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Incorporating alternatives into modern portfolios

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Incorporating alternatives into modern portfolios

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Incorporating alternatives into modern portfolios

23-10-2017

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Guy Fletcher, Head of Institutional Solutions & Research, explains how it can be done.

Investment managers, asset consultants and retirement fund trustees are faced with a hard fact: traditional asset classes are no longer yielding attractive or even real returns in this low interest rate environment, particularly internationally. With this background, additionally marked by geopolitical hostility and market instability, it makes sense to add alternative investments to portfolios as a powerful diversification tool, said Guy Fletcher, Head of Institutional Solutions & Research at Sanlam Investments. He was speaking at the Sanlam Investments Institutional Insights conference in Johannesburg in September.

Hedge funds (specifically targeting absolute return strategies), private equity (buy-outs and venture capital), private debt (loans), and real assets such as commodities, unlisted property, and infrastructure-funding equity or debt vehicles all hold the potential for providing higher than average returns, says Fletcher. The added benefit is that such holdings provide access to excess returns that are significantly less correlated to traditional asset classes such as listed property, equities and bonds.

Fletcher gave the example of the performance of Yale University’s Endowment fund whose performance was tracked over 30 years. During this period, the fund commenced with over 80% in typical listed financial instruments (ie, looking very similar to traditional South African retirement funds) and gradually moved into having more than 70% in alternative investments. As a consequence, it generated more than US$11 billion in extra returns.

Perceived barriers

Despite the potential, there are several deterrents for institutional investors, said Fletcher. Primarily, there are the restrictions imposed by Regulation 28 (limitations under the Pensions Fund Act). However, these are not exceptionally onerous. For instance, up to 15% of assets under management can be allocated to unlisted “alternative” vehicles (maximum 10% to hedge funds and 10% to private equity), 10% to listed commodity vehicles, 15% in unlisted debt instruments and 25% in property (listed, immovable or combination). Even if some 10% is allocated to listed property, then there is scope to allocate a further 55% to the broader definition of alternatives. By way of comparison, it is estimated that local retirement funds currently average less than 7% in these vehicles.

However, it should be noted that alternatives have specific attributes that differentiate them including reduced liquidity (an inability to convert the investment into cash), minimum lock-in periods (the investment may not be withdrawn within an initial designated period without penalty), asymmetric information (“insiders” have more information than “outsiders”) and the perception of less transparency (publically available information). The upside is that investors are rewarded with a healthy compensation, often called the Illiquidity Premium, in return for this investment.

It is this premium that long-term investors such as retirement funds, with limited requirements for liquidity, should be taking advantage of”.

However, most funds have not allocated meaningful funds yet due to the need to introduce greater oversight and more complexity into the investment process. It is this additional complexity that can be mitigated through using a simplified replacement process

“Many alternative investments carry similar risks as traditional asset classes, so the key to investing in them is to isolate that part of their performance that is independent and that carries significant potential ‘alpha’ — or expected outperformance of your benchmark,” said Fletcher. As an initial mechanism, Sanlam Investments Solutions team has broken down each alternative asset’s expected return into three specific components, namely:

  1. That part that is related to traditional asset classes and can thus be replicated by standard investment vehicles
  2. That part that is recompense for the lock-in periods (typically a function of volatility)
  3. The residual element that is the uncorrelated alpha described above

The first element identifies how the introduction of an alternative into a traditional portfolio alters the existing asset allocation mix, while the latter two should elevate the expected return (assuming that they are positive). This approach allows a fund to remain in the same risk (or expected volatility) space while introducing instruments that elevate return, effectively improving portfolio efficiency.

Portfolio Risk
Source: Sanlam Investments, October 2017

This process is neither simple nor trivial, and requires the use of reasonably complex mathematical formulae for accuracy. However, a greater problem is heterogeneity, that is the instrument or fund into which a client is investing can deliver markedly different results. By way of example, Private Equity funds are extremely diverse and can range from investments in small start-ups, to buy-outs of large listed companies. Hence, each investment must be decomposed individually with due recognition of estimation inaccuracy.

This certainly does not imply that investing in alternatives should be avoided, merely that it is an exercise that requires expert oversight.

“When done within a clearly articulated framework, it holds significant upside potential and is likely to become a strong and growing element of investment by retirement funds over the next decade”.

 

Related article:

Can alternatives transform retirement fund returns?

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