of which largely rests with manager selection.

 

A summary of the AQR analysis is provided below, first, the following section discusses the challenges and characteristics of achieving portfolio diversification.

 

The challenges and characteristics of Portfolio Diversification

AQR advocate that diversification is a better solution to mitigating the pain of severe sharemarket falls than trying to time markets.

Specifically, they recommend adding return sources that make money on average and have a low correlation to equities.

 

Lowly correlated assets can be tremendously valuable additions to a portfolio.

Lowly correlated means returns that are not influenced by the other risks in the portfolio e.g. hedge funds and liquid alternative strategy returns are largely driven by factors other than sharemarket and fixed income returns.

Therefore, although diversifying strategies can lose money in large sharemarket drawdowns, this does not mean they are not portfolio diversifiers. The point being, is that on “average” they do not suffer when equities do.

Unfortunately, portfolio diversification does not eliminate the risk of experiencing investment losses.

 

In contrast, a hedge is something you would expect to do better than average exactly when other parts of the portfolio are suffering. Although this sounds attractive, hedges come with a cost. This is discussed further below.

 

Adding diversifying strategies to any portfolio means adding new risks.

The diversifying strategies will have their own risk and return profile and will suffer periods of underperformance – like any investment.

Therefore, as AQR note, implementing and maintaining portfolio diversification is harder in practice than in theory.

Portfolio diversification in effect results in adding new risks to a portfolio to make it less risky.  Somewhat of a paradox.

This can be challenging for some to implement, particularly if they only view the risk of an investment in isolation and not the benefits it brings to the total portfolio.

Furthermore, adding more asset classes does not equal more diversification, as outlined in this Post.

 

Background

Most portfolios are dominated by sharemarket risk. Even a seemingly diversified balanced portfolio of 60% equities and 40% fixed income is dominated by equity risk, since equities tend to be a much higher-risk asset class. Although equities have had high average returns historically, they are subject to major drawdowns such that the overall “balanced” portfolio will suffer too.   The Balance Portfolio is riskier than many appreciated, as outlined in this Post.

 

A major sharemarket drawdown is characterised as a cumulative fall in value of 20% or more. Recent examples include the first quarter of 2020, the Global Financial Crisis (2008/09) and Tech Bust (1999/2000). Based on the AQR analysis of almost 100 year of data, drawdowns worse than 20% have happened 11 times since 1926 — a little over once per decade on average. The average peak-to-trough has been -33%, and on average it took 27 months to get back to pre-drawdown levels (assuming investors stayed invested throughout – there is considerable research that indicates they don’t stay the course and earn less than market returns over the investment cycle).

 

AQR’s analysis highlights that using market valuations as a signal to time market drawdowns has not always been fruitful. Market valuations has rarely been a good signal to tactically change a portfolio to avoid a market drawdowns.

However, it is worth noting AQR are not against the concept of small tactical tilts within portfolios based on value or other signals such as momentum, best expressed as “if market timing is a sin, we have advocated to “sin a little””.

Nevertheless, market timing is not a “panacea” for large sharemarket drawdowns.

 

Diversification Benefits

The AQR analysis highlights that diversification outside of equities and fixed income can benefit portfolios, for example the inclusion of Style strategies (long/short risk premium across several different asset classes) and Trend following. Both of which are found to be lowly correlated to equities and provide comparable returns over market cycles.

Interestingly, the benefits of diversification vary from where the source of funds is taken to invest into the diversifying strategies.

AQR look at the impact on the portfolio of making an allocation from a 60/40 portfolio to the diversifying strategies. They consider two approaches:

  1. Funding the allocation all equities; and
  2. Funding from a combination of equities and fixed income, at a 60/40 ratio.

They evaluate a 10% allocation from the funding source to the new investments and consider both the impact on returns during equity drawdowns as well as the impact on returns on average over the entire 1926–2017 period.

The analysis highlights that the funding source can matter just as much as the new diversifying investment.

