An Alternative Future for Kiwisaver Funds

I have blog previously on the benefits of Alternative investments for a robust portfolio.

They would benefit Target Date Funds (Life Cycle Funds) and they have benefited Endowments and foundations for many years.

As the Funds Under Management (FUM) grows within Kiwisaver there will be an increasing allocation to Alternative investments. This will include the likes of unlisted assets (Private equity, direct property, and direct infrastructure), hedged funds, and liquid alternative strategies such as Alternative Risk Premia strategies.

 

A recent paper by Preqin, Preqin-Future-of-Alternatives-Report-October-2018, assesses the likely size, shape and make-up of the global alternative assets industry in 2023, the emphasis being on private capital and hedge funds.

Preqin are specialist global researchers of the Alternative investment universe and provide a reliable source of data and insights into alternative assets professionals around the world.

 

Needless to say, Alternatives are going to make up a large 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.  Therefore, manager selection will be critical.

 

Preqin outlined the drivers of future growth as the following:

  • Alternatives’ track record and enduring ability to deliver superior risk-adjusted returns to its investors, Investors need to access alternative sources of return, and risk, such as private capital.
  • They note the steady decline in the number of listed stocks, as private capital is increasingly able to fund businesses through more of their lifecycle;
  • A similar theme is playing out in the debt markets, there are increasing opportunities in private debt as traditional lenders have exited the market; and
  • The emerging markets are seen as a high growth area.

 

According to Preqin the following factors are also likely to drive growth:

  • Technology (especially blockchain) will facilitate private networks and help investors and fund managers transact and monitor their portfolios, and reduce costs vs public markets.
  • Control and ESG: investors increasingly want more control and influence over their investments, and the ability to add value; private capital provides this.
  • Emerging markets: the Chinese venture capital industry already matches that of the US in size; further emerging markets growth will be a ‘double whammy’ of GDP growth + higher penetration of alternative assets.
  • Private individuals: the ‘elephant in the room’, as the mass affluent around the world would like to increase their investment in private capital if only the structures and vehicles (and regulation) permitted; technology will help.

 

The Preqin report covers many other topics and interviews in relation to the Alternative sector.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Alternatives Investments will improve the investment outcomes of Target-Date Funds

Including alternative investments in Target-Date Funds (TDF) will improve their investment outcomes.

This is the conclusion of a recently published research report by the Center for Retirement Initiatives at Georgetown University’s McCourt School of Public Policy, developed in conjunction with Willis Tower Watson.   The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes

The study concludes the use of alternative investment strategies “can improve expected retirement income and mitigate loss in downside scenarios.”

 

Many TDF are over exposed to equity risk, they are not truly diversified.

The above study notes that TDF need to increase their diversification away from equities and fixed interest that dominate their portfolios.  In short, TDF need to broaden their diversification to allow access to alternative return drivers.

This is seen as very important, “even more important step is improving the performance of the underlying investments. The use of alternatives in DB (Define Benefit) plans is an investment practice that should be considered in today’s DC (Define Contribution) plans, specifically in TDFs”

The article outlines the growing popularity of TDF and therefore the opportunity that is available to build better portfolios and improve investment outcomes for clients.

 

The study compared TDF’s comprising of only equities, bonds, and cash.  To this traditional portfolio they added individual allocations to Private Equity, Unlisted Property, and Hedge Funds separately.

The study first looked at outcomes of adding these alternative strategies in isolation to the Traditional Portfolio, and then when all are added to the Portfolio all together.

When adding the alternatives in isolation to a traditional equities and fixed interest portfolio they concluded that investment outcomes for TDF were improved by:

  • Increasing the amount of income that can be generated in retirement from the portfolio;
  • Increase the probability of maintaining positive assets after 30 years of retirement spending;
  • Delivering higher expected returns; and
  • Reducing downside risk, particularly reduce the negative impact of a negative market at time of retirement (reducing sequencing risk)

 

Therefore, investment outcomes for Target-Date Funds can be improved with greater levels of diversification (as can any portfolio which only invests in equities, bonds, and cash).

Investment outcomes were improved with any one of the alternative strategies implemented in isolation.

 

The study then looked at TDF when all the alternative strategies were added to the Traditional Portfolio.

As they note “previous examples look attractive in isolation, we now turn to considering how these strategies contribute to a diversified implementation that includes allocations to all these assets. Not only do these alternative asset classes provide diversification or differentiated return drivers relative to equities and fixed income, but they also provide attractive cross-correlation benefits when viewed in combination with each other (meaning they outperform and underperform at different times from one another).”

 

Importantly, portfolios were constructed to be of similar risk along the glide path, the increased diversification of adding alternative provides risk benefits over time.

