Alternatives Becoming Source Of Returns
By: Joe Hornyak
The headlines speak for themselves. When OMERS released its 2004 Annual Report, the best performing asset class was infrastructure, returning 31 per cent, while private equity returned 12.5 per cent and real estate 11 per cent.
HOOPP’s 2004 Annual Report showed its best asset class was private equity with a return of 21.17 per cent, followed by real estate at 15.84 per cent.
The Caisse and Ontario Teachers’ had similar stories. At the Caisse, alternative assets led the way, with real estate returning 22.7 per cent, private equity 20.5 per cent, and the hedge fund portfolio 7.8 per cent.
At Ontario Teachers’, it was private equity with a return of 27.6 per cent. However, absolute return strategies, which includes a 150 fund hedge fund portfolio, returned 13.3 per cent.
The fact is alternative investment strategies are becoming an important part of pension fund asset allocation.
Part of the reason, if the U.S. experience is taken into account, is institutional investors are attempting to bridge the gap between expected returns on investments and future funding needs by shifting money out of asset classes such as fixed income and into investments with the potential to deliver more robust returns, such as alternative asset classes.
Greenwich Associates’ 2005 U.S. Asset Allocation research reveals that U.S. public and private pension plan sponsors, endowments, and foundations reduced their average fixed income holdings from 26.8 per cent of total portfolio assets in 2003 to 23.7 per cent in 2004. During that period, U.S. funds kept allocations to domestic stocks roughly stable at approximately 47 per cent of plan assets.
This money is being reallocated to alternatives. Of those pension funds invested in alternatives, the average portfolio was about 8.1 per cent in real estate, 5.5 per cent in hedge funds, and 2.3 per cent in private equity.
The research also found that U.S. funds will continue to turn to alternative asset classes over the next three years. More than a third of U.S. institutional investors expect to make a significant increase to hedge funds in the next three years, while another 30 per cent plan sizable additions to private equity, and almost a quarter plan similar increases to their equity real estate.
In the UK, it is a similar story. A study by JPMorgan Fleming Asset Management blamed lacklustre equity performance for driving U.K. pension funds towards alternative investments. The study found about 58 per cent of the managers had changed their attitudes towards alternative investments because of the performance of equities in recent years.
So, whether it is hedge funds, real estate, private equity, or whatever, pension funds, in the quest for returns, are turning to alternatives.
Consider hedge funds, for example. When Alfred Winslow Jones first introduced the concept of hedge funds in the late 1940s, they were instruments that had exposure to both strong and weak sectors of the equity market. The first hedge fund established long positions in stocks that were expected to rise in value and short positions in stocks that were expected to decline in value. In other words, the fund was ‘hedged’ against a decline in the market.
In 2004, Canadian hedge fund assets were approximately $14.1 billion, about one per cent of total market assets, says Tom Schenkel, of Epic Capital. Writing in the April 2005 AIMA Journal, he said the compound annual growth rate of Canadian funds over the past six years has been 32.5 per cent and the number of alternative strategy managers in the country has grown steadily, increasing four-fold since 1999 to approximately 200 funds in 2004. However, the majority of managers have under $l00 million in assets under management.
Long/short equity is the dominant strategy in the Canadian hedge market today, accounting for approximately 50 per cent of all alternative funds. Strategies vary from long-biased managers and small-cap focused managers to event-driven managers and market neutral managers.
Real estate, on the other hand, appears to be transforming from an alternative investment to a core holding for investment portfolios, at least that is one of the findings of a report released by Deloitte & Touche USA LLP and Rosen Consulting Group.
‘Breaking Out: A Sea Change in Real Estate Capital Markets’ suggests that institutional real estate allocations could increase three-fold over the next decade, benefiting significantly from the growing percentage of the investment capital flowing into the market from pension funds. Allocations could jump to the 10 to 15 per cent range over the next decade.
There are a number of reasons for this.
Real estate outperformed other asset classes during the most recent downturn and recovery, with returns far exceeding those available in competing asset classes and with minimal volatility.
As well, as the population ages, pension funds require higher levels of cash flow, and greater predictability for those cash flows. Real estate addresses both of these needs.
The report says private real estate equity will remain the vehicle of choice for most equity investors during this period, with real estate investment trusts (REITs) also gaining in popularity.
However, increasing allocation holdings to five per cent will not begin to solve pension plan income problems. To make a meaningful impact on plan income, shifts will have to be relatively dramatic.
Private equity is playing an important role in the portfolios of some of the world’s most successful institutional investors, says Integrated Asset Management’s An Alternative View.