Funding from equities reduces the drawdown losses, however there is a trade-off, longer term returns are on average lower when compared to funding the allocation proportionally to the 60/40 equity / fixed income split.

When allocating to other traditional asset classes as a means of diversification e.g. Cash and Fixed Income, there is also a trade-off between a lower portfolio drawdown and lower average returns over time.

 

Therefore, alternatives offer a more compelling case relative to the traditional asset classes in diversifying a portfolio, given they provide the benefits of diversification and on average over time their returns tend to keep up with sharemarket returns.

 

The Cost of Hedging

As noted above Hedging is different to adding diversifying strategies to a portfolio.

Hedges may include assets such as Gold, defensive strategies – which hedge against market falls, and Put Option strategies.

The AQR analysis found that over the past 30 years the defensive strategies provided positive returns on average during sharemarket drawdowns and almost no periods with meaningful negative performance.

This is attractive for investors who are purely focused on lessening the negative impacts of sharemarket drawdowns.

However, there is a trade-off – “the strategies that are more defensively orientated tend to have lower average returns.”

The cost of avoiding the sharemarket drawdown is lower portfolio performance over time.

 

AQR Conclude

AQR conclude “As with everything in investing, there is no perfect solution to addressing the risk of large equity market drawdowns. However, we find using nearly a century of data that diversification is probably (still) investors’ best bet. This is not to say that diversification is easy.”

“Investors should analyze the return and correlation profiles of their diversifying investments to prepare themselves for the range of outcomes that they should expect during drawdowns and also over the long term.”

 

 

Happy investing.

Please see my Disclosure Statement

 

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

 

Hedge Funds vs Liquid Alternatives – both bring diversification benefits to a traditional portfolio says Vanguard

Vanguard recently concluded that investors should carefully consider liquid alternatives and hedge funds.

Their research highlighted that they both bring portfolio diversification benefits to a traditional portfolio of equities and fixed income.

They suggest “that liquid alternatives are often viable options for investors who value the regulatory protections, ease of access, and lower costs they provide”, when compared to hedge funds.

Although hedge funds and liquid alternatives deliver valuable portfolio diversification benefits, “it is crucial that investors assess funds on a standalone basis, as the benefits from any alternative investment allocation will be dictated by the specific strategy of the manager(s).”

The most important feature in gaining the benefits of hedge funds and liquid alternatives is manager selection.

This reflects the wide dispersion of returns and investment approaches within the categories of hedge fund and liquid alternatives.

 

The Vanguard Report undertakes an extensive analysis and comparison of the performance and characteristics of hedge funds and liquid alternatives.

The comparison of hedge funds and liquid alternative is particularly useful to those new to the subject.

For the more technically advanced, there is an in-depth performance analysis comparing the drivers of performance between hedge funds and liquid alternative strategies. Vanguard ran a seven-factor model and a customised regression model to identify the drivers of returns.

 

Benefits of Hedge Funds and Liquid Alternatives

Vanguard’s analysis highlights that hedge funds and liquid alternatives provide diversification benefits to a traditional portfolio of equities and fixed income. As noted above, capturing these benefits is heavily reliant on manager selection.

It is important to note that the diversification benefits of the different hedge funds and liquid alternatives strategy types vary over time, they have time varying sensitivity to equity markets and fixed income.

It is also worth highlighting that hedge fund and liquid alternative strategies do not provide a “hedge” to equity markets and fixed income markets.

Therefore they do not always provide a positive return when equity markets fall. Albeit, they do not decline as much at times of market crisis, as we have recently witnesses. Technically speaking their drawdowns (losses) are smaller relative to equity markets.

As evidenced in the Graph below provided by Mercer.

Mercer drawdown graph

 

Blending Alternative investment strategies can smooth the ride

Vanguard note that an additional layer of portfolio diversification can be attained by combining different hedge funds and alternative strategies.

Vanguard’s analysis suggested global macro (including managed futures) and the market neutral strategies are the best diversifiers when combined with other hedge fund and liquid alternative strategies.