A higher allocation to return seeking assets is able to be maintained over time given the diversification benefits of adding alternatives to the TDF.

Again investment outcome were improved upon compared to a Traditional Portfolio of Equities and Fixed Interest, higher retirement income (+17%) and improved downside risk outcomes (+11%)

 

Importantly, they noted:  “One straightforward way to mitigate downside risk is to shift more equities into fixed income, though that approach would materially lower expected returns and adversely impact participants who intended to utilize the funds as a source for income throughout retirement.  Additionally, shifting from equities to core fixed income lessens equity risk but increases other risks such as interest rate and inflation. Instead, participants may be better off by further diversifying their portfolios.”

 

Notably they comment that this is part of an overall plan to improve retirement income outcomes:

“In order to improve retirement income outcomes, plan sponsors must pull all of the levers at their disposal across their organizations. While a number of enhancements have been made with investment vehicles …., plan design…….., and communications, DC plans still lag behind other large investment pools in the use of alternative asset classes. There is a reason why alternative assets are used more often in other investment pools: They can improve investment efficiency and the net-of-fee value proposition.”

 

Implementation Considerations

The paper covers a number of implementation issues, such as Governance, liquidity, and fees.

Their comments of fees hits the mark:

“To include the potential benefits of alternatives in TDFs, plan sponsors need to be comfortable increasing total fund fees, which can be accomplished through a prudent process focused on enhancing potential outcomes for participants. The fee compression in TDFs has come at the expense of the potential increased returns, lower volatility and portfolio efficiency alternatives could provide.”

Think about after fee outcomes.

 

Concluding remarks

Overall the outcomes from this Study are hardly surprising.  The use of alternatives has been shown to improve the investment outcomes of other investment portfolios and are widely used e.g. endowments, Insurance Companies, Super (Pension) Funds, and as mentioned Defined Benefit Funds.

The Study notes “As of 2016, the largest corporate pension plans in the Fortune 1000 (assets greater than $2.1 billion) held average allocations of 4.2 percent to hedge funds, 3.4 percent to private equity, 3.0 percent to real estate and 3.6 percent to “other” asset classes.” And “public pensions allocate even more to alternative investments (approximately 25 percent), according to the National Association of State Retirement Administrators.”

This is not to take anything away from the Study, it is great analysis, enhances our understanding of TDF, and is well worth reading.

 

Lastly, investment outcomes for Target-Date Funds can also be enhanced with the more active management of the glide path strategy.  This may include delaying the pace of transitioning from risky assets (which would include alternatives!) to safer assets or stepping off the glide path given extreme risk environments.

Investment outcomes for clients can also be improved if more client information is used over and above age to determine an investment glide paths e.g. changes in salary leading to a higher expected standard of living.  This is where technology can have a massive impact on the industry.

Many TDF have their limitations, particularly they have no goal and the glide path is based solely on age.

The experience in retirement is changing, we are living longer, more robust retirement solutions are needed.

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Asness on Hedge Fund Returns and Buffet Bet Revisited

Earlier in the year I wrote a post about the Buffett Bet.

To recap, “The Bet” was with Protégé Partners, who picked five “funds of funds” hedge funds they expected would outperform the S&P 500 over the 10 year period ending December 2017.

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

Needless to say, Buffet won.  The S&P 500 easily outperformed the Hedge Fund selection over the 10 year period.

I made three points earlier in the year:

  1. I’d never bet against Buffet!
  1. I would also not expect a Funds of Funds hedge Fund to consistently outperform the S&P 500, let alone a combination of five Funds of Fund.

This is not to say Hedged Funds should not form part of a “truly” diversified investment portfolio.  They should.  Nevertheless, I am unconvinced their role is to provide equity plus returns.

  1. 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

Finally, someone from the Hedge Fund Industry has come out a said it: Hedge Funds should not be compared to the performance of investing in equities.

Cliff Asness from AQR has, and not for the first time, recently written an article about why Hedge Fund returns should not be compared to equity market returns such as the S&P 500 Index, see The Hedgie in Winter.

The key point Asness makes is that Hedge Funds are not 100% invested in equities.  He estimates that they are in effect 50% invested in equities.  If we use beta terms, where a beta of 1.0 =  100% equities, Hedge Funds have a beta of 0.5.  (For those who are wondering what Beta is, Beta is a measure of how sensitivity an investment is to a market index e.g. S&P 500.  Put another way, how much of the returns from the market index can explain the returns of the investment.  Therefore, with a beta of 0.5 we would expect hedge funds to be less volatile than equities and equity markets performance would only explain some of the returns from hedge funds.)

Asness expresses it more succinctly:

“Comparing hedge funds to 100% equities is flat-out silly. Hedge funds have historically, rather consistently, delivered equity exposure (beta to my fellow geeks) just under 50%. In fact much of their point is, supposedly, to be different from equities. I mean that they are at least partly hedged investments. Put more bluntly, it is in the freaking name!”

