Taking the bull by the horns

With Australian superannuation funds having secured another year of double-digit returns, some serious questions are again being asked about asset allocation strategies and the role of so-called alternative investments.

While most major funds have increased their exposure to alternative investments such as hedge funds, private equity and direct property over the past 36 months, the driving force behind superannuation fund returns has continued to be equities, particularly domestic shares.

But despite three straight years of double-digit superannuation returns driven primarily by equities, consultants are continuing to urge funds to remain well diversified and to maintain their exposure to alternative investments, recognising that risk exposure can be as important as returns.

Mercer Investment Consulting in a recent review of alternative investments makes the point that alternatives have always been about managing risk.

“Alternatives have always been about diversifying risk away from equities,” Mercer’s Dragana Timotijevic says.

She adds that alternative strategies are not only about diversifying risk away from conventional allocations such as equities, commodities and credit, but also about accessing a wider range of manager skills and, therefore, increasing consistency of returns.

While some consultants began recommending clients increase their exposure to alternative investments in the wake of the slump in superannuation returns between 2001 and 2003, others had long-recognised the inherent value of such allocations.

Frontier Investment Consulting’s Mike Wyrsch points out that alternative investments have been well used in allocations for most of the past 10 years, particularly with respect to the now mainstream vehicles of infrastructure and direct property.

This is something evident in the allocations of many of Frontier’s industry fund clients, who have long-standing direct property and infrastructure portfolios.

Looking at the current situation with respect to superannuation fund asset allocations towards alternative investments, Wyrsch acknowledges that hedge funds remain popular, and are increasingly becoming mainstream.

He said some funds were also increasingly looking towards commodities, and that emerging markets were also becoming popular.

“The popularity of hedge funds has a lot to do with the price of bonds at the moment,” Wyrsch says. “Bonds appear to be expensive and credit spreads are tight, reducing the likely return from fixed income sectors. Investors are seeing hedge funds as a more attractive option than fixed income, as the sector offers greater return potential and a similar level of risk.”

Timotijevic takes a similar view to Wyrsch, saying infrastructure, property and private equity have become more popular over time.

The problem with a number of the alternative investment allocations, particularly areas such as property and infrastructure, is that they are illiquid, but neither Wyrsch nor Timotijevic see this as a problem, given the longer investment timeframes usually employed by superannuation funds.

Timotijevic says infrastructure, property and private equity were all illiquid, and it followed that institutional investors such as superannuation funds were looking to extract an illiquidity premium.

“You can invest in liquid/listed versions of these assets, even private equity, but you introduce a greater measure of market risk and volatility,” she says.

In the end, one of the primary motivations for pursuing alternative investments is diversification of risk, and Timotijevic points out that there are not just alternative assets, but alternative strategies.

“There are alternative assets such as infrastructure and commodities, and there are alternative strategies such as long/short,” she says. “In general, we can say that alternatives have been not only about diversifying risk away from market risks, but also accessing managers skills, increasing consistency of returns and achieving a better risk/return ratio.”

While both Wyrsch and Timotijevic acknowledge that manager selection is a key element with respect to alternative investment strategies, Wyrsch says that the manager relationship is more prevalent where US hedge funds are concerned.

“In the US, it is more about managers — they have a franchise and entrepreneurs go to them” he says.

“Everyone wants to go to the top managers.”

Timotijevic believes that where superannuation fund allocations are concerned, there is a lot of room for hedge fund allocations to grow, as well as for some specialist/opportunistic property.

For Wyrsch, the issue with hedge funds continues to be fees. He admits that fund-to-fund fees are definitely coming down, but still sees them as hard to justify.

Timotijevic is less bullish about commodity allocations, which she does not expect to grow significantly.

According to Timotijevic, a number of alternative investments are becoming increasingly mainstream.

“Infrastructure and property are definitely maturing, especially domestically, but the opportunities overseas have increased hugely over the past two years and are expected to remain very strong,” she says.

Wyrsch says looking forward, fund managers will always be looking for new things, but not necessarily the outlandish.

“Investment should increase in certain commodities and in the energy markets over time. A lot will depend on tax and legal structures,” he says. “Recently, property advisers have been looking for expansion too, with increased interest in India and China. In addition, infrastructure is set to expand globally.”

Notwithstanding the strength of equity markets and the emergence of private equity and emerging markets, hedge funds remain the primary means by which most superannuation funds have maintained their exposure to alternative investments.

This appears set to continue, with both Timotijevic and Wyrsch suggesting that allocations into hedge funds were likely to be maintained.

Timotijevic says that the risk/return profile for hedge funds had remained largely unchanged.

She said that some of the negative perceptions of hedge funds were based on the fact that investors had focused on only the return side rather than the risk side.

“Volatility is increasing and there is more dispersion in the market, which should create a more favourable environment,” Timotijevic says.