Their research highlighted that combining multi-strategy hedge fund and liquid alternatives with a few other strategy types provided additional portfolio diversification benefits.

Again they highlight the importance of undertaking fund-by-fund basis analysis to better capture these diversification benefits – i.e. manager selection is important

 

Framework for Manager Selection

Vanguard suggest a framework for manager selection

  1. Identify your investment objective for including hedge funds and liquid alternatives. Investors have an array of objectives, which may include return enhancement, portfolio diversification and risk reduction, and inflation protection.
  2. Before selecting a manager determine a suitable strategy type(s). This is undertaken in consideration of investment objective(s) and any constraints. This could take into consideration risk and fee budgets, tolerance for level of leverage, and operational implementation issues. Ideally you would want to identify a number of strategy types so as to gain the diversification benefits from having a blended investment solution.
  3. Undertake manager selection within the strategy types. Undertake research as to the benefits of a particular manager and their ability to consistently deliver return outcomes consistent with the overarching investment objectives within the strategy type.
  4. Maintain a policy of regular review and monitoring of the manager and strategies in meeting desired investment objectives.

 

Liquid Alternatives are often the Prudent Option

The report highlights that investors will place varying degrees of value on the relative benefits of hedge funds and liquid alternatives.

Vanguard note that liquid alternatives may provide valuable portfolio construction benefits for investors who are not interested in undertaking the additional due diligence required for, or paying the costs associated with, investing in hedge funds.

They conclude that liquid alternatives maybe a viable option. Compared to hedge funds liquid alternative often have:

  • Lower fee structure that are easier to understand;
  • Greater transparency of underlying holdings; and
  • Greater liquidity i.e. easier access to getting your money back.

 

Performance Comparison

The Vanguard analysis reveals that hedge funds have performed better than liquid alternatives. They have also performed better on a risk adjusted basis.

However, the dispersion of returns between hedge fund managers is greater.

Vanguard undertook extensive performance analysis of hedge funds and liquid alternative returns, using factor analysis. Vanguard ran a seven-factor model and a customised regression model.

This analysis highlighted that liquid alternatives have more consistent factor exposures than hedge funds. Their returns are driven more by market factors such as value, momentum, low volatility, credit, quality, and liquidity.

Different factors drove the returns of different liquid alternative strategies – thus the diversification benefits of combining different strategy types.

Conversely, hedge funds are driven more by manager skill, returns are less sensitive to market factor returns.

 

To Conclude

Liquid alternatives provide an exposure to more “generic” hedge fund strategies – “hedge fund beta” exposures that have been found to be relatively stable over time. The market sensitivities vary across the different strategy types.

Investing in hedge funds, provides access to more unique return sources (alpha). Albeit this is harder to identify. Therefore, manager selection is even more important, given the larger dispersion of returns amongst hedge fund strategies and managers.

However, both the hedge fund alpha and the liquid alternative beta can provide diversification benefits to a traditional portfolio. Therefore, both can play a role in a portfolio.

Individual preferences and constraints will largely drive allocations to each.

Appropriate due diligence and focus on returns after fees will increase the likelihood of capturing the portfolio diversification benefits.

Manager selection is key.

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

What does Portfolio Diversification look like?

What does a diversified portfolio look like?

This is answered by comparing a number of portfolios, as presented below.

Increasingly Institutional investors accept that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.   Investors are compensated for being exposed to a range of different risks.

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

As a result, the inclusion of alternative investments is common place in many institutionally managed portfolios.

 

This Post draws heavily on a number of sources, including a very good article by Willis Tower Watson (WTW), Lets get the balance right.

The WTW article is extensive and covers a number of issues, of interest for this Post is a comparison between WTW Model portfolio and 30%/70% low cost Reference Portfolio (30% Cash and Fixed Income and 70% Equities).

To these portfolios I have compared a typical diversified portfolio recommended by US Advisors, sourced from the following Research Affiliates research paper.