That’s right, Hedge Funds look to reduce their equity market exposure, hedge it out.  Therefore they will not capture all of an equities market upside.  Similarly, when equity markets fall significantly, they are not capturing all of this downside as well! i.e. Hedge Funds tend to outperform equity markets in equity bear markets.

Certainly, hedge funds are not going to outperform equities in a strong bull market, as we have recently experienced, as they are not 100% invested in equities.  They are not equities.

Well, you probably would expect a hedge fund manager to say this.  Yip, but I would say he is right on the money.

Furthermore, it is not as if Asness lets Hedge Funds off the hook.  From further analysis in the paper Asness notes that Hedge Fund performance has been “petering out” since the Global Financial Crisis (GFC).  This means they have not added or subtracted much value since the GFC.

I take this to mean they have struggled to meet their investment objectives and historical rate of returns, albeit they may well have delivered mildly positive returns.  Which is not as disastrous as often reported.

The “petering out” of Hedge Fund performance is highlighted by Asness as an area of concern.  The data he presents provides no proofs as to why.  He concludes that Hedge Funds may be less special than before.

That is certainly something to dwell upon.  Hedge Funds can play an important role in a robust portfolio and achieving true portfolio diversification.  The observation by Asness should be considered in the selection of Hedge Fund managers and strategies.

Lastly, there is change occurring across the Hedge Funds industry.  This expected change is captured in the recently published AIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund IndustryAIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund Industry. This includes more transparency and lower fee structures.

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

This is consistent with Hedge Funds playing a valuable role in a truly diversified portfolio.

Happy investing.

Please see my Disclosure Statement

 

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

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Future’s Hedge Funds

A really interesting article by the Chief Investment Officer: A New Generation of Hedge Funds Can Provide Stability, Australia’s sovereign wealth fund CIO is betting hedge funds can help reduce risk.

The article covered a number of themes from my earlier Blog Post Perspective of the Hedge Fund Industry

The hedge fund industry, and the “hedge fund”, have changed dramatically over the last few years.  This is captured in the recently published AIMA paper (Alternative Investment Management Association), Perspectives, Industry leaders on the future of the Hedge Fund Industry.  The AIMA paper is covered in the Post above.

The following Quotations from the Chief Investment Office article by Raphael Arndt, CIO of Australia’s A$166 billion sovereign wealth fund, the Future Fund, are consistent with the AIMA Paper:

  • “Hedge funds have an important portfolio role to play in generating returns that are uncorrelated to equity markets,” Arndt said last week in a speech before the Insurance Investment Forum in Torquay, Australia.
  • “For the Future Fund, hedge funds have a very specific purpose in our portfolio.  This is to reduce risk—and in particular to provide returns during market environments involving prolonged periods of losses in equity markets.”

 

From Kiwi Investor’s perspective a well designed and implemented Hedge Fund solution is particularly attractive for an insurance company.

 

Arndt, continues:

  • “I recognize that hedge funds have historically had a public relations problem, being associated with high fees, a lack of transparency, and perceptions of poor ethics and customer focus,” said Arndt.
  • But Arndt said this perception of hedge funds is a dated stereotype that he refers to as “hedge funds 1.0,” which has given way to what he calls “hedge funds 2.0”—a newly evolved generation of hedge funds.

 

This sentiment very much comes out in the AIMA paper As Arndt emphasised, many hedge funds run institutional-quality investment process.  If they don’t, they don’t receive institutional money.  This not only relates to the investment management process, it includes issues such as management of counter party risk, operational risk management, regulatory risk management, and transparency of portfolio risk exposures.

Lastly, after outlining the type of hedge fund solution the Future Fund runs, Arndt comments:

  • “I encourage industry participants to consider such a program in their portfolio to protect against the risks associated with a repeat of a GFC type event in equity markets,” said Arndt. “The fees paid, while unquestionably high, are worth paying for skilled managers who collectively can add significant value to the portfolio overall.
  • “It’s time to re-examine what hedge funds offer,” he added. “The industry has evolved and improved, and features a new breed of managers that are different from their predecessors.”

 

These comments are also consistent with points made in my earlier post on Investment Fees and Investing like an Endowment – Part 2 and Disaggregation of Investment Returns.

 

In effect, the Future Fund uses Hedge Funds to provide return diversification, they use Hedge Funds so they can invest into riskier assets like equities and illiquid asset such as infrastructure, property, and private equity.

We all know a robust portfolio is broadly diversified across different risks and returns.

Combined the Future Fund has a more robust portfolio.

