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(June-2004) In from the cold
After a short spell in the wilderness, alternative investments are back on the agenda.
Institutional investors have begun to realise the truth about alternative investments — they are a long-term proposition. Firstly, to get the most out of them you need to prioritise and plan. This means choosing the category of alternative investment you want to pursue so the time you spend on research and due diligence is effective. Beyond that, investors should ask themselves six questions.
1. Alternative to what?
The first question to ask is: why invest in alternatives compared to conventional investment classes? The answer lies firstly in looking at your existing portfolio and seeing where gaps might be filled to provide a better balance of risk and return across the whole portfolio. Answering this also provides a benchmark against which the alternative investment opportunities can be tested.
2. How long do I have to wait for the return?
This question can be a deal-breaker. You can save a lot of research and due diligence time if the answer is “that’s too long”.
For alternatives, which are illiquid or require a long holding period like 10 to 15 years, you have to be sure it can hold its place in the portfolio.
Negative cash flow may reduce the total portfolio size and increase alternative exposures as a percentage of the total. This issue particularly applies to Australian super funds offering member investment choice where switching options lead to money shifting away from the option that holds the alternative investments.
3. Where does it belong?
This is a tough one and there’s no clear answer for some investments. It may depend on how much is to be allocated, whether it’s opportunistic or a permanent holding and what level of aggression is already built into the main asset classes. Given the changing availability of quality offerings, it tends to be more efficient to have an overall alternative category with a dynamic benchmark built bottom-up from the return targets or individual constituent investments.
4. What is the manager’s advantage?
Investing in shares can be justified on a passive or active basis. It’s fairly clear from long-term trends that economic growth leads to sharemarket returns. Long-term investors can see a place for shares regardless of how actively they are managed. This isn’t the case for alternatives. The investment case for future returns has to be made by the manager based on their inherent advantages in capturing opportunities that will produce the higher returns required.
5. Will it make a difference?
To justify the effort in research and due diligence, there must be a significant allocation to alternatives. For long-term portfolios, this means a level of 5 to 10 per cent depending on the number of different alternatives and managers and the level of diversification. Historically, some funds have taken only token exposures to alternatives which are really not going to show up in returns.
In determining whether the return will make a difference, it’s critical to have a transparent view of leverage and fees (particularly at this low point in the interest rate cycle), and to see reasons to invest other than “it reduces risk” — so does cash!
Super funds need to satisfy some searching questions from the Australian Prudential Regulation Authority on leverage. Alternative investment fees operate in a totally different way compared to the conventional flat basis points on assets of listed asset classes.
To assess fees it is necessary to do cashflow modelling because of the different paths of fees and returns. The effective level of fees as a reduction in the compound rate of return can often work out to be two to three times the quoted percentage scale.
6. What is in vogue now?
We’re seeing most activity in hedge fund-of-funds and a number of single strategy offerings in long/short and global macro funds (the new generation tactical asset allocation).
These strategies can be fitted into most funds, because liquidity and time horizon aren’t as critical as with other categories of alternatives. For those with the time horizon to cope with it, private equity is gaining interest. In Australia it has been maturing and is no longer the poorer cousin to the longer running global private equity fund-of-funds specialists.
Institutional super funds seeking to differentiate themselves with superior long-term returns could reap rewards from patiently holding to significant alternative investment allocations.
— Bruce Gregor is a principal with Mercer Investment Consulting.
AUTHOR
External
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