 

Lastly, I have compared these portfolios to the broad asset allocations of the KiwiSaver universe.  Unfortunately I don’t have what a typical New Zealand Advisor portfolio looks like.

I have placed the data into the following Table for comparison, where Domestic reflects Australia and US respectively.

WTW Model Reference Portfolio Typical US Advisor
Domestic Cash 2.0%
Domestic Fixed Interest 13.0% 15.0% 28.0%
Global Fixed Interest 15.0%
Domestic Equities 15.0% 25.0% 35.0%
International Equities 20.0% 40.0% 12.0%
Emerging Markets 5.0% 5.0% 4.0%
Listed Property 3.0%
Global Property 3.0%
Listed Infrastructure 3.0%
Alternative Beta 8.0%
Hedge Funds 7.0% 8.0%
Private Equity 8.0% 4.0%
Unlisted Infrastructure 5.0%
Alternative Credit 8.0%
US High Yield 4.0%
Commodities / Real Estate 4.0%
Emerging Markets Bonds 1.0%
100.0% 100.0% 100.0%
Broad Asset Classes
Cash and Fixed Income 15.0% 30.0% 28.0%
Listed Equity 49.0% 70.0% 51.0%
Non Traditional 36.0% 0.0% 21.0%
100.0% 100.0% 100.0%

Non Traditional are portfolio allocations outside of cash, listed equities, and fixed income e.g. Private Equity, Hedge Funds, unlisted investments, alternative beta

The Table below comes from a previous Kiwi Investor Blog, KiwiSaver Investors are missing out, comparing Australian Pension Funds, which manage A$2.9 trillion and invest 22.0% into non-traditional assets, and KiwiSaver Funds which have 1% invested outside of the traditional assets. Data is sourced from Bloomberg and Stuff respectively.

Allocations to broad asset classes KiwiSaver Aussie Pension Funds
Cash and Fixed Interest (bonds) 49 31
Equities 48 47
Other / non-traditional assets 1 22

From my own experience, I would anticipate that a large number of Australian Pension Funds would have a larger allocation to unlisted infrastructure and direct property than outlined above.

 

If a picture tells a thousand words, the Tables above speak volumes.

The focus of this blog is on diversification, from this perspective we can compare the portfolios as to the different sources of risk and return.

 

It is pretty obvious that the Reference Portfolio and KiwiSaver Funds have a narrow source of diversification and are heavily reliant on traditional asset classes to drive performance outcome. Somewhat concerning when US and NZ equities are at historical highs and global interest rates at historical lows (the lowest in 5,000 years on some measures).

Furthermore, as reported by the Bloomberg article, the allocations to non-traditional assets is set to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

Globally allocations to alternatives are set to grow, as outlined in this Post.

 

The WTW Model portfolio has less of a reliance on listed equity markets to drive investment returns, maintaining a 49% allocation relative to the Reference Portfolio’s 70%.

Therefore, the Model Portfolio has a broader source of return drivers, 36% allocated to non-traditional investments.  As outlined below this has resulted in a similar return over the longer term relative to the Reference Portfolio with lower levels of volatility (risk).

 

Concerns of current market conditions aside, a heavy reliance on listed equities has a number of issues, not the least a higher level of portfolio volatility.

The Reference Portfolio and the KiwiSaver portfolios have a high allocation to equity risk. In a portfolio with a 65% allocation to equities, over 90% of the Portfolio’s total risk can be attributed to equities.

Maintaining a high equity allocation offers the prospect of higher returns, it also comes with higher volatility, and a greater chance for disappointment, as there is a wider range of future outcomes.

Although investors can experience strong performance, they can also experience very weak performance.

 

Comparison Return Analysis

Analysis by WTW highlights a wide variation in likely return outcomes from a high listed equity allocation.

By using 10 year performance periods of the Reference Portfolio above, since 1990, returns over a 10 year period varied from +6.4% p.a. above cash to -1.5% p.a below cash.

It is also worth noting that the 10 year return to June 2019 was the Cash +6.4% p.a. return. The last 10 years has been a very strong period of performance. The median return over all 10 year periods was Cash +2.6% p.a.