 

It has worked well for them, the article states: “As of the end of March, the Future Fund reported a return of 8.5% per year over the last 10 years, compared to a target benchmark return of 6.7% per year during that same time period.”

This is a very good result, successfully managing into their stated investment objectives.

 

Happy investing.

 

Please see my Disclosure Statement

 

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

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Perspectives of the Hedge Fund Industry

The hedge fund industry, and the “hedge fund”, have changed dramatically over the last few years.

This is capture in the recently published AIMA paper (Alternative Investment Management Association), Perspectives – Industry Leaders on the Future of the Hedge Fund Industry

From the report: “Most people today look to hedge funds for diversification, i.e., an alternate return stream, with low beta and correlation to traditional investments. In the past, the driver of hedge fund interest was high expected returns and growth of capital.”

Hedge fund’s largest clients are Pension Funds, University Endowments, and Sovereign Wealth Funds.

Access to hedge fund strategies is becoming increasingly available to retail investors.  Hedge Funds, and hedge fund strategies, are no longer the exclusive domain of High Net Wealth Worth individuals.

 

Summary of the Report’s Executive Summary

  1. Paradigm shift. The industry is experiencing significant transformation as investors seek new investment solutions to more cheaply access different return streams. This has witnessed an innovation of investment solutions that fit between the traditional hedge fund and the traditional actively managed listed market funds.  These new investment solutions are providing the benefits of increased portfolio diversification for lower fees and increased transparency relative to the traditional hedge fund.  These cheaper return streams are the factor betas and alternative hedge fund betas. There has been a disaggregation of investment returns as a result of recent investment solution innovation.
  1. Hedge Funds can still produce alpha (risk adjusted excess returns) but it is getting harder due to increased competition and the greater ease of access to financial data and computing power.
  1. Therefore, an increasing employment of artificial intelligence and advanced cutting-edge quantitative techniques will likely grow across the hedge fund industry.
  1. The integration of Responsible Investing will likely rise across the hedge fund industry.
  1. The hedged fund firm is likely to change from its current traditional model, employing outside of the traditional business school graduate, employing a greater diversity of talent, flatten organisational structures, and encourage more collaborative environments.
  1. Hedge Fund firms will likely look to partner more with investors and co-invest.
  1. This will see a different focus on distribution and ownership models.

 

Points One and Two are of the most relevant to the focus of Kiwiinvestorblog.

The changing dynamics of the hedge fund industry has implications for the wider funds management industry e.g. downward pressure on fees, the blurring of the lines between traditional fund managers and hedge fund managers investment solutions, and the increased weight on traditional active equity managers to deliver genuine alpha – the closest index fund is on the endangered extinction list!

Importantly, the change taking place is making it easier, cheaper, and more transparent to implement truly diversified and robust multi-asset portfolios.  This is evident in the thoughts expressed in the quotes provided below and throughout the Report.

Section One of the Report formed the basis of an earlier blog on the Disaggregation of Investment Returns between market beta, factor and hedge fund beta, and alpha (linked aboved).

Pages 37 – 43 of the Report has a good discussion on whether hedged funds can still generate alpha (risk adjusted excess returns).

Understanding these sources of returns will help in building truly diversified portfolios.  It will also make the quotes more meaningful.  A greater appreciation of where the industry is moving will also be gained.

 

The following quotes from the Report help bring this all together.

Happy investing

 

Key quotes from within the Report:

“The past years have brought significant changes to the hedge fund industry. What was once a boutique industry serving high-net-worth individuals now serves some of the world’s largest investors. The products offered by hedge fund firms are changing to meet the needs of this wider and more diverse investor universe. The alpha-beta returns dichotomy of yesteryear is being replaced with a new range of investment solutions tailored to the needs of a wider range of investors.”

 

“A majority of investable assets in the total hedge fund pot will go to some form of risk premium investment strategy or a low-to-average correlation type of investment product, because investors have become increasingly more technical and have caught on to the fact that some investment strategies can be replicated for lower fees. Going forward, I expect more than half of the hedge fund investable universe will comprise of the top ten largest investment strategies being commoditised into more low-cost investment products—the so-called liquid alternatives. The remainder of the universe will comprise of high-end niche investment strategies that are capacity constrained, and are able to deliver true alpha.”

 

“Changing investor expectations are forcing hedge fund firms to rethink the investment solutions that they offer. The pace of technological change and the rise of artificial intelligence is leading some to question whether the hedge fund proposition will even exist in a few years. Responsible investment, meanwhile, is becoming more of a priority for hedge fund firms, as they gradually overcome their reluctance to constrain themselves. All of these changes are in turn forcing hedge fund firms to re-evaluate their own inner workings, from how they service investors through to how they build a business that outlasts its founders.”

 

Please see my Disclosure Statement