Alternative assets have become increasingly important in a low-yield world with muted return expectations across traditional asset classes and with an aging population in which capital preservation and stable yield in retirement is so important. For example, the A$163 billion Australian government’s Future Fund has a 29.2 per cent allocation to alternatives and private equity. But alternatives are inherently more complex, which means it’s essential to develop a deep understanding of the risk and return characteristics of these investments in a portfolio.
This was the focus of discussion of the expert alternative investment panel; as part of Channel Capital’s Asset Allocation Virtual Series. The session offered insights into the virtues of both liquid and illiquid alternative investments to add genuine diversification to a balanced portfolio.
To put alternatives in perspective, it’s important to understand that while traditional bond and equity investments have been the mainstay in investor portfolios for decades, this thesis is changing. “With cash rates around the world at zero, 10-year bond yields below one per cent and equity market valuations in the US and Australia at record levels, the question is what role do alternatives play in this environment?” questioned moderator Craig Ferguson, Director of Strategy with Antipodean Capital.
Sage Capital Chief Investment Officer Sean Fenton, noted central banks are playing a much greater role in financial markets, which has consequences for investors.
“That’s been positive for equities, but it’s difficult to see bonds representing value in this environment. It also makes investors cautious about future equity market valuations. Furthermore, it calls into question what diversification looks like in the future.
Investors need to think outside the box in terms of how they get returns and balance risk across the portfolio. That's where we see alternatives stepping up and having a substantial role to play to open up a whole range of investment strategies that are less correlated than what has been driven by central banks across traditional markets. Investors need to consider allocating more funds to a range of different alternative investments to broaden risk and return sources.”
Key to this will be unlisted assets and private equity opportunities, according to Chris Yoo, Founder and Partner of Genesis Capital, a private equity manager specialising in healthcare and technology.
“On the investing side, it comes down to where you're playing from a size perspective. There has been a shift to larger buyout funds and managers who over time have become large asset managers. They're competing in pools of capital and with a weight of capital that has meant their return hurdles have come down. It's a difficult job for large private equity firms which are really under pressure to deploy capital.”
Yoo notes this also plays out in the way funds use debt. “Super low interest rates means there’s lots of leverage available and that creeps into investments’ risk profiles. At some point when the music stops, that will come to bear in the returns in those structures. In contrast, we operate in the mid-market and look to build up businesses that the public markets or larger private equity investors would not be interested in, so we’re more impervious to market dynamics. We’re more in the real economy.”
Panellists stressed how important it is to be able to manage risk in alternatives, including leverage, market exposure, diversification and style neutrality.
“Managers who deliver returns by leveraging themselves to the market and then varying market beta – this is difficult to do repeatedly. From our perspective, successful investing always comes from diversification. The ability to implement a range of different investment ideas is key,” Fenton told the audience.
“Having a broad investment process that's repeatable and being able to take positions across a range of different assets is essential,” he adds.
Ferguson explained that institutions, endowments and family offices have already shifted their asset allocations to include much larger exposures to liquid and illiquid alternatives.
“Looking at one of the top five endowment funds in the U.S. − Brown University Endowment, the financial year return for 2019 was over 12%, which it attributes mainly to its alternative asset allocations like private equity and absolute return strategies – and some public equity exposure.
Sharing a similar bias to endowment funds, family offices also have a greater allocation to alternatives, albeit a greater need for income. Family offices tend to do a lot of this investing direct, with private equity representing around 18% of global family office asset allocations, according to the UBS/Campden Wealth Global Family Office Survey 2019. When we look at these return profiles over much longer time periods, we find consistent patterns in private equity, venture capital and real estate, with return profiles significantly higher. These models could be useful for advisers to embrace – who have traditionally focused on age-based asset allocations that can be problematic, as often they don’t provide the appropriate portfolio protection through uncorrelated assets.”
When it comes to more illiquid assets, Yoo said a key measure of a strong performing private equity manager is realised returns and how quickly they're able to return capital.
“A good manager deploys their funds across three to four years, but by the time they get to year three they should have returned a good amount of capital. A lot of fund managers get caught up in continued accumulation of assets that can't be realised. The most highly regarded Australian private equity managers are not too attached to the companies they're building. They recognise their job is to invest capital and exit at the right time to return capital to investors.”
Fenton agreed that what’s key is consistency of returns. “You need to be looking at how those returns are generated. The broader the investment process, the more decisions you're making and the more likely your returns are going to be consistent and repeatable. It’s all about consistency, repeatability and performance.”
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