 

The returns outcomes of WTW Model are narrower. Over the same performance periods, 10 year return relative to Cash range from +6.2% and +0.2%.

 

Over the entire period, since 1990, the Model portfolio has outperformed by approximately 50bps, with a volatility of 6% p.a. versus 8% p.a. for the Reference Portfolio, with significantly lower losses when the tech bubble burst in 2002 and during the GFC. The worst 12 month return for the Reference Portfolio was -27% during the GFC, whilst the Model Portfolio’s loss was 22%

 

A high equity allocation is detrimental to a portfolio that has regular cashflows i.e. Endowments, Charities, and Foundations.  They need to seek a broad universe of return streams. This was covered in a previous Post, Could Buffet be wrong?

Likewise, those near or in the early stages of retirement are at risk from increased market volatility and sequencing risk, this is cover in an earlier Post, The Retirement Planning Death Zone.

For those wanting a short history of the evolution of Portfolio Diversifications and the key learnings over time, this Post may be of interest.

 

Let’s hope we learn from the Australian experience, where there has been a drive toward lowering costs. There is a cost to diversification, the benefits of which accrue over time.

As WTW emphasises, let’s not let recent market performance drive investment policy. The last 10 years have witnessed exceptional market returns, from which the benefits of true portfolio diversification have not been visible, nor come into play, and the low cost investment strategy has benefited. The next 10 years may well be different.

 

In summary, as highlighted in a previous Post, KiwiSaver Investors are missing out, their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives, as highlighted by the WTW analysis.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

KiwiSaver Investors are missing out

This is a great article by Stuff outlining the KiwiSaver risk ladder, rung by rung.

However, what struck me is that there is a rung missing on the KiwiSaver ladder.

That rung being the lack of exposure to non-traditional investments, such as Alternatives, including liquid alternatives, hedge funds, Private Equity, Venture Capital, and investments into Direct Property and unlisted infrastructure.

Based on the Stuff article, there is just 1% within all of the KiwiSaver Funds invested outside of Cash, Fixed Interest (bonds), and Equities (the traditional asset classes).

We don’t have to look far to see how much of anomaly this.

By way of comparison, the Australian Pension Fund Industry, which is the fourth largest Pension market in the world, invests 22.0% into non-traditional assets.

As can be seen in the Table below, Australian Pension Funds, which manages A$2.9 trillion, invests 22.0% into non-traditional assets, meanwhile KiwiSaver has 1% invested outside of the traditional assets. (KiwiSaver Total Assets are just over $50 billion).

Allocations to broad asset classes

KiwiSaver

Aussie Pension Funds

Cash and Fixed Interest (bonds)

49

31

Equities

48

47

Other / non-traditional assets

1

22

As recently reported by Bloomberg, allocations to non-traditional assets is expected to continue in Australia ”with stocks and bonds moving higher together, investors are searching for other areas to diversify their investments to hedge against the fragile global economic outlook. For the world’s fourth largest pension pot, that could mean more flows into alternatives — away from the almost 80% that currently sits in equities, bonds or cash.”

The increased allocations to Alternative is a global trend, which is not just in response to current market conditions.

As outlined in a previous Post, Preqin a specialist global researcher of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world, expect Alternatives to make up a larger share of investment assets in the future.

Preqin’s estimates are staggering:

  • By 2023 Preqin estimate that global assets under management of the Alternatives industry will be $14tn (+59% vs. 2017);
  • There will be 34,000 fund management firms active globally (+21% vs. 2018). This is an issue from the perspective of capacity and ability to deliver superior returns – manager selection will be critical.

The expected growth in Alternative investments was also highlighted by a recent CAIA Association Survey, which outlined the drivers of this expected growth and likely trends.

Globally the trend toward increasing allocations to non-traditional assets has been in play for some time. As one of my first Posts notes, the case for adding alternatives to a traditional portfolio is strong.