Consider, for example, Ontario Teachers’ who have more than $4 billion invested in private equity. Last year, the private equity portfolio was its best performing asset class, with a return of 27.6 per cent.
Much of the total return from private equity comes from the ability of the manager to add value to the portfolio companies. Since this takes time, there may be little short-term income after the investments have been made. The return comes when the investments are realized later in the life of the fund, usually through either an IPO or a sale to a strategic buyer.
Income trusts were first introduced in the Canadian market in the late 1990s. This structure involves the conversion of a corporation to a trust structure that permits the entity to payout a regular cash distribution to shareholders. This has the combined effect of providing a yield-generating vehicle to investors (much sought after in the current low interest environment), while at the same time dramatically reducing the tax burden to the trust.
Regardless the asset class or strategy, the reality is that alternative investments are quickly becoming a core asset in pension fund portfolios. Given that, and the insatiable appetite for returns, one can only speculate over what the next breed of alternative investments will be.
Hedge Fund Strategies
The Standard & Poors Hedge Fund Index has three distinct styles of hedge fund strategy – Arbitrage, Event-driven, and Directional/Tactical.
Equity Market Neutral
Funds take both long and short positions in equities. Stock positions are usually diversified, so that no one position has a disproportionate effect on the portfolio. Related short positions hedge out much of the systematic risk in the long positions on either a dollar- or betaadjusted basis so that the overall portfolio has a limited exposure to market moves.
Fixed Income Arbitrage
Fixed Income Arbitrage funds exploit the relative values of fixed income instruments. The manager takes positions in government bonds and investment-grade corporate bonds, government agency securities and swap contracts, and futures and options on fixed income instruments. The manager generally constructs the portfolio on a market neutral basis and often constrains it to be duration neutral within a given country (often developed countries).
Convertible bonds range from investmentgrade credits to busted convertibles, and a fund may concentrate on high-delta, middle-delta, and low-delta convertible strategies. Convertible Arbitrage funds attempt to exploit the mispricing in convertible securities. As the mispricing in convertible securities is typically small, this strategy will usually employ leverage. Merger Arbitrage The Merger Arbitrage strategy involves taking positions in companies that are either currently, or likely to be, engaged in corporate mergers and acquisitions.
Merger Arbitrage funds typically buy shares in the target and sell an appropriate quantity of shares in the acquirer in a merger deal. In a completed deal, they will typically have an equal and opposite position in the acquirer, and will have earned a spread in the meantime. Factors that affect returns include the extent of the spread that can be earned through this transaction, the likelihood of a deal coming to fruition (it may break for regulatory, financial, or company- specific reasons), and the likely date of completion of the deal. Variations occur when the acquirer is bidding for the target with cash, or when the ratio of shares of the acquirer to be offered is dependent on the price of the shares.
Distressed Security funds generally invest in securities of financially troubled companies (companies involved in bankruptcies, exchange offers, workouts, financial reorganizations, and other special credit event-related situations). These managers may identify distressed securities in general or focus on one particular segment of the market such as senior secured debt. Investments may be accumulated with a view to an exit via the secondary market, or with the expectation that the company will be recapitalized, restructured, or liquidated, where the fund manager may either seek to be actively or passively involved in the process.
Special Situations encompasses funds that seek profit opportunities from a broad range of corporate events. Managers are either generalists, who engage in trading keyed to corporate events such as a merger, distressed finances or share prices, and changes to an index, or specialists who concentrate on a specific niche they can exploit. Value-oriented funds invest in undervalued obligations including bank debt, high-yield bonds, trade claims, and equity securities created by discrete and often extraordinary events.
Equity Long/Short funds take long and short stock positions. The manager may attempt to profit from ‘alpha’ generation on both long and short stock positions independently, or profit from the relative outperformance of long positions against short positions. The stock picking and portfolio construction process is usually based on bottom-up fundamental stock analysis, but may also include top-down macrobased views, market trends, and sentiment factors. Equity Long/Short managers specialize by region or by sector.
Managed Futures programs take long and short positions in liquid commodity or financial futures such as currencies, interest rates, or stock market indices. Investment decisions are typically based on strict quantitative methods, notably, trend following models.
Macro funds take long and short positions in currencies, bonds, equities, and commodities. The manager tries to exploit perceived divergences between and within these various asset classes.The investment decisions are based on a manager’s top-down or macro views of the world, economy, government policy, interest rates, inflation, market dynamics, and sentiment. The manager may also base investment decisions on relative valuations of financial instruments within or between asset classes.
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