This Post highlights that the movement toward Alternatives and non-traditional assets is not revolutionary nor radical, it is seen globally as evolutionary, a natural progression toward building more robust Portfolios that can better weather sharp falls in global sharemarkets.

Interestingly, the US Department of Labor (DOL) recently provided guidance that US Defined Contribution retirement plans can invest into certain Private Equity strategies, where previously there had been a hesitation to do so.

The DOL emphasised this would be of benefit to “ordinary investors”.

Being more specific about Alternatives, Prequin note 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

Therefore, motives to investing in alternatives range from enhancing returns (Private Equity) and reducing risk through better diversification (Hedge Funds) and hedging against inflation (infrastructure and real estate (property), high exposures to non-traditional assets have benefited Endowments and foundations for many years.

I have Posted extensively on the benefits of Alternatives, for example highlighting research they would benefit Target Date Funds and the benefits of Alternatives more generally.

So the Question needs to be asked, why do KiwiSaver Funds not invest more into non-traditional assets? Particularly, when globally the trend is to invest in such assets is well established and further growth is expected, while the benefits are well documented.

Therefore, KiwiSaver Investors are potentially missing out.  Their portfolios could be a lot more robust and better diversified. The risks within their portfolios could be reduced without jeopardising their long-term investment objectives.

Happy investing.

Please see my Disclosure Statement

 

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

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

“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

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

Further growth expected for an Alternative future – Prequin

The outlook for Alternative investments continues to look bright according to the recent Prequin Global Alternatives Report.

Prequin note investor’s motivations for investing in alternatives are quite distinctive:

Private equity and venture capital, motives = high absolute and risk-adjusted returns

Infrastructure and real estate, motives = an inflation hedge and reliable income stream

Private debt, motives = high risk-adjusted returns and an income stream

Hedge Funds, motives = diversification and low correlation with other asset classes

Natural Resources, motives = diversification and low correlation with other asset classes

Prequin comment “Set against these objectives, it becomes clear why investors have not only consistently increased their allocations to alternative assets over the past decade, but also why they are planning to continue to do so in the years ahead (not to mention the growing number of investors that come into alternatives each year – i.e. growing ‘participation’).”

Interestingly, investors are expressing an increasing allocation not only to those alternatives that have exceeded expectations recently (Private equity and venture capital, private debt, infrastructure, real estate), but are also looking to increase allocations to areas where recent performance has disappointed – notably hedge funds and natural resources. As they note “the diversification and low correlation offered by these assets may be especially attractive in a challenging returns environment.”

 

Importantly, the Prequin survey is set against a backdrop where investors “see a challenging environment ahead for returns.”

They also note that continued growth is expected despite alternative assets having enjoyed a “tremendous decade of growth” and “becoming ever more vital in investors’ portfolios worldwide;”

 

With regards to expected growth, “Preqin is sticking with its forecast for further growth of alternative assets to 2023: from $8.8tn in assets under management in 2017 to $14.0tn in 2023.”

 

The full Prequin report is available and covers each of the Alternative strategies outlined above.

The Preqin-Alternatives-in-2019-Report, for example, provides some interesting facts and figures on Hedge Funds:

  • 59% of Surveyed investors believe we are the top of the equity cycle, 40% intend to position their portfolios defensively
  • 79% of surveyed investors intent to maintain or increase their level of allocation to hedge funds over the next 12 months

 

For further articles on Alternatives by Kiwi Investor Blog:

  1. An Alternative Future for Kiwisaver Funds
  2. Alternatives Investments will improve the investment outcomes of Target-Date Funds
  3. Future’s Hedge Funds
  4. Investment Fees and Investing like an Endowment – Part 2
  5. Perspective of the Hedge Fund Industry
  6. Adding Alternatives to and Investment Portfolio – Part 3 – Investing Like an Endowment Fund
  7. Adding Alternatives to and Investment Portfolio – Part 2
  8. Adding Alternatives to and Investment Portfolio

 

 

Happy investing.

 

Please see my Disclosure Statement

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